Ad valorem platform fees, indirect taxes, and efficient price discrimination

• Date: 01 May 2017
• DOI: http://doi.org/10.1111/1756-2171.12183
• Published date: 01 May 2017
• Author: Zhu Wang,Julian Wright

RAND Journal of Economics

Vol.48, No. 2, Summer 2017

pp. 467–484

Ad valorem platform fees, indirect taxes,

and efficient price discrimination

Zhu Wang∗

and

Julian Wright∗∗

This article explains why platforms such as Amazon and Visa rely predominantly on ad valorem

fees, fees whichincrease proportionally with transaction prices. It also providesa new explanation

for why ad valorem sales taxes are more desirable than specific taxes. The theory rests on the

ability of ad valorem fees and taxes to achieve efficient price discrimination, given that the value

of a transaction to buyers tends to vary proportionally with the cost of the good traded.

1. Introduction

Ad valorem fees and taxes, which depend positively on transaction prices, are widely used

in practice. Platforms that facilitate transactions between buyers and sellers typically charge

sellers ad valorem fees, with fees for a transaction being a percentage of the transaction price

set by sellers. Well-known examples include online marketplaces (such as Amazon and eBay)

and payment card networks (such as Visa and MasterCard). Given these platforms do not incur

significant costs that vary with transaction prices, their use of ad valorem fees raises the question

of why ad valorem fees are so prevalent. Ad valorem sales taxes are also widely used, with their

desirability vis-`

a-vis per-unit (or specific) taxes the subject of a substantial literature.

In this article, we provide a new rationale for the use of ad valorem fees and taxes. The

theory explains why profit-maximizing platforms favor ad valorem fees even if they do not incur

any variable costs of enabling trades. The same theory also implies that a regulatory authority

∗Federal Reserve Bank of Richmond; zhu.wang@rich.frb.org.

∗∗National University of Singapore; jwright@nus.edu.sg.

We thank the Editor and four anonymous referees for their valuable comments and suggestions. We also thank Boyan

Jovanovic, Bin Grace Li, llyaSegal, Thomas Tregouet, Glen Weyl, and participants at the 2012 International Industrial

Organization Conference, the 2012 North American Econometric Society Summer Meeting, the 2016 Asia Meeting of the

Econometric Society, the 2016 Annual Congress of the European Economic Association, as wellas seminar participants

at the Federal Communications Commission, Federal Reserve Bank of Richmond, Hong Kong University of Science

and Technology, and National University of Singapore for their helpful comments. Finally, we thank Andy Lee for his

excellent research assistance.

The views expressed are solely those of the authors and do not necessarily reflect the viewsof the Federal Reserve Bank

of Richmond or the Federal Reserve System.

C2017, The RAND Corporation. 467

468 / THE RAND JOURNAL OF ECONOMICS

TABLE 1 Platform Fee Schedules

Amazon Visa

DVD 15% +$1.35 Gas station 0.80% +$0.15

Book 15% +$1.35 Retail store 0.80%+$0.15

Video game 15% +$1.35 Restaurant 1.19% +$0.10

Game console 8% +$1.35 Small ticket 1.50% +$0.04

that maximizes social welfare subject to covering a platform’s fixed costs should similarly make

use of ad valorem fees when regulating fees for such platforms, and that a tax authority should

prefer ad valorem sales taxes rather than per-unit sales taxes.

The key idea behind our theory is that when a market involves many different goods that

vary widely in their costs and values that may not be directly observable, then ad valorem fees

and taxes represent an efficient form of price discrimination because the value of a transaction

is plausibly proportional to the cost of the good traded. The situation captures the usual scenario

facing platforms, regulators, or tax authorities. For example, within any specific market category

(e.g., electronics), Amazon and eBay havegoods traded that are worth a few dollars and others that

are worth hundreds or even thousands of dollars. In such a setting, per-unit fees and taxes havethe

problem that they distort the price elasticity of demand across goods, as they add proportionally

more to the price of a low-cost, low-value item compared to a high-cost, high-value item, thus

reducing the efficiency of revenue extraction. Ad valorem fees and taxes that are proportional

to the transaction price do not lead to such a distortion and so can ensure the optimal Ramsey

pricing. In fact, we show that in our setting, charging ad valorem fees and taxes allows the

platform, regulator, or tax authority to achieve the same level of profit or welfare that could

be obtained under third-degree price discrimination as if the relevant authority could perfectly

observe the cost and valuation for each good traded and set a different optimal fee for each.

We then extend the theory to accommodate the fact that many platforms charge sellers

a small fixed fee for each transaction in addition to the main ad valorem component. Table 1

illustrates two such examples.1To do so, we allow for the fact that platforms typically incur a small

marginal cost per transaction. We show that an affine fee schedule (a fixed fee per transaction

plus a fee proportional to the transaction price) is optimal if and only if demand for the sellers

belongs to the class with constant curvature of inverse demand (which includes linear demand,

constant-elasticity, and exponential demand).

This result allows us to explore policy questions surrounding the use of ad valorem fees by

platforms, for example, whether platforms that do not incur proportional costs should be allowed

to charge a percentage-based fee structure. The issue is particularly relevant for the payment card

industry and is currently under debate in many countries, including Australia, Canada, and the

United States.2We address this policy question by considering a regulated setting in which the

regulator seeks to maximize social welfare but allows the platform to recover its costs, including

fixed costs, and has to decide whether to use ad valorem fees to do so. In contrast to the policy

makers’ concerns regarding the use of ad valorem fees, we show that for the class of demand

functions that rationalizes a platform’s use of affine fee schedules, welfare in this constrained

case is always higher when a proportional fee is used to recover costs, in addition to a fixed per-

transaction fee. Thus, our theory also suggests a policy maker that wishes to regulate platform

fees to cover costs should also make use of ad valorem fees.

1Table 1 reports fees that Amazon and Visa chargeto sellers for each transaction on the platfor m. Note that Visa

fees shown in Table1 are debit card interchange fees for the US market. These fees, set by Visa, are paid by merchants

to card issuers through merchant acquirers.

2Merchants and policy makers point out that debit and prepaid card transactions do not provide credit or float and

bear very small fraud risk; therefore, they do not warrant a percentage-based fee structure (see, e.g., Standing Senate

Committee on Banking, Trade, and Commerce, 2009).

C

The RAND Corporation 2017.