Distribution Is a Cost of Doing Business

Starting July, Etsy increased the transaction fee on all sales from 3.5% to 5% and also started to apply it to the shipping price. For example, selling an item that is $30 plus $3 for shipping, under Etsy’s new fee structure sellers would pay $1.65 for the transaction - $1.50 for the item and 15 cents for shipping. Compared to $1.05 before.

Sellers were, unsurprisingly and unanimously, angered.

This increase in the marketplace fee asks a question of what is that fee buying. And thus why is the fee on Etsy used to be 3.5% and is now 5%, and why most categories on Amazon have a fee of 15%. It’s a question of the optimal platform pricing strategy, and the decisions marketplaces make to win short-term or long-term.

Etsy increased the fee to, as it claims, “make further investments in marketing to attract buyers, enhance customer support, and drive product innovation.” In other words, the higher fee is to be used to increase Etsy’s overall sales through marketing, in turn increasing sales for each seller. Win-win if it works.

After all, the fee charged by marketplaces is fundamentally buying just one thing - distribution. Distribution is a cost of doing business and thus doesn’t come for free. Any seller on Etsy is free to build their own distribution channels or they can pay Etsy to use theirs. This is why marketplaces exist. And why for hundreds of years retail stores and later malls existed. Google search is distribution, Facebook ads is distribution, marketplaces are is distribution, and Walmart brick-and-mortar is distribution. The each play the same role.

As a result as marketplaces grow bigger their value proposition gets bigger too. The same fee now buys more visitors, or access to more Prime members on a marketplace like Amazon. But this doesn’t mean the fee needs to get bigger too. Otherwise sellers look elsewhere to achieve distribution and customers look for cheaper prices elsewhere too. It might work short-term, but long-term the platform will fail to sustain.

“There is a big difference between what you can extract versus what you should extract.”

Bill Gurley of Benchmark Capital

Naturally lower fees are better. But lower fees and lower distribution is worse than higher fees and higher distribution. This is why the fees charged by Amazon are almost incomparable to anything else. Those fees buy access to 100 million Prime members worldwide and half of the US e-commerce spending. Fees charged by other marketplaces don’t. The relationship between the fees and distribution is often missed.

eBay could disrupt Amazon by lowering fees. In China two decades ago this is how Alibaba’s Taobao made eBay China irrelevant - they didn’t charge any transaction fees and thus users didn’t see value in eBay anymore. But if eBay’s fees were 5%, 10% lower than on Amazon, which would allow products to be priced 10% cheaper, it’s probably unsustainable to main the platform. And it would still take a decade to attract Prime-committed Amazon customers.

One of the most interesting “tweaks” to the marketplace business model is allowing those who want more exposure and thus volume to pay more on an opt-in basis. This appears in many forms, but is most common as advertising. Part of the genius of this is that when prices go up due to bidding and competition, sellers blame their competition not the platform. This is why Amazon advertising exist and the why it will continue to grow. It will both increase Amazon’s average rake and won’t raise it on those who don’t want to pay more.

As marketplaces accrue distribution and adjust the fees the key metric to balance is liquidity. Liquidity is probably the most important metric for a marketplace.

“Liquidity isn’t the most important thing. It’s the only thing.”

Simon Rothman of Greylock Partners

Liquidity is the reasonable expectation of selling something you list or finding what you’re looking for. For retail marketplaces liquidity is “the percentage of listings that lead to transactions within a certain time period.” On Etsy and Amazon, it is the percentage of total stock sold in a given time period. As transactional fees increase sellers are forced to increase prices to maintain profitability. Higher prices mean liquidity is likely to go down as customers start to price-shop elsewhere.

A marketplace with 0% fees is as unlikely to work as one with 50% fees. The first one has no resources to invest into growing distribution, the second one doesn’t deliver enough value to match the high fee. Although increasingly sellers on Amazon are paying fees approaching 50% - when transactional, FBA, and advertising fees are combined. And yet they still do pay those fees because they unlock distribution. Although some have called the fee Amazon charges as the Monopoly Tax.

Setting the fee is a balancing act. Etsy’s increase will take years to materialize in impact as the prices sellers charge increase or some of them move elsewhere hoping to create their own distribution. It’s up to Etsy to continue building the platform to reach wider and to balance liquidity. Luckily for Etsy there aren’t many competing options to offer the same audience with lower fees. Amazon Handmade has a 15% fee, three times that of Etsy, and is much smaller in audience.

In the end, a sustainable marketplace is one where the value of being on it clearly outweighs the transactional costs charged.

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Juozas Kaziukėnas

Founder of Marketplace Pulse, Juozas wears multiple hats in the management of Marketplace Pulse, including writing most of the articles. Based in New York City. Advisor to other startups and entrepreneurs. Occasional speaker at conferences.

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