The Amazon-Macmillan ebook kerfuffle: an ode to price discrimination

Lynne Kiesling

[I love the word kerfuffle]

Price discrimination is the basic economics question in the current iPad-induced Amazon-Macmillan kerfuffle, even more basic than the DRM/property rights issues and the antitrust/resale price maintenance issues I discussed in my last post on the matter. Lots of people have weighed in on the subject in the past 36 hours, and I recommend some of them to your attention:

To see why this controversy is so important, let’s compare the old “wholesale pass-through” pricing model and the new “agency” model. Martin very helpfully provides that comparison in his post, so I’ll summarize here:

  • Wholesale pass-through pricing: Retailers negotiate a fixed wholesale price per unit with the publisher, and then set the retail price. In this case, Amazon has negotiated a 50% discount from full hardcover retail for their ebooks and charges $9.99 for most of them, so on any book with a hardcover retail price higher than $19.98 Amazon loses money on that sale. The publisher’s revenue on the sale is 50% of full retail.
  • Agency pricing: The publisher pays a percentage-based commission to the retailer, based on a negotiated retail price. Reports indicate that this commission is around 30% (which passes the gross margin smell test for me), so if a $29.95 hardcover sells in ebook version at $15.99, the publisher actually makes less money and the retailer makes more.

Note that under the agency pricing model, Amazon actually makes money on each ebook it sells, which at the moment it does not. The fact that it is fighting so hard to keep low ebook pricing is consistent with the hypothesis that they want to price ebooks below their marginal cost as a “loss leader to sell gadgets”.

But where the economics gets really interesting is considering the book supply portfolio and the demand for specific titles over time. That’s where the dynamic pricing flexibility of the agency model is welfare-creating — it can make Amazon, Macmillan, Macmillan’s authors, and consumers better off relative to the equilibrium with wholesale pass-through pricing, and what’s makes that possible is price discrimination.

Here’s an example: over Christmas I read Wolf Hall by Hilary Mantel (which was truly outstanding and I recommend it very highly). It was released in the US in October with a list price of $27.00. Under wholesale pass-through pricing, Macmillan receives $13.50 from Amazon for every ebook version sold at $9.99, leading to a loss per unit to Amazon of $3.51.

Under agency pricing, Macmillan could, say, commit to pricing the ebook version at $17.99 for the first week, $14.99 to the end of December, and $9.99 thereafter. Under that scenario, those Hilary Mantel fans with low price elasticity of demand would buy in the first week, those who are willing to pay $14.99 would wait a few weeks and then buy it, and those who have more price-elastic demand would wait until the price fell to $9.99, which seems to be a trigger price for a lot of current Amazon Kindle customers. This is an application of third-degree price discrimination, and in the simple static model it results in more output sold and higher profit, but generally lower consumer surplus. In a dynamic sense, though, the welfare of all parties can go up, because the price discrimination may induce the publisher to contract with more authors for more works, making all four parties better off.

Virginia Postrel mentions the price discrimination aspect in her post on the subject:

The other side of the equation is consumer response: How many more copies will people buy if the price goes down? Or, in economic lingo, what is the price elasticity of demand? Book publishers talk (and often act) as though book buyers aren’t particularly price sensitive. The Borders and Barnes & Noble coupons in my email suggest otherwise. So does what little academic research exists on the subject. In a paper looking at people buying physical books using a shopbot, economists Erik Brynjolfsson, Astrid Andrea Dick, and Michael D. Smith found very large elasticities: A 1 percent drop in price increased units sold by 7 percent to 10 percent.

Of course, people who use shopbots are likely to be more price sensitive than average. But there’s anecdotal evidence that prices matter a lot for e-books. As The New York Times reported recently, most of the books on the Kindle bestseller list are being given away for free. And comments on various discussion threads among Kindle users suggest that many are bargain hunters looking for a good, cheap read rather than a specific title.

Rather than cut prices for everyone, Macmillan hopes to be able to price discriminate, so that eager readers pay more than casual ones. It’s a reasonable strategy. But the publisher seems to envision a traditional method of dividing the market: charging more for brand-new titles and lowering prices over time. That approach works for paperbacks, which come out roughly a year after hardback editions. But paperbacks are, of course, physically inferior to hardbacks, while e-books are all the same. Discriminating by publication date works only for titles that are fashion items–you want to talk about Game Change this week, not in six months–or blockbusters with impatient fans (the latest Twilight installment). Most books fall into neither category.

That’s an interesting angle on the topic. James McQuivey from Forrester offers some evidence that may point in the same direction:

In fact, the pricing mess is only going to get messier. Our surveys have found that people are willing to pay as much as $17.81 for a new e-book, but only if the hardback costs $25. That’s the rub. People expect to pay less for digital books, compared to the price of the physical book in the market. But books don’t cost that much. Today I can buy a hardback copy of Elizabeth Gilbert’s Committed on Amazon for $12, a discount of $14.95 from the list price. And the book was just published four weeks ago. So spending $14.99 for the digital version is a bit silly.

