Google has released a video explaining the logic behind bidding on keywords using Adwords:
"Our Chief Economist, Hal Varian, explains the AdWords Ad Auction and how your max CPC bid and quality score determine how much you pay for a click on Google.com."
Disclaimer: Whenever he says, "Google wants to make a good experience for both the advertiser and the user so that they come back and use our services in the future" - he really means, "Google wants to keep advertisers and users connected through their revenue machine."
