After consulting with many people I've never seen so much confusion regarding how bids are determined by Google.
Some people believe that you pay what your Max Bid is and others believe that you pay 1 penny more than the
person below pays.

Neither of those are actually true. It's rather a combination of those. This confusion has lead many to pay way to much for there bid position because they don't see the necessity in monitoring bids.

Let me give you an example:

Bidder 1: Max Bid is .55 but pays .51 per click.
Bidder 2: Max Bid is .50 but pays .21 per click.
Bidder 3: Max Bid is .20 but pays .06 per click.
Bidder 4: Max Bid is .05 but pays .02 per click.
Bidder 5: Max Bid is .01 and pays .01 per click.

Hopefully you are seeing a pattern here. The truth is that you actually pay only 1 penny more than the person below you's Maximum Bid.

But then why is it important to monitor bids you might ask if Google makes you only pay 1 cent more than the Max Bid of the person below you?

In the senario above the best value position is being in #2 because #2 is paying 30 cents less per click than bidder #1. The bid gap difference between position #2 and #3 is only 15 cents.

So you can have nearly as many clicks as position #1 for over half the cost. If you have 1,000 clicks position #1 is paying $510 and position #2 is paying only $210. You are saving over half which means increased profit margins for your company.

But here a bidder can use a dirty trick to raise how much you are paying per bid with a little known technique which I call Bumping!

Let's say you are Bidder 2 and you get used to paying 21 cents per click.

If Bidder 3 is savvy (and more and more bidders are) he could Bump up what you are paying.

He/She can increase their Max Bid to 49 cents, while still only paying 6 cents per click. All of the sudden you are paying over double per click than what you were paying before.

With Google being more and more competitive this is happening more frequently and is used to cause you to over pay for your clicks, put you out of business or drop your position, so that they can take over position #2 for a lower cost than what you are paying.

To avoid having this happen to you, you really need to monitor all of your bids to make sure that no one is "BUMPING" you. However, since everyone is always changing their bid prices over the many keywords you have, it is nearly impossible to keep up with monitoring this without a specific software...