Google has recently come out with a video to help all of us understand the basics of how AdWords auction works. According to the Official Google Blog:
"We've decided to take some time to get back to basics and talk about how the AdWords auction actually works. To help you, we've brought along our Chief Economist, Hal Varian, to walk you through the auction and explain how your maximum cost-per-click (CPC) bid and Quality Score determine how much you actually pay for an ad click on Google's search results pages."
Have a look at this video:
"When people think of an auction, they often think of a prize being sold for the highest bid. But the AdWords auction works a little differently, where the winner only pays the minimum amount necessary to maintain their position on the page. That means you'll only pay the minimum necessary to beat the person below you. In fact, our quality-based pricing system ensures that you'll often pay less than your maximum bid." – Austin Rachlin, Inside AdWords crew