There’s been a lot of discussion lately about arbitrage – the practice of buying something for a low price and then quickly reselling it for more than you paid. Arbitrage takes into advantage of inefficiencies between markets – nice work if you can get it, but it usually doesn’t last. About a week ago, Bambi Francisco suggested (registration required) that websites in the business of pre-qualifying leads are engaged in arbitrage, buying traffic for a low price and selling it to merchants at a high price. Heh – she even threw in a comparison to Boo.com and other casualties of the bubble.
Something that takes place a week ago is old news, and I wasn’t planning on blogging about it. The equation of lead prequalification with arbitrage was already rather spectacularly rebutted by Sean O’Rourke and Niki Scevak. I thought the argument had died a natural death – until I read Ross Mayfield’s article, Adword Arbitrage, in this morning’s WebProNews (also available on his blog.) An excerpt:
Say the keyword ‘dvd player’ costs $1 on Google’s auction market. On Nextag’s market it costs $2. Nextag does add value, by decreasing search costs for vertical merchants, say by $0.50 (lets not drift into a discussion of how they are extending the Long Tail, but this is about Fat Tails). Nextag also does have its own transaction costs, say $0.50. Overall, Nextag pockets a profit of $0.50 for their ‘value add’ — but if you assume the transaction was straight through processed and there were no credit or operational risks, this is risk free profit.
Risk-free profit, huh? Ross is a smart guy, but he’s overlooking the most significant risk of all – paid traffic coming in doesn’t necessarily convert to paid traffic going out. So it can justify its higher cost-per-click fees, a comparison shopping site has to send its clients leads from people more likely to buy, which means the comparison shopping site has to qualify and filter the traffic it purchases. Not every user can be simply passed on to a merchant. At the same time, a comparison shopping site has to keep its own conversion rate high, in order to minimize the amount of non-converting traffic it buys. Using Ross’ example – if a site attracts a user for $1 and sends that user to a merchat for $2, it makes money. But what happens if a site attracts a user for $1 and that user never clicks-out to a paying merchant?
Ross, surely you’ll admit there’s more than a bit of risk involved here. A comparison-shopping sites aren’t “buying from one market where there is a low price and selling in another where the price is higher” – instead, a comparison-shopping site buys from one market at a low price, attempt to add value to its purchase, and then tries to resell what it’s bought for a higher price – a transaction that’s not always successful. Because of this, what a comparison-shopping site does can’t be called arbitrage in any sense of the word. There’s no such thing as easy money.
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I may well be wrong about this, but I don’t think Nextag is holding inventory as you describe.
This is probably a failure on my part to be clear.
Comparison shopping sites only get paid when a click-out is made to a merchant. No click, no pay. Here’s my thinking – comparison shopping sites buy traffic. That’s their ‘inventory’. They don’t immediately ship it out the door to a merchant – if they did, it’d be arbitrage. Instead, there’s anywhere from ten seconds to a few minutes where the user surfs around the site, processing the information there. During that time, the traffic is, effectively, ‘inventory’, and the comparison shopping site’s got to ‘resell’ that inventory in order to get paid – if the browsers don’t leave the comparison shopping site to go to the merchant, no money comes in. To make the sale, the comparison shopping site must provide enough useful information to the user to make that user click onward to a paying client instead of clicking on the ‘back’ button. This is by no means guaranteed. Every comparison shopping site loses traffic they’ve purchased to the back button. The challenge is to provide a useful enough service to keep your users clicking onward. Doing this is both difficult and risky.