So what’s the “new equilibrium”? Retailers and publishers will evolve and adapt as technologies and consumers do, but will it involve content as loss leader, authors contracting with Amazon and disintermediating publishers, or something else. One thing we know is that the Internet has created lots of new ways to price discriminate, and ebooks may be susceptible to that pricing model too, to the benefit of all parties.

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6 thoughts on “The Amazon-Macmillan ebook kerfuffle: an ode to price discrimination

  1. From the consumer angle, there is also some merit to “our” expectations that digital content should be cheaper than print.

    1. I pay .99 for a song purchased on iTunes (precedent)
    2. According to Amazon Terms & Conditions, you never actually own the Kindle book, only the limited rights to view it. (Amazon has actually removed purchased e-books from user accounts without warning or reimbursement).
    3. E-content is cheaper to produce and distribute than print.

    I am annoyed that more competition hasn’t so far resulted in cheaper prices, but very interested to see the outcome, and grateful for your well thought out economics lesson.

    BTW – My husband argues we consumers should be willing to pay more for the convenience, but what does he know.

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  3. Very good points.

    But on elasticity, what about the time factor? It seems more to me that price is declining on a schedule by time, since the value diminishes. The price is still fixed. If I won’t pay a buck for a day-old stale loaf of bread, and I won’t pay $2 for a fresh one, I’ll never buy the store’s bread.

    I’ve seen paperbacks prices lower than the e-book on Amazon, mainly when the cover price of the paperback is $7.99 while the e-book’s “digital list price” from the publisher is still $27, and Amazon sets the e-book price at $14 so it won’t lose $. I find it hard to believe that publishers who do that understand any level of economics.

    That’s not even accounting for the fact that the difference in price between an e-book and a hardcover should reflect the reduced value of a non-transferable, non-loanable file.

    The e-book “value” is being determined by what hardcovers are selling for. Amazon seems to have a grasp of that. Publishers – not so much.

    I think publishers still don’t get it.

    I don’t think Amazon prices to sell Kindles, and I dd get the impression (long details here: http://trueslant.com/rogertheriault/2010/02/03/who-wins-the-ebook-wars-amazon-macmillan-apple-publishing/) that publishers are simply trying to hold their e-book prices at unsustainable levels.

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  5. One of the biggest flaws in some of the economic analysis I’ve read about the ebook pricing war is the assumption that big publishers like MacMillan are somehow gaining more pricing flexibility, when in fact they are demanding less, and that they will seek to maximize their ebook revenue, when in fact they will to try maximize their total revenue which means prioritizing the higher-profit-margin print versions of books (and helping higher-pricing retailers stay in business!).

    On the first point, under the prior system, publishers had total control to set book list prices and Amazon had to pay 50% (or more) of that list price back to the publisher. When the list price is very high, Amazon simply isn’t able to absorb the losses and prices its ebooks higher than $9.99, sometimes significantly so. It’s a myth that Amazon prices all or most ebooks at $9.99. A recent survey found just 16% at that price (and about 30% higher). As a frequent shopper in the Kindle store, I can tell you that over the past two years, ebook prices have been creeping up — an experience validated by some surveys as well. And that flexibility happened in real-time as prices for a single ebook can vary quite widely over time. Amazon is, as you may realize, one of the greatest experiments in pricing feedback and revenue maximization of all time.

    What MacMillan has demanded is the right to set retail prices itself and at just three price points, $14.99, $12.99 and $5.99. It will have far less direct information about sales in real time than Amazon had and the company has set on a far less flexible scheme than what prevailed previously. There is also a lot of evidence that MacMillan and the other major publishers have no interest in lowering ebook prices. At ebook stores run by retailers more friendly towards publishers (or, said another way, with much less market sway than Amazon), ebook prices are as high or higher than prices for print versions, even on older titles. It’s been reported that many MacMillan titles on Fictionwise.com which are available in mass market paperbacks sell for $14.99. Scrollmotion, a publisher-financed iPhone app maker, famously failed at trying to sell ebook versions for that platform at full hardcover list prices. And in a quite similar situation, music labels identically said they needed more flexible pricing from Apple and promised 99 cent tracks would be sold at three price points, 69 cents, 99 cents and $1.29. What’s happened since? Most tracks that sell are priced at the high end and you can’t find a popular 69 cent track to save your life, even on pretty old music.

    Finally, MacMillan’s incentives are not to maximize revenue from ebook sales. If so, why would they be pushing a scheme that will lower their revenues and lower ebook sales overall? Their incentive is to maximize revenue from all sources. If, as they seem to believe, sales of cheap ebook versions are cannibalizing higher priced (and higher margin) sales of print books, they can maximize their revenue by raising ebook prices and reducing cannibalization.

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