Meet Hal. Hal works at Google.

Hal Varian, Chief Economist at Google explains how AdWords works.

Google apparently uses a second-price auction.

Every time someone types a search on Google, an auction is run. The advertisers pay for each time they receive a click. So advertisers bid their value for the advertisement.

Google also makes sure the links are of quality, so users will not think they are "lemons," or irrelevant links. This increases the expected value of each link, making users more likely to click on the links.

This guy's pretty dry, but his explanations are clear.