Is agency or wholesale pricing better? It depends on who's asking the question

As part of the ongoing discussion about the U.S. Justice Department's eBook price-fixing case, there's been a lot of back-and-forth about which pricing model, agency (where publishers set retail prices) or wholesale (where retailers set their own prices), is better. I'll cut to the chase: Agency is better for publishers and some retailers (who either can't or won't compete on price,) while wholesale is better for other retailers (those who are willing and able to compete on price) and consumers. Agency allows publishers to eliminate discounting--they authorize every reseller to sell their eBooks at the same price. If a publisher wants to make more money, it simply raises its prices, and those price increases are passed directly onto consumers.

Under wholesale pricing, publishers sell their eBooks to resellers, who have the right to resell them at any price they choose. They can change prices and respond to consumer demand without getting permission from publishers. Without wholesale pricing, there would be no discount resellers in the U.S. Barnes & Noble would have to compete with independent booksellers solely on selection, not price. 

Publishers, or for that matter, any vendors of products or services, don't seek to control retail prices in order to make them lower for consumers--they do it to maintain or increase prices. Decades ago, the term "fair trade" referred not to helping improve income and conditions for producers in developing countries, but to a policy of requiring all resellers to sell the same product at the same price (also called "price maintenance".) The first statute allowing manufacturers to force everyone to sell at the same minimum price went into effect in 1931 in California. Here's a quote from Wikipedia: " (Fair trade laws) were ostensibly intended to protect small businesses to some degree from the competition of the very large chain stores during a time when small businesses were suffering. Many people objected to this on the grounds that if the manufacturers could set the price, consumers would have to pay more even at large discount stores." The last of the fair trade laws was repealed in 1975.

My parents ran a small store that discounted its merchandise. They couldn't sell Sony electronics or Seiko watches, because both companies refused to sell to discounters. So, they instead sold Panasonic electronics and Citizen watches, helping both companies to establish a foothold in the U.S. The fair trade laws kept consumer prices high and created a price umbrella under which competitors could enter the market at lower prices.

That demonstrates a fundamental flaw in the publishers' thinking about agency pricing: In the short run, it bolsters the price of their eBooks, but in the long run, it attracts substitute titles into the market that are sold at lower prices. Experience shows that book buyers are very price-sensitive--that's how Barnes & Noble and Borders killed most independent booksellers, and how Amazon built such a big eBook market share. We're already seeing the effect with the growth of self-publishers who are selling their eBooks at dramatically lower prices than the Big 6.

Price maintenance is a strategy that rarely works in the long run. Resellers figure out ways to get around it, consumers pressure their legislators to outlaw the practice, or the courts intervene.

U.S. eBook price-fixing trial set for June 2013; Apple and publishers still have issues

Reuters reports that Judge Denise Cote has set June 3, 2013 as the the start date for the U.S. eBook price-fixing trial against Apple, Macmillan and Penguin. According to another report from the Associated Press, the Department of Justice has asked the judge for permission to continue gathering evidence for the case until March of 2013, but Apple wants the DOJ to wrap up its discovery by the end of 2012. (Apparently, the publishers are siding with the DOJ on this issue, not Apple.)

A third report from CNET News says that the three publishers that are in the process of settling with the DOJ--Hachette, HarperCollins and Simon & Schuster--are asking to be treated as "non parties" to the lawsuit, so that they won't be required to provide discovery in the case unless a party provides "good cause." The DOJ says that the publishers aren't entitled to "special treatment" because there was no allowance for it in their settlement agreement, the companies are likely to be "sources of highly relevant evidence," and they've turned over documents to European investigators that they haven't turned over to the DOJ.

Did Apple and the book publishers get what they wanted?

With all the Sturm und Drang surrounding the eBook price-fixing charges against Apple, Hachette, HarperCollins, Macmillan, Penguin and Simon & Schuster, and the counter-charges that their actions prevented Amazon from establishing an eBook monopoly, a fair question to ask is: Did Apple and the publishers get what they were after? The short answers are "no," "yes" and "don't forget the Law of Unintended Consequences."

Apple: It may have hoped to become a major bookseller by getting the publishers to force all its competitors to sell eBooks at the same price, but if that was its hope, so far it's failed. Apple's eBook market share in the U.S. is, at best, in single digits, while Amazon still controls around 60% of the market and Barnes & Noble has approximately 25% market share.

The publishers: They wrested pricing control for their eBooks away from Amazon and were successful in getting Amazon to raise its prices. They also, at least in part, enabled Barnes & Noble to become a viable competitor to Amazon in the eBook market (although a good part of the credit should also be given to B&N's own strategies, including selling and supporting its Nook tablets and eReaders in its stores.)

The unintended consequences:

1. Amazon moved quickly to develop a supply of titles that are beyond the control of the Big 6 publishers, first by strengthening its self-publishing efforts with the Kindle Direct Publishing program, and then by entering the publishing business itself with Amazon Publishing. Amazon is now competing directly with the Big 6 for contracts with top authors and licenses for popular backlist titles. Had the publishers not taken away Amazon's pricing power, the company probably would have gone much slower in building up its own publishing business.
   
2. Price-fixing lawsuits have been filed in the U.S. by the Federal government, 16 state governments and private individuals, and in Canada by private individuals. Lawsuits are being considered by the European Commission and Australia. These lawsuits have the potential to cost Apple and the publishers hundreds of millions of dollars in damages and legal costs, not to mention years of management distraction, reputational damage and constraints on how they do business. Hundreds of millions of dollars may be negligible to Apple, which has $110 billion in cash and equivalents, but the cost is much more significant to the publishers. 

