Your margin is my opportunity.

Jeff Bezos, Amazon Founder and CEO. 

In 1958, Harvard Professor Malcolm McNair demonstrated that new retailers start typically by inventing a lower cost structure. They then pass on these cost savings to customers in the form of lower prices and attracts customers. As they grow, these new retailers drive volume away from competitors, gaining economies of scale (and increasing the competitors’ cost structure) and allowing them to expand even more. When they capture significant market share and drive competitors out of business, the goal shifts away from attracting new customers to generating profits through higher prices. As they raise prices, they become vulnerable to new lower-cost entrants, starting the cycle anew. Up until Amazon came along, this phenomenon that he coined the “Wheel of Retailing”, had been ably demonstrated by Walmart, who undercut then retailers with fat margins and passed those savings to the customer via lower prices.

So when I recently came across an HBR article where Harvard Professor James Heskett pondered whether Amazon could break the wheel of retailing theory, it got me thinking. When viewed as a retailer (as the article and most of the accompanying comments do), Amazon continues to offer the lowest prices to customers and hence is immune to low priced competitors, at least until another new entrant beats Amazon to an innovation that can offer even more lower prices (or equal prices with better convenience like Amazon did to Walmart). However, when viewed as a marketplace, it’s a completely different story – one that, in my opinion, makes Amazon vulnerable to the wheel of retailing.

Amazon’s Ecommerce Structure

Amazon’s Ecommerce business can be divided into two segments:

  1. Amazon Retail (denoted as shipped and sold by Amazon on Amazon’s website) – where Amazon takes ownership of the product from the manufacturer, typically stocks the product in fulfillment centers (FC) around the country, sets the price to the end consumer, pays for inbound (from manufacturers to Amazon FCs) and outbound (from FCs to customers) shipping, and is the seller of record.
  2. Amazon Marketplace – where Amazon allows third-party sellers or merchants to sell to Amazon customers through Amazon’s website, taking a cut of each sale (known as the referral fee in Amazon parlance, and coined rake by VC Bill Gurley). Within Marketplace, there are two models:
    1. Merchant Fulfilled Business aka MFN (denoted as shipped and sold by seller on Amazon’s website) – where the seller stocks the product in their own warehouses, sets the price to the end consumer, ships the product straight to the customer, pays for the cost of shipping, and is the seller of record. Amazon charges the seller a referral fee percentage (typically 15%) calculated on the total sales price, excluding any taxes, and including the item price and delivery or gift wrapping charges.
    2. Fulfillment by Amazon aka FBA (denoted as sold by seller, fulfilled by Amazon on Amazon’s website) – where the seller pays for “storage space and fulfillment services” from Amazon’s fulfilment centers, sets the price to the end consumer, pays for inbound shipping to Amazon FCs (while Amazon pays for outbound shipping from FCs to customers), and is the seller of record. In addition to the FBA fees for storage and fulfillment services, Amazon also charges the referral fee (just as described in #2a above).

These are two distinct business models – Amazon Retail follows what is traditionally called the Reseller or Wholesaler model (with control over pricing and inventory), while Amazon Marketplace is a two-sided marketplace platform (with no control over pricing and inventory). I wrote about platforms from a pricing lens earlier; within Amazon Marketplace, the MFN model falls into the Paid Cross-side Platform model while FBA in my view falls into the Hardware Cross-side Platform model.1

Monopazaris & Supernormal Profit Theory

Cross-side platforms without competitors are neither a monopoly (from greek mónos “single”, and polein “to sell”) nor a monopsony (from greek mónos “single”, and opsōnia “to purchase”) since there are (theoretically) many sellers (even for the same product) who sell, and there are many buyers who purchase. Instead, when only one or two marketplaces exist for sellers and buyers to interact, those marketplaces are either monopazaris (mónos “single”, and pazári “marketplace”) or oligopazaris (Uber-Lyft, AirBnB-HomeAway, Amazon Marketplace-Walmart Marketplace, Apple-Google appstores, Google-Yelp etc.) – one of the few places with the technology for sellers and buyers to connect, interact and transact.

