The Wall Street Journal reported Thursday that the Department of Justice has warned Apple and five major publishing houses (Simon & Schuster, Hachette Book Group, Penguin Group (USA), Macmillan, and HarperCollins Publishers) that it plans to sue them for “allegedly colluding to raise the price of electronic books.”  The DOJ allegations highlight an issue raised by the European Commission in December 2010 when it began investigating the same publishing houses (see here).  At the center of the controversy is a 2010 shift from the “wholesale model” to the “agency model,” and the outcome of the DOJ’s probe may determine the future of the ever-growing e-book industry.

The popular business model for hard copy books, and the model for e-books until 2010, is the wholesale mode, where the publisher sells the book to a retailer, such as Barnes & Noble, for roughly half of the title price, and the retailer sells it for whatever price it chooses.  However, when Amazon began selling e-book bestsellers at a significant discount to the title price ($9.99), publishers feared that hardcopy retailers would be unable to compete with Amazon’s low prices, and that consumers would continue to expect lower prices, thereby constraining future e-book and hardcopy prices.  But, around the time that Apple launched the iPad in 2010, Steve Jobs apparently found a solution that would appease publishers: a shift from the wholesale model to the agency model.

The primary difference between the models turns on who sets the ultimate price.  Unlike the wholesale model, under the agency model, the publisher—not the retailer—sets the final price, and the retailer takes a 30% cut of that price once sold.  As Jobs apparently explained to his biographer, Walter Isaacson, when a publisher contracts with retailers under the agency model,  e-book retailers like Amazon cannot sell the e-book for lower than the publisher prefers.  If a retailer like Amazon rejects the agency model or the price established by the publisher, the publisher will simply refuse to contract with Amazon and Amazon will face market exclusion.  Moreover, Apple’s contracts with the major publishers, and now Amazon’s as well, include a “most favored nation” clause, which prohibits the publisher from selling to other retailers for lower prices than it has agreed upon with the favored retailer.

These “most favored nation” clauses have also been a cause of controversy.  In his 2010 letter to Apple, then Connecticut Attorney-General Richard Blumenthal noted that, while “most favored nation” clauses are not “per se illegal” they “have the potential to impair horizontal competition by encouraging coordinated pricing and discouraging discounting.”

The publishers claim that there was no collusion, and that the shift to the agency model has in fact increased competition by allowing a greater number of e-book sellers to enter the market.  According to Barnes & Noble CEO William Lynch, the agency model prevents a single e-book retailer (see Amazon) from dominating the market.  Authors Guild president Scott Turow agrees, believing the government is going to stifle competition.  But, if the major publishers and retailers continue to operate under the agency model and implement “most favored nation” clauses that bind the publishers from lowering prices—even when the retailer may have lower operating costs than other retailers—how can competition thrive among retailers?

One problem with the agency model is that the publishers set the prices, and yet the publishers have interests beyond maximizing e-book sales alone.  As James McQuivey of Forrester Research points out, the economics of selling a greater number of e-books for lower prices can be favorable for the publishers, but “publishers don’t want that because then it would make you think, well, wait a minute, why is the paper copy 24.99?”  Indeed, hard copy prices reflect significantly greater production costs than e-books, including printing, shipping, and shelving.  Despite the lower costs, McQuivey suggests that publishers are simply not ready for such a dramatic, yet inevitable, switch to e-books.  And if consumers are willing to pay prices for e-books that are closely pegged to hardcopy prices, publishers will enjoy a greater profit margin, given the decreased production costs.  Theoretically, publishers can artificially increase e-book prices as a means of staving off a meltdown in the hardcopy-book market, while increasing profits in the e-book market.

It seems that the DOJ’s probe will lead to a settlement that may demand a modification of–if not a departure from–the agency model.  The best way to ensure competition will probably be a return to the wholesale model.  This would allow e-book retailers to set the ultimate prices, increasing competition among retailers and lowering costs to consumers.  The price would better reflect production costs, and consumers would have greater access to cheaper books.

On the other hand, the wholesale model would probably cause a decrease in the production of hardcopy books.  But is this an unfavorable consequence?  The hardcopy book is certainly more traditional and perhaps invokes nostalgia, but it is hard to envision a marketplace where consumers will pay significantly higher prices for hardcopy books when the e-book is cheaper, once the consumer owns an e-reader.  What do you think, JETLaw blog readers?  Are consumers ready to abandon the hardcopy book if the DOJ probe ultimately results in deflated e-book prices?

– Mike Dearington

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3 Responses to The Agency Model’s Dénouement? The DOJ Probes Alleged Price-Fixing by Apple and Book-Publishers Over E-Book Prices

  1. ADM says:

    Reading this, my initial concern was the effect freely competitive e-book pricing would have on authors, whose books would be distributed at a marginal cost of essentially $0. However, upon looking into it a little further, it became clear that competitive e-book pricing could actually bring in more money for authors. Amazon buys books like any wholesaler, at a fraction of the retail price. Once it has purchased the book, the author receives his or her cut, which is usually 25% of the price Amazon paid. At that point, Amazon can sell the book at whatever price it pleases without harming the author’s income UNLESS people start spending, on aggregate, less on e-books than they do on print books. However, if you’ve ever been bored on a car trip or stuck behind your computer somewhere, I think you might agree with me that easy one-click internet access to books will not slow down sales. And the added benefit to authors is that many royalty contracts actually increase the percentage of revenues that the author receives as the volume of sales goes up. Yes, this could mean that hard-copy sales suffer, but what is the harm in that? As evidenced by the continued existence of CD stores or at least online availability of CDs, it will be a long time before books stop being published in hard copy all together. Until that time, those who value turning paper pages or using books as household decor will still have access to to hard copies. In fact, they may even be willing to pay a premium for the privilege of purchasing a book on paper.

  2. Whitney says:

    I think Kendall is right about the license. With my Nook, short of handing the entire of device to someone else, only another Nook user can “borrow” another e-book from me using the “Lend Me” feature, which limits the “borrowing” of the e-book to that user once for three weeks.

    Regarding the DOJ investigation, I’m very troubled by the “most favored nation” clause in the contracts. Given recent evidence, it seems highly likely that Apple orchestrated this sit-down with the publishers to construct the agency model. If that’s not colluding for price fixing, I don’t know what is. While I saw plenty of outrage at Apple and the book publishers, I did see plenty of resentment directed at Amazon. These people indicated that Apple was merely trying to compete with Amazon, and the DOJ investigation and lawsuit was going to stifle competition. Admittedly, Amazon has been cornering the market with their ability to sell e-books at a loss to themselves in order to induce consumers to buy the Kindle; unsurprisingly, competition is leading to a monopoly. However, there’s nothing illegal about Amazon’s competitive behavior. Apple needs to find a way to break up Amazon’s monopoly without engaging in behavior that is anti-competitive in the long-run.

  3. Kendall Short says:

    I think one thing to note is that the e-book versions are often just licenses rather than a full “copy” of the book in question. Unlike with a physical book, you cannot readily lend or resell your e-book version to a friend. Amazon has tried to set up a lending library for its Kindle customers, but that is clunky and limited to just one book a month, unlike a physical library. I know this has also come up in the textbook context since school systems typically buy a set of textbooks and reuse them for multiple years, which wouldn’t be possible with e-books (See http://m.npr.org/news/Books/145457942). With the ability to transfer e-books limited, I think the lower prices are warranted. Until publishers allow e-books to be used more like their hard copy counterparts, retailers should be allowed to treat (and price) them differently.