Setting Referral Fees in Affiliate Marketing

Affiliate programs offer affiliates referral fees in return for directing potential customers into a merchant's Web site. Affiliates are commonly paid based on the number of leads converted by the merchant into customers (pay-per-conversion) or based on the number of leads referred to the merchant (pay-per-lead). Given the prevalence of both, interesting questions for research are as follows: Why do both formats prevail? Under what conditions is one format preferred over the other? The authors find that pay-per-lead is more profitable when a merchant negotiates a separate deal with an affiliate. In this case, pay-per-conversion is not optimal for the affiliation alliance because it leads to suboptimal pricing by the merchant. In contrast, pay-per-lead is less profitable than pay-per-conversion for a merchant that works with a large number of affiliates all under the same terms because it is susceptible to bogus referrals that cannot be converted into customers.