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: (a) why do both formats prevail? (b) Under what conditions is one format preferred over the other? We find that pay-per lead is more profitable when a merchant negotiates a separate deal with an affiliate. In this case, payper-conversions is not optimal for the affiliation alliance because it leads to sub-optimal pricing by the merchant. In contrast, pay-per-lead is less profitable than pay-perconversion 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.