Go back to Amazon’s Ecommerce structure for a second. Look carefully at Amazon Retail and reflect whether it could be a monopoly. The answer is complicated despite what many liberal news organizations may proclaim. Amazon Retail isn’t a monopoly in my view because (1) they have less than 23% of the US Ecommerce market segment,2 and (2) outside of certain categories such as books, customers have a variety of other retailers (online and offline) such as,,,, and several others to buy from. I’m not saying that they do (although the numbers suggest that they do), but that they could. In fact, I am an Amazon employee and I routinely buy from those websites (primarily when products aren’t available from Amazon Retail such as this).3

In Amazon Marketplace’s case, however, there are very limited other marketplaces – Walmart, eBay, Newegg. These websites have not gained much traction with sellers (and consequently with customers) primarily because they follow almost the exact same referral fee model followed by Amazon. eBay did try a lower referral fee, but in my view, if not for their lack of single detail page structure (multiple listings for the same product) that hurts the customer experience, they would’ve been able to capture more customers from Amazon than they eventually did.4 Amazon Marketplace has developed proprietary marketplace technology including multi-listing matching, single product page buybox logic, restricted products technology, transaction risk/fraud detection tech and so on. More importantly, Amazon Retail’s instock Prime selection, sharp pricing and delivery experience attracts customer traffic from which sellers of any product on the platform benefit. Sellers also benefit, when using FBA, from Amazon’s fulfillment and delivery infrastructure. These are experiences a new entrant cannot easily recreate, and as a result, Amazon exhibits Supernormal Profit tendency (demonstrated in the section below) through its exorbitant referral fees. Note that supernormal profit is profit greater than the opportunity cost rate of return. In other words, normal profit is one that would be deemed by Amazon itself as sufficient to make a marginal investment worthwhile; supernormal profit is margin significantly greater than this normal rate.

Amazon Marketplace Profitability

Since Q1 2017, Amazon has begun to provide more details on financials for Amazon Marketplace, but does not break out revenue from referral fees or profitability of the marketplace business; however, we can estimate revenue and profitability using proxies, some general assumptions and publicly available information.

In a press release in January 2017, Amazon announced that FBA delivered more than 2B units and constituted 55% of all third-party (aka Marketplace) units. Jeff Bezos, the CEO, has also announced in the past that about 50% of all units sold on the platform come from Marketplace sellers. In addition to these, I will use data from Amazon’s Q1 2017 results (page 13) that provide unaudited revenue numbers from third-party services for the preceding four quarters. This third party revenue is a combination of FBA fulfillment fees revenue, FBA referral fees revenue, and MFN referral fees revenue. For ease of analysis, I will try to breakdown the P&L for the MFN portion of Amazon’s Marketplace Business.5

I estimate that, in 2016, Amazon Marketplace’s Merchant Fulfilled business (Marketplace minus FBA, aka MFN) generated $44.6B in GMV and $7.8B in Revenue with an operating profit of $5.3B (operating margin of 69%) for an effective rake of ~20% (see Table B; shout-out to Luke Constable for corrected and updated numbers). Very few companies generate such operating margins – examples are Mastercard (54% op margin) and Visa Inc. (53% op margin) in the payment processing industry.6 Apple, a company that sells premium and differentiated products, ended the year 2016 with a 28% op margin.7 Alibaba and eBay, who both operate marketplaces not unlike the Amazon Marketplace, ended the year 2016 with 30% and 26% operating margins respectively (Table C). Alibaba and eBay generated $22.9B and $8.9B in revenue over $547B and $84B in GMS, for an effective rake percentage of 4% and 11% respectively (Alibaba primarily in the form of search ads on the platform and not a direct rake). Based on Alibaba and eBay’s financial statements, I estimate Amazon’s breakeven referral fee to be between 5-8%, and at their current 17% effective rake, ~10 percentage points of referral fee is Amazon’s supernormal profit.8

 Threat of New Entrants

Another way to look at whether Amazon Marketplace is vulnerable to the “Wheel of Retailing” is to evaluate the opportunity for new entrants or competitors to reduce their referral fee for sellers, who can then pass off the lower fees to customers in the form of lower prices. In my view, an online marketplace has medium to low barriers to entry (while network effects is a strong barrier, there is no other significant barrier). A new entrant (or a competitor such as Walmart) could offer sellers a ~7% referral fee, customers an 11% discount and still make a profit. Table D demonstrates an example of how a competitor can offer higher profits back to consumers in the form of lower prices. Assuming the product is price elastic, this new entrant can attract sellers by offering higher profits to the seller even with a lower price to the customer.

