Lakshman Krishnamurthi and I have been wondering about the pricing of e-books and e-readers. Before Apple’s entry into the e-book market,  Amazon was selling almost all their e-books for $9.99. In many cases, this was below the price Amazon paid to the publisher (according to the NYT of May 31st, 2009 about $13 to $14). Why? Second, why did publishers object to a model where Amazon sets the price of the book particularly when it, Amazon, was prepared to incur a loss to make the sale?

Lets begin with Amazon’s pricing pre iPad. The Kindle and e-books are a razor and blade business. So, shouldn’t Amazon be making its profits in books and not the Kindle? Perhaps Amazon sought to increase the installed base of Kindle readers. But one could have achieved that by dropping the price of the Kindle.Lakshman reasons that  Amazon used the lack of competition in e-readers to set  a reference price for the device. Admittedly, the Kindle was not the first e-reader, but it did create the greatest awareness of the product and pushed for content as well.

He points to how Apple launched the iPod in 2001.  It started with a high price and sequentially skimmed the market with a range of products.  Made the hardware expensive, and the software (songs) cheap; the opposite of the razor/blade strategy. To quote Lakshman directly:

Apple got away with this because of lack of competition and the significant differentiation of the iPod.  Also, they did not lose any money on songs sold through iTunes.  If Apple had started with a lower price on the iPod, would have sold more iPods initially, but the prices of subsequent iPods would have come down more than they did, and most likely would have made less money because in total would not have sold a lot more songs.

So, Lakshman is arguing that if there is variation in willingness to pay for the device (iPod, e-reader), then the seller may have an incentive to deviate from the razor and blades model to price discriminate on the device. But this does not explain why Amazon would choose to lose money on the books. Lakshman speculates this might have been an attempt to force publishers to lower the price of e-books to Amazon. I don’t see why.

Turning to the publishers, if they received the same revenue from an e-book that they did from a traditional book, why should it matter if Amazon chooses to price at $9.99?  This  could possibly harm retailers of hard back books, but why should publishers care about this? Or, perhaps $9.99 e-books reduce a publishers ability to price discriminate (hardback vs. paperback)?

Now consider Apples entry. It has resulted in a dramatic drop in the price of e-readers. In addition, Apple offered publishers an agency model: publishers set the price and Apple keeps a percentage of the selling price. Amazon has been forced to switch to the same model. The result is higher prices for e-books. Are publishers made better off?

Some arithmetic will be useful. Currently, under the non-agency model the publisher would make, say, $15 per book. Assuming a 30% fee to Apple or Amazon, the publisher would have to price the book at about $21.50 to recover the same revenue after paying the fee. Thus, the price of the book goes up at least $6. So, a $120 reduction in the price of an e-reader would be wiped out after purchasing 20 books! Alternatively, perhaps the publisher would like to sell e-books at a price lower than hardback but above paperbacks. Say the publisher sets a price of $13 for the e-book. Under the agency model, the publisher pays Amazon or Apple $3.90. This leaves the publisher with $13-$3.90 = $9.10, less than what they make now per e-book. The publisher come out ahead only if e-book unit costs are smaller or there is a compensating increase in volume.

Now, let us step back from the details to ask the question we always tell our students to ask: who values what? So as to avoid the confusion caused by competition it is useful to imagine a world consisting of a single publisher, a single e-reader producer and a single reader. Suppose, to begin with this reader is a `heavy reader’. Meaning, that before the advent of the e-book, they read copiously, purchasing books at about $20 a pop. In short, the e-book will not change their book buying habits. The value they attach to the e-reader stems from the convenience and portability it provides. The producer of e-readers can capture no more value than what this heavy reader assigns to these features.  The publisher can capture no more than the value the heavy reader assigns to the books the publisher puts out. In this world, there is no tension between publisher and producer of e-books. Now suppose a second type of reader, one whose book consumption habits would change with an e-book. This is a reader who buys a book that they wouldn’t otherwise because of the ease with which a purchase is possible using an e-book. Think of read once books……like Blink. You’ve heard people talking about it. It seems interesting (it isn’t, but that is another story) but not so interesting that one would make a special  trip to the bookstore for it. For this second type of reader, value comes from the combination of e-reader and publisher. This is the source of the tension between e-reader provider and publisher. How to capture this value and divide it between them is the issue.