Knowledge Problem

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:

• Laura Miller at Salon provides a good overview to the controversy, including a discussion of how publishers think the agency model will enable them to pay the overhead and author royalties that are the lion’s share of production costs (and that do not vary for ebooks relative to print books), as well as enabling them to avoid books/content becoming “a loss leader to sell gadgets”. The more I think about it, the more I think this “loss leader” point is a big driver in their strategy.
• Charlie Martin writes at Pajamas Media about the death of the print publishing business model; I actually think he may be incorrect about this, for reasons I’ll describe below that have to do with price discrimination, but he lays out some useful details nonetheless.

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.