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  • Business Model Change Prompts Government Lawsuit

    Last week, the Department of Justice (DOJ) sued five book publishers and Apple for colluding to sell e-books together and shifting to an “agency” pricing model to collectively raise e-book prices. Three of the five publishers (HarperCollins, Simon & Schuster and Hachette) have agreed to settle the case whereas Macmillan and Penguin have vowed to fight the lawsuit. Apple has been charged with keeping all publishers informed of the status of their negotiations to sell e-books on ipad and ensuring identical deals to all publishers. Interestingly, Random House, a major publisher, is not part of the law suit because they did not agree to the agency model in the initial stages.

    At a broad level, the DOJ lawsuit is about cracking down on secret agreements between competitors to reduce consumer welfare. At the heart of the suit is the business model shift by publishers from wholesale pricing to agency pricing. In the wholesale model, the books were sold to the retailers, who then set the final prices. This model gave retailers the leeway to discount book prices as they deemed fit. In the new agency model, the publisher sets the final prices and provides a margin to retailers who act as publisher’s agents. This model required identical pricing across all channels and hence price discounting is controlled. The legality of the agency model is not under question here. Only the issue that all the five publishers (allegedly) conspired to come up with the same higher prices has caught the attention of the DOJ.

    Who are the real gatekeepers of the publishing world? This question has prompted many of the actions by the major players in the past few years. In the wholesale model, the publisher took about 50% of the retail price while the authors netted about 20% with the remaining going to the retailers. But Amazon has broader ambitions than remaining as a mere retailer. They aspire to be a major publishing player as well. Recently they hired Laurence Kirshbaum (former CEO of Time Warner Book Group) as the Vice President of Amazon Publishing. Through its forays into publishing through backward integration, Amazon could dis-intermediate publishers and provide larger royalties to best-selling authors who sign exclusive deals. Since the book business, like the movie and music businesses, is very driven by a few hits and lots of losses, the pressures on publishers are very intense to get the next big author. More importantly, Amazon happens to be both the channel partner and a competitor for publishers. Hence the relationships between the publishers and Amazon were beginning to get frayed.

    When Amazon introduced the Kindle in 2007, Jeff Bezos announced that he would sell e-books at $9.99 in order to spur sales of the new device. Ironically Apple embarked on a similar strategy with the music industry with 99c music offerings with its ipod player a few years ago. Obviously this announcement of lowered prices for e-books was met with consternation by the publishers who felt that these prices were unsustainable and would jeopardize their ability to sell physical books at higher prices. Remember books are complementary products to Amazon’s Kindles whereas they are the core business for publishers. As such, Amazon could sustain a loss-leader pricing strategy for e-books and make money off Kindle. With Amazon’s sizeable market share in e-books coupled with the low price that is unmatchable by competitors without losing big money, the $9.99 price would have become an impenetrable barrier to entry into the e-books category. Publishers feared that Amazon’s chokehold in the e-books category would drive the publishing industry to the ground. Scott Turow, President of the Author’s Guild, called Amazon the Darth Vader of the literary world. However, the wholesale pricing model rendered publishers helpless to act against Amazon.

    Enter Apple with their ipad in 2010. Apple apparently promised pricing power to publishers, i.e. the switch to agency pricing for a 30% guaranteed margin. Book prices went up after this switch. Apple was allegedly assured that publishers would raise retail e-book prices at all other competitors as well.In the two years after the switch, Amazon’s share in e-books dropped from 90% to 60% whereas Barnes & Noble’s share has gone up dramatically. Interestingly, the DOJ lawsuit has resulted in B&N’s falling share prices.

    Apple apparently kept all the big five publishers in the loop about their pricing negotiations. More importantly, Apple extracted a “most favored nation” clause (one that the DOJ has focused on in the lawsuit) that gave the right to Apple to drop its sale price to match the lowest price offered in the market. Since Amazon and Barnes & Noble have identical clauses in their contracts, I’m not sure how this would have benefitted Apple alone. To me, this clause prevented mutually assured destruction in the e-books market.

    The three publishers who settled may be able to continue a “modified” version of agency pricing. See this link for details. The DOJ appears to understand the problems of predatory loss-leader pricing by Amazon and hence acknowledge that these three publishers may retain the ability to limit discounted pricing so as to prevent a retailer from selling the entire catalog at a sustained loss.

    What does it mean for consumers of e-books? At one level, it could immediately spell lower prices for consumers. 16 states have already filed class action lawsuits. But are lower prices necessarily better in terms of consumer welfare? Is it possible that a behemoth like Amazon could wipe out its competitors through a discounted pricing strategy? Could a suit that seeks to penalize collusion among competitors lead to no competition at all in the long-run? Or, as argued by Richard Epstein, could lower prices lead to lower royalties to authors and hence lead to lower levels of book production? The next few months are going to be interesting to watch as this episode unfolds right before our eyes.

     

    _________________________
    Raj Echambadi
    Professor of Business Administration and
    James F. Towey Faculty Fellow and
    Executive MBA Academic Director