E-book Price-Fixing: Finding the Best Model for Publishers — and Readers

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In a case that has attracted worldwide attention, Apple and five book publishers were sued this spring by the U.S. Department of Justice on the grounds that they colluded to fix prices for e-books sold on Apple’s iBookstore website. The government suit charged that by adopting a sales strategy known as “the agency model,” Apple and the book publishers (HarperCollins, Hachette, Macmillan, Penguin and Simon & Schuster) reduced competition in the e-books industry, raising prices and harming consumers. Although three of the five book publishers have since signed settlements with the DOJ, Apple, Macmillan and Penguin are still preparing to defend their cases in court.

The case has cast a bright spotlight on the agency model — otherwise known as the “platform model” — of e-commerce, in which an increasing range of manufacturers are selling their products directly to consumers over the web, while setting their own prices for those products. The agency model differs from the more traditional “wholesale model” of e-commerce in which “e-tailers,” such as Amazon.com, purchase goods from manufacturers and then resell those goods to consumers at prices that the e-tailers themselves set.

(MORE: How Apples’ Steve Jobs and Book Publishers Cost Consumers Millions)

The legal controversy over Apple’s efforts to use the agency model when selling books directly to its consumers offers a good opportunity to examine the benefits and costs of adopting that approach, both for online retailers and their customers, notes Wharton marketing professor Z. John Zhang, who has done numerous studies in this area with co-authors Vibhanshu Abhishek, a current Wharton PhD student, and Kinshuk Jerath, a professor at Carnegie Mellon University. Does the agency model of selling online harm consumers — and society in general — by raising prices for numerous products, not just for e-books? Or might the agency model offer significant, if often overlooked, economic and social benefits over the wholesale model for manufacturers, retailers and the general public? The researchers’ most recent paper exploring these questions is titled, “To Platform-Sell or Resell? Channel Structures in Electronic Retailing.”

Selling More Kindles

The origins of the conflict date back to the early days of the e-book industry, when Amazon.com, one of its pioneers, used the wholesale model to sell all of its e-books at a price of $9.99, says Zhang. “Amazon was using e-books as a ‘loss leader,’ apparently because it calculated that if it made e-books cheap enough for consumers, more people would buy its Amazon Kindle,” the only hardware device on which Amazon’s e-books could be read. Amazon’s longer-term strategy seemed to be based on the idea that as Kindle’s share of the e-book reader market expanded, the company would eventually make more money from the device and control the gateway to the e-book market. However, book publishers grew fearful that if Amazon.com charged only $9.99 for all of its e-books, they would be unable to charge more than that for their own e-books. “Publishers worried that Amazon might also [force them] to lower their prices on e-books at some point, as the mammoth Walmart does to its suppliers,” Zhang adds.

That’s why the book publishers got together, as alleged by the Justice Department, with Apple to adopt the same agency model that Apple has traditionally used for selling its own software applications — rather than the wholesale model used by Amazon. Apple software application developers have long set their own online prices for their products, while giving Apple a 30% cut of the gross proceeds. Thanks to the agency model agreement between Apple and the publishers, the publishers were now able to set their own prices for their e-books on Apple devices, just as Apple has set its own prices for software.

Predictably, Apple e-books became more expensive than those sold by Amazon.com, and book publishers began urging Amazon to adopt the same agency model to sell their e-books on Amazon.com. In 2010, Amazon gave in to the pressure, and e-book prices on Amazon.com began to rise as a result. Many buyers of e-books on Amazon.com were irked by the price increases that ensued.

Avoiding a ‘Huge Markup’

On balance, though, has the agreement between Apple and these publishers really hurt consumers? Or does the agency model have hidden benefits that the Department of Justice has overlooked or disregarded? To address such issues, Zhang and his collaborators have done extensive economic analyses, some published and some not, on the impact of the agency model on competition. A starting point in their research, notes Zhang, was their realization that the wholesale price model used by traditional e-tailers “is not very efficient” to start with because both the wholesaler and the retailer want to maximize their own profits, leading to a big markup in the prices paid by customers. “Economists agree that the huge markup doesn’t help consumers or manufacturers or even retailers [including e-tailers],” he says. “Lots of economists identify this problem with the wholesale model as the ‘double marginalization problem.’” When this model is used, “end prices are too high to maximize channel profitability. The interests of the manufacturer and retailer are not aligned in a way that maximizes social welfare, either.”

 (MORE: Why Apple is Winning: Innovation, Opportunity and Execution)

For years, people have been trying to find a way to align those conflicting interests. One obvious solution is for a manufacturer to integrate forward — that is, opening its own stores and selling its own products directly to consumers. Apple does just that, thus eliminating retail price markups. However, few companies can do this in the world of brick-and-mortar stores, notes Zhang, because “most manufacturers lack the resources” to set up their own stores, and most manufacturers — unlike Apple — “don’t produce enough varieties of products to sell them in their own store.”

If, for example, you sell only toothpaste, you can’t open a store selling just toothpaste, even if you make it in several flavors. The best most manufacturers could do when selling through traditional channels is to use a so-called store-within-a-store format — essentially, an agency model for brick-and-mortar retailers. This format is widely adopted for virtually all product categories in department stores in Asian countries such as Japan, Singapore and China. According to Zhang, there are telltale signs that U.S. brick-and-mortar retailers are also moving in this direction.

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