Given Apple's inability to turn the deal into significant market share and the publishers' inability to keep Amazon from maintaining control of a majority of the U.S. eBook market, it's hard to argue that Apple's and the publishers' actions were worth the cost.

Apple's potential defense: The publishers didn't need us to collude on pricing

I've been wondering about Apple's apparent resolve to fight the eBook price-fixing charges leveled against it by the U.S. Justice Department, states and private individuals. Apple's defense and decision not to settle have, so far, made no sense to me. The relative cost and inconvenience of settling with the Justice Department and states would be minimal compared to the potential distraction of Apple's management and reputational damage resulting from years of litigation. So, why is Apple holding out? Keep in mind that I'm not a lawyer, but here are some thoughts:

The publishers wouldn't possibly have been stupid enough to talk directly with each other about adopting uniform agency terms and pricing. Apple would have had to serve as the "switchboard", acting as an intermediary between the various publishers. The problem is that if the Justice Department charges are correct, the publishers did meet face-to-face multiple times to discuss business issues including "the Amazon problem," and also had myriad communications between each other by phone and email. Years ago, when I took a Business Law course in college, my professor said that such contacts between competitors simply shouldn't happen. Even if all the parties do nothing more than talk about the weather, the very fact that the meetings took place can be used as evidence of collusion among competitors. That may explain why, according to the Justice Department, there were never any corporate counsel at the face-to-face meetings held by publishing CEOs in various Manhattan restaurants.

The CEOs could never agree on how to take on Amazon and force the company to increase its selling prices for eBooks; it took Apple to propose first agency terms, and then a "Most Favored Nation" clause that would guarantee that Apple would always have the lowest eBook prices. The publishers could have come up with a similar scheme and worked the details out among themselves. It was convenient for Apple to do the work for them, but Apple wasn't necessary to either create or further the collusion.

The problem for Apple is that the Justice Department appears to have evidence that the company did, in fact, act not only as a "switchboard" between the publishers, but that its role was essential to getting the five publishers on board with exactly the same terms and conditions. There's also evidence that Steve Jobs himself intervened to try to convince Random House to join the other five Big 6 publishers in implementing agency terms. That may be enough to prove that Apple was integral to the conspiracy.

The "Most Favored Nation" landmine

Reuters is reporting that the U.S. Justice Department could file suit against Apple and one or more publishers for eBook price-fixing as early as Wednesday. I won't rehash the details of the case; you can read this or this for background. In this post, I want to discuss one of the sticking points in the case--the "Most Favored Nation" clause. Apple's "Most Favored Nation" clause requires publishers to price eBooks that they supply to Apple at least as low as the lowest price offered by any other reseller. If the publisher or one of its resellers lowers the price for a title below that of Apple, Apple has the right to drop its sale price to maintain the lowest price.

It's very important to understand that Apple isn't the only eBook retailer with a "Most Favored Nation" clause; both Amazon and Barnes & Noble have them as well. In fact, Amazon is far more aggressive at exercising its clause than the other two retailers. Amazon regularly scans the prices for eBooks at competitive websites and will automatically drop the price of any title that it finds lower at another site, without giving notice to the publisher (or, for a self-published eBook, the author.)

The effect of Amazon's "Most Favored Nation" clause is magnified by another clause the company demands: For non-agency titles (in other words, titles that Amazon purchases to sell under the wholesale model,) Amazon reserves the right to set and change the price as it sees fit, although it will still remit the same wholesale amount back to the publisher or author. If Amazon drops its price for a title below that of Apple or Barnes & Noble, even without the knowledge of the publisher or author, Apple and Barnes & Noble have the right to match Amazon's price.

You may already see where this is going. If, either by design or error, the price of an eBook drops at one retailer, the others have the right to drop their prices. Any pricing mistake can quickly cascade. Is it possible that the price could go to zero? Self-publishers have been giving away some of their eBooks to encourage customers to buy others, so finding a title priced at zero wouldn't necessarily be flagged as an error. In at least one case, Amazon mistakenly found a self-published eBook priced at zero at another retailer, and dropped its price on the title to zero.

Okay, so what happens when the price accidentally goes down to zero? All the publisher or author needs to do is make a phone call or send an email to the retailers in order to fix the problem, right? That assumes that they can figure out who to contact at the retailer, and that the retailer takes action quickly to correct the problem. So let's say that you're an author whose eBook is, through no fault of your own, now priced at zero. You contact Amazon, Apple and Barnes & Noble, and they all agree to correct their prices. Amazon goes first, and you're back at, say, $4.99. Then, before the other retailers have a chance to change their prices, Amazon's scanner checks Barnes & Noble's website, sees that their price is zero, and sets Amazon's price back to zero. Then, Barnes & Noble corrects the price, until the Barnes & Noble price scanner sees that Amazon is selling your eBook for zero, at which point Barnes & Noble also sets its price back to zero.

There are two big takeaways:

1. "Most Favored Nation" clauses suck for everyone except retailers, and
2. Just getting Apple to get rid of its "Most Favored Nation" clause without doing something about Amazon and Barnes & Noble isn't going to fix the problem.

Update. April 30, 2012: According to The New York Times, Apple selected "After Friday Night Lights" to be part of its "Pick of the Week" promotion that allows Starbucks customers to get a free copy of the eBook. Amazon saw the promotion as a giveaway and dropped its price for the eBook to zero. Then, Byliner, the publisher of "After Friday Night Lights," withdrew the eBook from Amazon until the conclusion of the Apple/Starbucks promotion on May 1st.