KtoTam - 2:57 am on Jul 9, 2012 (gmt 0)
The process is quite simple, and it's been described by Google in the past.
Google is making money when people click on the ads. So, Google promote higher paying ads by moving them higher. Which doesn't mean higher bids, but higher ( bid x clicks ).
So, even if a merchant is willing to pay $5 per click and you agree to pay only 5 cents, in the end of the day it only matters who brought higher income to Google. In other words if noone clicked on that $5 ad for a week, but 1000 ppl clicked on your add, Google just got paid from your 5 cent ads, which was $50 from your pocket to Google's. So what Google does is she moves you above that $5 ad.
What's more is it sends more clicks your way, so Google wins again, while you might actually lower your bid to 4 or 3 cents per click and stay #1 !
P.S. A couple of years ago I actually experienced that. My old (very auld) ad that I forgot about, was #1, above all the merchants. Too bad the product was out of style by that time, so I killed the ad. I have no idea how long it took for the ad to reach #1 position, but I know for sure I used to pay 50 cents per click in the beginning just to be on the 1st page, but then it was just 7 cents and I was number 1.