E-Books and Economics

With today's news that MacMillan has settled with the DOJ over its pricing investigation, the discussion about what exactly is going on with this industry is back on the front page (for limited values of "front page"--no doubt most people don't care at all).

One comment I've often seen is some variation on the idea that what the publishers and Apple were doing was taking power away from customers and handing it back to publishers.


Almost.  It shifts power away from distributors back to the publishers.  This, of course, is why the publishers signed on in the first place.

In neither the Amazon nor the Apple model is the customer the one with power.  Amazon is using its weight to crush competing bookstores by purchasing books from publishers and then selling them at a loss in order to encourage people to invest in their store.  Apple, on the other hand, tried to use its weight to stop Amazon, which actually would have eliminated the Amazon price advantage and made it possible for multiple bookstores to run digital versions, because they'd have to compete on things other than trying to match Amazon's negative margin.

The question is which is better for the customer, and is one or both illegal?



The fact is that Amazon's approach forces consolidation by making it impossible to compete. With few exceptions, ebooks are commodities.  You get the same content and the same barely adequate formatting from any store.  So why would you shop on anything other than price? Amazon's model is predatory--by getting you in with extremely cheap services, they become the conduit through which you buy everything. Once competitors fall off, they can then begin monetizing your loyalty and effective lock-in.

Apple's model is also predatory, only instead of trying to get you to commit on price, it's the infamous "halo effect" that they're counting on--if Amazon, Barnes and Noble, indie bookstore, Google, and Apple all sell for the same price, then you're going to go with the one that you have the closest ties to otherwise.  The market will still eventually settle with a few large companies sharing the pie.

Both tactics are at minimum borderline anticompetitive. Collusion to fix prices by a group of entities with individual or combined market power is problematic under Section 1 of the Sherman Act.  Apple and the publishers, by agreeing to a model under which all distributors were treated to the somewhat counterintuitively-named "most favored nation" (MFN) mechanism, sold their ebooks at a fixed price and promised not to sell to others at a lower price.  This in and of itself is not the problem, contrary to popular belief. The Clayton Act makes price discrimination illegal if the intended effect is to create or maintain a monopoly, which nicely segues into Amazon's approach of predatory pricing, unlawful under, among others, section 2 of the Clayton Act.

The problem for the publishers and Apple is that actual collusion is a shorter hurdle to clear than unilateral action in competition law and that by effectively setting a 30% commission for the industry on top of MFN provisions, they fixed the prices for competitors instead of creating room for flexible pricing strategies.

The practical solution and a more robust approach would have been for Apple to pursue a model in which the publishers sold to all distributors equally, but did not set a commission as part of that structure and instead simply required that distributors cover all costs and not sell at a net loss (perhaps with some promotional/sale exemption).  In other words, if the publisher's list price for a given ebook is $7, then all distributors would pay the same $7.  Apple could use its standard model and price the ebook at $10.  Assuming Apple's costs are $2 per book, that would net them $1 per sale.  If Amazon has the same $2 per sale costs, they would be required to sell at a minimum price of $9, but could choose to eschew profits for the sake of attracting customers.

Amazon could also work to lower its costs per sale to $1.75 and would then be able to undercut Apple and sell the ebook for $8.75.  Since this is structured as a protection against predatory pricing and not a prescribed pricing model, there is still some flexibility and incentive for competition, but it addresses the problem of significant underselling--Amazon paying $7 for the book and then selling it for $6.50, a price virtually no one else could afford to offer.  This approach would be far more likely to survive a legal challenge.

In essence, although Amazon's approach is also anticompetitive, Apple and the publishers overstepped in trying to correct that market inequity, exposing themselves to investigation. There are no clean hands here, and neither model favors the customer individually.  The short-term benefits to customers with Amazon's model are not healthy or sustainable. It's all too easy to forget that competition law isn't just about stopping anyone creating upward price pressure; it's also about stopping people from unfair downward pressure.