While Amazon’s Marketplace’s parity clause (S-4 Parity with Your Sales Channels) in existing seller agreements mandates that sellers must “ensure that the price of an item you list on are at or below the price at which you offer the item via any other online channel,” it is difficult to enforce at scale – particularly when a new entrant provides an alternative marketplace that offers lower fee and one-click export and upload of Amazon listings into their website listings. Moreover, when used to deprive customers of lower prices, this clause may be scrutinized by the US FTC and DOJ under antitrust laws.9


In essence, Amazon Marketplace is a high fixed cost (primarily in software development) business where the marginal cost of one additional  sale of an item is minimal. Yet, Amazon charges its sellers several percentage points for access to its marketplace platform. Amazon Marketplace could reduce their marketplace referral fee to 7.5% and still maintain an operating margin of 28%10 that is more in line with other Marketplace businesses such as eBay and Alibaba.

In theory, it is possible for Amazon Marketplace to maintain these supernormal profits in the short run, wait for other players to signal willingness to enter, and then compete by matching their prices (in this case, referral fee). Moreover, a new entrant will not only find it difficult to build all the tools and systems that Amazon has painstakingly built over the last two decades, they will also need significant capital for investment in growth (because the lower rake will not provide sufficient cashflow for big initial capital expenditures). However, in the long run, these supernormal profits should eventually attract new entrants and/or competitors (who will capture market share by charging lower referral fee and passing off savings to the customer) that will erode profitability until only normal profit is available, thus reaching a long run equilibrium stage.

Note: This blog post does not contain confidential Amazon information; these are my personal views and does not represent the views of Amazon or its management.

  1. At first glance, it may seem that customers don’t care about Amazon’s physical fulfillment footprint – if the products are available elsewhere, why would they? In reality though, customers would pick based on the tradeoff between cost and faster delivery. FBA enables faster delivery for sellers at a lower cost than they could do themselves because Amazon leverages their scale to pass off better costs to sellers. Whether a competing platform with lower rake would be able to capture FBA sellers is debatable because it depends on the tradeoff between cost and delivery speed of products.

  2. In Q3 2017, Amazon announced revenue from Ecommerce to be $26.4B (page 13, Q1 Results) and US Dept. of Commerce announced the total US Ecommerce sales to be $115.3B.

  3. Yes, surprising, but Apple and Amazon has always had a frosty relationship; Apple has never allowed Amazon Retail to sell the iPhone even though they have allowed Walmart, Target and several others to do so. All iPhones available on Amazon are almost always sold by third-parties.

  4. Jeff Bezos, the CEO, has spoken about single detail page several times including both 2015 and 2016 shareholder letters.

  5. FBA has additional costs involved in storing, fulfilling, shipping and C-returns that are harder to tease out from Amazon’s financial statements. To estimate MFN revenue, I made two major assumptions – (1) that Average Selling Price (ASP) is the same across Amazon Retail, FBA, MFN, and (2) FBA fulfillment fees constituted 25% of marketplace revenue; I sampled a handful of Amazon products using FBA calculator to arrive at this estimate.

  6. These are also Paid Cross-side Platforms. and would’ve been vulnerable to lower priced competitors if not for their (what I think is an anti-competitive) clause that forced merchants to set the same retail price irrespective of whether customers paid by credit card or other forms of payment. More on that in another post.

  7. Apple Appstore is an exception; Apple charges a 30% rake for their app store because of their hardware differentiation – iPhone buyers are unlikely to go buy an Android phone even if the apps on Google Appstore are 50% cheaper; they would if they found Android hardware better or cheaper. In Amazon MFN’s case, however, customers will go to a platform that offers them cheaper effective prices for the same product because there is no hardware differentiation.

  8. I agree that absolute dollar profit and free cash flow trump percentage margins. For example, a profit margin of 1% on a revenue of $100B is almost always better than 70% profit on a revenue of $1B if you’re getting paid at the same time, and getting paid earlier is always better than later if you’re making the same money (especially positive cash flow cycles, where you get paid before your costs are paid out). In fact, Jeff Bezos puts it perfectly in this HBR interview when he says “Percentage margins are not one of the things we are seeking to optimize. It’s the absolute dollar-free cash flow per share that you want to maximize, and if you can do that by lowering margins, we would do that.” The reason I also like to look at percentage margins in addition to cash flow is that higher percentage margins indicate opportunity to undercut and pass savings to customers to capture market share – yes, exactly what Prof. McNair theorized all those years ago.

  9. This controversial clause has already been removed in EU after EU investigations: official German FTC Press Release, and coverage from Haerting DE news. US FTC and DOJ prohibit business practices that deprive consumers of the benefits of competition, resulting in higher price.

  10. This assumes sellers pass all savings from lower referral fee to customers.