The program, called AdWords Select, ranks ads based partly on how much an advertiser pays and partly on popularity, or click-through rates. AdWords Select requires advertisers to pay only when a visitor clicks on the ad.
Google's previous program, AdWords, was based on a traditional online system that required payment by the number of impressions delivered.
"It's not just about how big your wallet is anymore; it's about creating the most relevant ads for our users," said David Krane, a Google spokesman.
The move escalates the battle between Google and rival Overture. Both are searching for new ways to generate revenue in an increasingly tight ad market. Overture's stock price has seesawed in recent weeks as investors have been gauging the potential effect of Google's moves on the company's growth prospects.
On Wednesday, Overture shares tumbled more than 10 percent after Google announced its new ad program--the company's second tumble in two weeks. Last week, the stock surged after Overture beat earnings expectations for its most recent quarter.
Some analysts have downplayed the Google threat.
In a statement Wednesday, U.S. Bancorp Piper Jaffray analyst Safa Rashtchy pointed out that Overture has a "lock" on the major Web portals, having struck deals with AOL Time Warner's America Online service, Microsoft's MSN and Yahoo--although Yahoo has said it plans to create its own paid search service within the next few months.
He added that Overture has a huge lead in this market, with 54,000 advertising partners compared with an estimated 1,000 partners for Google.
In a separate report issued Wednesday, Merrill Lynch analyst Justin Baldauf said Google's move could affect Overture's shares in the short term, but eventually Overture's deals with AOL and Microsoft will prove winning partnerships.
"Because Overture is much bigger than Google, Overture can afford to pay distribution partners more money" and therefore retain them, Baldauf said.
He said Merrill Lynch expects Overture to pay $250 million to distributors in 2002 on revenue of more than $440 million. "By contrast, we have heard that Google (a private company) currently generates less than $100 million in annual revenues.
"Importantly, Google is to some extent caught in a catch-22 as it competes with Overture," Baldauf said. "It will be difficult for Google to increase distribution before it can grow its advertiser base. At the same time, growing the advertiser base is difficult without greater distribution."
Protesting pay for play
Though it's been heralded as a way to boost earnings, the pay-for-play concept has drawn fire from consumer groups and trademark holders, who claim it can lead to customer confusion.
Diet pill maker Mark Nutritionalsfour pay-for-play sites two weeks ago, alleging they were aiding trademark infringement. The company claims the search sites are breaking the law by listing links to competitors' sites when a person types the phrase "body solutions" into the search bar.
Google is actively trying to avoid running into the same trouble by clearly marking the search results that show up on the right-hand side of the page as ads. Unlike Overture and for-fee listing service FindWhat.com, which incorporate paid listings into their main search results, Google is allowing pay for placement only along the right-hand side of its search page.
In addition to pay-per-click ads, Google sells "premium" sponsorships on the top of its results that are targeted to keyword searches. The paid placements sell for a flat rate based on the number of impressions, or ads, delivered. They cost between $25 and $80 per thousand impressions.
News.com's Stefanie Olsen contributed to this report.