Who pays? Understanding fee incidence in online marketplaces and why it matters for pricing
“High volume combined with a modest rake is the perfect formula for a true organic marketplace and a sustainable competitive advantage.” (Bill Gurley)
Optimising marketplace platform pricing is hard, but Bill Gurley’s advice is both concise and correct. As the marketplace operator, you will — in most cases — want to grow transaction volume by maintaining a "modest" rake. But, every marketplace has at least two sides, and, as we’ll see, it’s not always obvious which side is really paying the fees.
In this short series of articles, I will focus on the tricky pricing question of fee incidence. Understanding fee incidence is important because, as the marketplace operator, it can affect your approach to pricing, and impact the fundamental operations of your marketplace.
What is fee incidence?
Incidence is usually mentioned in relation to taxes, but the same idea applies to marketplace fees. The key concept is the burden of the fee does not necessarily fall where the fee is collected.
Or, to put it another way, the person whose wallet is being emptied isn’t necessarily the person who is really doing the paying! This is important — as we’ll discuss — but fee incidence is often ignored when considering marketplace operations and defining marketplace fee structures. (Unfortunately, politicians often misunderstand or just ignore incidence, when contemplating changes to taxation policy)
Fee incidence occurs wherever multiple buyers and multiple sellers/suppliers are “match-made” by a third party who mediates the transaction and takes a fee. Fee incidence is an issue regardless of whether the marketplace deals with services, digital goods, physical goods or experiences. And it can happen whether the fee is a fixed amount, or a percentage of the value of the transaction, or a mixture of both.
Let’s say I run a marketplace for online tutors: TutorWarehouse. TutorWarehouse enables high-school students to choose from and connect with tutors, who’ll provide live online tutorial sessions. The tutors are free to choose their hourly rate. TutorWarehouse, as the marketplace owner, mediates every transaction, keeping 10% for itself. So (excluding taxes) a tutor who bills £30 per hour will take home £27, and TutorWarehouse will keep £3. All the money is collected from the student's parent's credit card.
So, who is really paying the 10% fee?
For example, would the tutor have received £30 if TutorWarehouse didn’t charge fees? Or would the tutor’s hourly rate actually then be £27?
There’s no single answer to the question “who pays?”. It’s all dependent on context and the specifics of each marketplace. But we must understand who is paying because it can have such an impact on how our marketplace works.
You probably already use some services affected by fee incidence. For example:
When Airbnb levies a fee on the host (typically between 3% - 10%), is that fee passed on to the guests via higher daily rates?
Do restaurants on Deliveroo or DoorDash charge a premium on their takeaway prices to cover the fees?
In this series, I’ll introduce a framework for thinking about and understanding fee incidence so that you can see how it affects your marketplace, and how you can approach your pricing structure with fee incidence in mind.
A helpful way to consider this is to look at what happens when the marketplace operator changes the fee structure. What happens if the marketplace raises its fees?
As the owner of TutorWarehouse, I decide to double my fee to 20% of each transaction, with the objective of driving more net revenue per transaction. How might our tutor and parent respond?
Scenario A: Tutor swallows the fees
If everything else stays the same, that £30 per hour tutor will now take home £24, down £3 (or 11%) from £27 and TutorWarehouse keeps £6, up £3 (or 100%) from £3. The parent still pays £30. In this case, the incidence of the higher fee falls entirely on the tutor in the form of lower take-home, even while the money is still collected from the parent’s credit card.
When the price stays the same and the supplier (the tutor) absorbs (or “swallows”) the fee, this is called backward shifting.
Scenario B: Tutor raises the hourly rate, and the parent pays more
But what if the tutor responds by raising his/her hourly rate, in order to maintain the same take-home as before the fee increase? A session will now cost the parent £33.75, up £3.75 (or 12.5%) from £30, leaving the tutor’s take-home unchanged at £27. The fee incidence in this scenario has now fallen entirely on the parent. When the supplier (the tutor) passes the fee on to the customer (the parent), this is called forward shifting.
As the marketplace owner, I’m doing very well in this scenario. TutorWarehouse keeps £6.75, up £3.75 (or 125%) on £3. By raising the hourly rate to entirely cover the elevated fee, the tutor maximises the marketplace operator’s revenue per transaction.
Scenario C: Parent & tutor share the pain
It’s easy to imagine a scenario where the parent and tutor share the pain. The tutor raising their price a bit, but not enough to fully cover the marketplace’s higher fees on their take-home pay. Result: fee incidence is shared between the parent and tutor. The parent pays £31.75, up £1.75 (or 5.8%) on £30. The tutor takes home a little less: £25.40, down £1.60 (or 5.9%) from £27; and TutorWarehouse keeps £6.35, up £3.35 (or 112%) from £3.
It’s worth noting that although the marketplace operator has notionally increased the platform fee by 100% (i.e. by doubling it from 10% to 20% of the transaction) in scenarios B & C they actually receive more than a 100% increase in value of their cut.
Scenario D: Disintermediation
The tutor and the parent move to disintermediate TutorWarehouse by transacting privately, instead of via TutorWarehouse’s platform. In this scenario, the tutor might even lower their hourly rate and split the difference with the parent. At £28.50 per hour, the tutor is up £1.50 and the parent has saved £1.50, compared to the default 10% fee scenario.
By getting disintermediated, not only has TutorWarehouse lost 100% of their fee on this transaction, but they’ve also lost 100% of the value of any potential future fees which would otherwise have been earned if this tutor : student pairing undertaken further sessions.
Disintermediation is usually an ever-present threat on marketplaces which seek to repeatedly take a cut between the same customer : supplier pair. In the case of TutorWarehouse, after the first few sessions between a student and a tutor, trust is established, and the primary motivations to transact via TutorWarehouse will have been diminished. It’s then TutorWarehouse’s problem to demonstrate value beyond the initial match-making.
Other scenarios!
So far, it’s not obvious what any specific tutor or parent will choose to do when the marketplace fee rises. Moreover, there are other possibilities we haven’t covered in the table above. For example:
The parent could switch to a different tutor on TutorWarehouse, who charges a lower hourly fee
The parent could switch to an alternative substitute solution: for example enrolling their child in enrichment classes, using an automated app/service, buying additional textbooks, or attempting to tutor their child themselves.
The parent could abandon TutorWarehouse and go to a competing tutor marketplace - with lower fees.
So, we return to our initial question of “who pays?”. In part 2, we’ll answer this by reviewing the factors which affect price incidence in different marketplaces.
