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.
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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, [Wharton marketing professor Z. John] 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.”
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.
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Despite the negative image of the agency model generated by the headline-grabbing lawsuit, the Internet has been a boon for this approach, notes Zhang. Apple’s “platform” (or agency) model for apps allows software developers to run their own stores and sell their own products directly to consumers. “In theory, the agency model is a very good way to solve this double marginalization problem because there is only one layer,” he points out. When, for example, a book publisher pays a constant 30% fee to Apple, “this doesn’t distort the price at which the publisher sells to the end user.”
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Why then, in the case of e-books, does the Department of Justice want to stand in the way of the agency model? For many, the most objectionable outcome of the alleged collusion between Apple and the publishers is that prices for Amazon’s e-books — and, in fact, e-books in general — increased, thereby harming consumers. However, Zhang questions whether this argument examines all of the ways the agency model has had an economic impact on the market for e-books. For example, although prices of Amazon e-books have risen, prices of Kindle readers also went down over the same period. “You can’t say that the consumer only gets the short end of the stick as a result of the agency model. You have to balance all of the interests of consumers.”
Moreover, he suggests, the first wave of people who purchased Kindle readers were often more affluent consumers who were less sensitive to price and possibly more willing and able to pay somewhat higher prices for e-books. “For those people, there was very little impact when Amazon raised its e-book prices.” Society as a whole also gained when consumers who could finally afford a now-cheaper Kindle gained access to the thousands of e-books still available at little or no cost on Amazon’s website. Indeed, with the agency model taking hold in the publishing industry, “you will see that iPad, Kindle and Nook will all come down in price, competing even harder for new readers,” notes Zhang.
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Initially, the agency model “may lead to higher prices for e-books, as we have observed,” Zhang concedes. This is because Amazon has been using loss-leader pricing to achieve its market share objectives. In addition, the agency model does have a tendency to reduce inter-store competition: If a publisher sells a book through both Apple and Amazon, “you can bet the publisher will not try to lower its price at Amazon to cut into its sales of the same book at Apple.” However, in that case, Zhang and his collaborators have shown that all bets are not off on price competition, as the agency model opens up inter-publisher price competition. “To sell a book, [one publisher] will have to compete much harder with other publishers with similar titles for readers.”
In their most recent paper, Zhang and his coauthors address a key question that e-tailers are now facing: When should they use a platform — or agency — model instead of the more conventional reselling format? In developing a theoretical model for their study, the researchers focused “on the effects of two main factors on the resulting selling format in electronic retailing: competition among e-tailers, and reaction by the manufacturer due to the impact of the electronic channel on sales in the traditional channel (brick-and-mortar retailing).” The results of their work suggest that “whenever sales in the electronic channel lead to a negative effect on demand in the traditional channel, e-tailers prefer to set up platforms, whereas when sales in the electronic channel lead to a substantial stimulation of demand in the traditional channel, e-tailers prefer reselling contracts with manufacturers.” Furthermore, “this preference is moderated by competition among e-tailers — as competition between them increases, e-tailers prefer to set up platforms.”
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PG will point out that technology such as ereaders always goes down in price and/or up in power over time. This is a function of improved designs and the tremendous economies of scale that kick in with higher manufacturing volumes. He doubts the price drops were related to increased margins due to agency pricing of ebooks.