An Affiliate Marketing lesson in Microeconomics

I never thought I'd put my microeconomics to good use, but here it goes.

The setup:

PPC-"e-Retail" arbitrage is using PPC search, such as Google AdWords, to drive traffic to an e-Retailer, such as Amazon, for a particular product and earn revenue from an affiliate commission.  Essentially, this is very basic affiliate marketing.

Here it is again, by steps:

1. Pick a product you want to promote.  Something between $100-$200 will work well.  I'll use the example of the Rock Band video game for Playstation 3 ($169.99).
2. Establish an affiliate relationship with an e-Retailer like Amazon.  Commissions typically range between 4%-8% depending on volume.  I'll use 6% as the market average.
3. Go to your PPC Search provider of choice, create an ad, and select specific keywords to bid on.  I'll use Google AdWords as an example.

Although this is one of the most basic forms of affiliate marketing, this is not an affiliate marketing "how-to" so I won't go into too much strategy or depth. 

The ad will want to look like something like this:

$170 Rock Band for PS3
Rock Band Special Edition for PS3
Free Shipping from Amazon.

The ad will direct the visitor to the product page at Amazon.

In order to have our ad displayed, we have to bid on keywords--competing against others who want to display ads for the same keywords.  So, you will want to bid on keywords like this: "buy rock band ps3, buy rock band bundle ps3, buy rock band se ps3".  Very targeted, very specific keywords increase the likelihood of the visitor converting (buying the product).

Now run the ad.  The key here is not volume, but highly targeted, motivated buyers.  Typically a 5% conversion rate on Amazon is rather good.  That means for every 20 people you send to Amazon from your ad, one of them will purchase the product. 

Assuming these numbers will stay true and relatively constant, we can calculate the most we can pay-per-click (per visitor) in order to break-even:

• We know that our commission will be 6% of $169.99, which is about $10.20.
• We also know that typically 5% of the traffic we send to Amazon (if we are good) converts, meaning they purchase the product.
• So in order to break even, we can bid roughly 5% of our commission, $10.20, per click.  Remember, we are competing for our ads to be displayed.  So we can bid a max of $.51 to break even.

Now, if we want to make a profit we have to do one of three things:

1. Improve our conversion rate
2. Increase our commission
3. Hope the visitor buys an additional product which is pure profit if we are bidding for break even..  This is not uncommon.

Now for the interesting, academic part:

When searching for specific products using very targeted keywords, you will notice that the ads displayed are almost always pointing to retailers.  There are generally two types of people bidding on these keywords displaying these ads: (1) The Retailers, (2) Affiliate Marketers.  The retailers generally have higher profit margins and can make higher bids, so they are generally in the high ad positions displayed.

Because the Internet is so efficient--many profit-seeking firms, many price-taking consumers, and near perfect information--competition over prices is increasing and consumers are more easily able to compare prices across retailers.  Professor John Morgan at the Haas School of Business gathers and analyzes plenty of data on Internet Competitiveness among retailers along with his colleagues.  You will find his Internet Competitiveness Index an interesting insight and academic perspective on this topic.  He can also provide you with data that I cannot. 

Also, because of this competition, the ranges of prices among retailers are narrower.  Borrowing Professor Morgan's definition from his Price Range Index: "The Price Range summarizes the percentage difference between the highest and lowest prices for each product in our database. When the price range is zero, prices charged do not vary across sellers."

Similarly, the Price Gap Index tracks the percentage difference in prices between the two lowest prices.

To sum all of this data up: Internet retail is becoming more competitive.  More firms are entering the marketing and competing over price, narrowing the price range and price gap.

So then, the effects of this competition on affiliate marketers in the situation described above are as follows:

• Most affiliates are competing at roughly the same commission rate for the same product price (because retailers are competing with each other and the price range and price gap are small).  Thus, the range of commissions among affiliates is rather narrow and close to the average.
• The affiliates are essentially only competing against each other (as well as retailers posting ads) on bids for PPC search.
  

Thus, when there are competitive bidding markets for keywords Marginal Revenue (the commission rate multiplied by the product price multiplied by the conversion rate) equals Marginal Cost (the bid amount, or what you are paying per click).  In competitive markets, like the ones described, average profit for the affiliates will be zero.  This is the same as the break even analysis done earlier.

So to sum this up: You need to have a distinct advantage over your competitors in order to profit.  This can mean having a higher commission rate, having better converting ads, or finding ways to have the visitor buy more products. 

One solution to all of this is to find a market that is not as competitive!