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This article has been written by Anurag Mawai who is pursuing LLB from Faculty of Law, Delhi University. In his article, the author discusses “How Did Apple Convince Book Publishers to make books available despite offering lower shares than Amazon?”

In July of 2013, The Southern District Court of New York ruled in an antitrust suit filed by Department of Justice and 33 States of U.S.A, that Apple along with five major publishing houses indulged in anti-competitive practices and conspired to increase the price of EBooks. Apple denied all charges of wrongdoing and announced that it will appeal against the decision, while the major publishing houses settled separately with the Department of Justice. A major question which comes to mind after this incident is how can one company which until three years back had not even entered the EBook market, change the entire market’s pricing models and to such extent that an antitrust suit is filed by the federal government of the United States.

The Background

 To delve into this story, we have to look at the EBook market as it existed in 2009 where the only vendor ruling the market was Amazon, controlling more than 90 percent of the distribution network. Its success was because of Kindle and its loss leader formula of prices i.e. making available e-books at a price of $9.99, but paying the book publishers the cover price of $15 and even as high as $20, just to capture market share and drive rest of eBook vendors out of business. The Publishers even though were happy for the increased sales volume, they feared that customers will begin to form a perception that the justified price of an eBook is $9.99 and any more than that is gratuitous overpricing. To add more to the woes of Publishers, eBook sales were cutting into the hardcover sales, and decimating the brick and mortar stores which served as profit centers to the publishers besides Amazon. This made the Publishing houses tied to Amazon in the near future for any distribution strategy. The publishers saw the reaper in Amazon but then came a digital knight in the form of Steve Jobs, Apple desired to launch in January 2010 its IPad and on it, an eBook store connected to iTunes as there were predictions of the eBook market to grow from $42 billion in 2009 to around 10 times in the next four to five years. With the IPad launch and thousands of credit cards available in iTunes, Apple was not willing to fight Amazon on the loss leader turf it had created, so it instead changed the whole market model.

 The Problematic Wholesale Pricing Model

Traditionally books both hardcover and eBooks were sold through a “Wholesale” Model which meant the publisher used to set the cover price for a book and bookstores paid a negotiated wholesale price, usually around 50 percent of the cover price. The bookstore after that will set the retail price, like a book with a cover price of $40 will have a wholesale price of around $20 and the bookstore may sell it for $35 and show $5 as discount. (Most of the authors have royalty agreements on the basis of cover price like a 10% royalty agreement will be paid on $40 not $35). Amazon under this model played fast and loose with the retail price to its strategy of being the loss leader and driving the competitors out of business. It was giving deep discounts on every article like a book with cover price of $15 or even $20 was sold for $9.99  suffering a loss of up to even $10. This price was not viable and made other vendors close shop it was a classic sales technique of Amazon by which it penetrated markets and gathered market share and reduce costs by logistics and volume growth. But this had the book publishers worried as even though they were getting paid the cover price, the general public preferred to buy the cheaper e-book of $9.99 than the hardcover of $27, publishing houses began to delay eBook releases to Amazon to shore up any hardcover sales they could get but this led to increased risk of piracy and violation of copyrights leading to further losses. This eBook price warfare had even built a perception in the general public that eBooks are inherently made with less cost so the $9.99 is the real valid price which should be charged. This perception led to fear among publishers that if this is to continue they will be trapped in this whirlpool of loss as major book publishing costs are incurred in proofreading, editing, advertisement, marketing and the manpower costs rather than printing costs making eBooks just as expensive to make as hardcover, eBooks may have advantages regarding storage costs and transport but still these could not bring the price difference to the Amazon figure of $9.99. The Publishers knew if this model was continued for long Amazon would hold the sole control of book selling business and hardcover business would be rendered waste in light of this sentiment.

The Ingeniously Collusive Solution

When Apple approached Harper Collins and other publishers it was not willing to fight Amazon on price as it knew it would be like bidding against itself for a competition to the Red Line Balance Sheet. So it convinced the publishers to change from wholesale model, to an “Agency” model, the publishers readily agreed as they themselves wanted out of the price perception game hence they renegotiated the terms of distribution along these new lines with other distributors including Amazon as well. Amazon first protested to this renegotiation but later gave in as all major Publishing Houses put up this condition for renewal. But what exactly was this “Agency” model, and how could it alleviate the publishers pain.

What is Agency Model 

In “Agency” Model publishers would set the retail prices directly and vendors will sell books only at that price reducing the space for price maneuver, vendors will not pay the whole cover price to the publishers but only a certain portion of the new given retail price keeping some portion as their own profit (publishers will get 70% of the price instead of the whole cover price), in this manner Publishing Houses cut out the vendors from  the price negotiation process. Apple uses this model in its App Store and Mac App store where they paid the developers 70 percent of the price of the app and the rest 30 percent is taken by Apple. This actually gave the publishers lower returns than the wholesale model under Amazon, where the whole cover price was paid but the publishers agreed as not only they get to decide the cover price according to the margins and revive the pulp sections of their inventory but now they get to write the perception story of eBooks.

There is nothing inherently wrong with the “Agency” model per se, as we have seen Apple uses this model to pay for App Store which has never been accused of antitrust violation. The actual problem arose when two key clauses which Apple inserted with book publishers that led to price collusion between the Publishing Houses as manufacturers and Apple as their leading vendor- Price tier with caps and MFN (Most Favored Nation) clause.

  • Price Tiers with Caps- Apple’s executives knew in order to capture a fair market and not be ridiculed they had to be in range of Amazon’s price range so they introduced two price caps on of $12.99 and another of $15.99. The $12.99 was for eBooks whose hardcovers were priced from $24 to $27 and $15 for the hardcovers priced around $27 to $30. There was also a range of $16.99 and $19.99 for eBooks whose hardcovers were priced more than $30 with a $5 increment for new releases. The price tiers prevented publishers from setting unreasonably high prices, as Apple knew it had to be within some dollar range of Amazon products to effectively compete with it.
  • MFN Clause- Most Favored Nation clause means that if Publishing Houses gave a discount to any vendor then they have to give the same to Apple as well. If any vendor had lower prices than Apple, Apple could match it and pay Publishing Houses on that price only guaranteeing profit to Apple even at a lower price for example- if in the future Amazon had a sale where it was selling Times Bestsellers at a discounted rate of $10, even if the retail price fixed by Publishing Houses was $15, then Apple could also match that price without violating the agreement, and pay 70% of $10 to the Publishing Houses removing any additional burden of higher prices.  MFN Clause ensured that Apple was always ahead of the price curve compared to other platforms and stores and retained its customers as they knew if the eBook was available somewhere else at a cheaper price, soon it will be available at that same price in ITunes too. This strategy also gave Apple a steady customer base with practically zero price competition.

The New Mechanism of “Agency” model coupled with the clauses of Price Tiers and MFN enabled the publishers and Apple to decide the price of eBooks and neither Amazon nor any other retailer like Barnes and Noble could change the price significantly, the only wiggle room they had was some discount on the listed price given at the expense of taking huge losses whose competitive advantage was taken care by MFN Clause in these vendor agreements.  Apple wanted to launch IPad in the market on its own terms and with the publishers having negotiated Agency model and other clauses with the rest of distributor chains in eBook industry it was ready to make the machines dance to the tune of its ballad.

The Work in motion

Due to these changes in EBook market when in 2010, the IPad launched it started a chain reaction in eBook price wars, soon many publishers began increasing their prices and even started to remove their titles from Amazon, if it did not agree to the new pricing models. Times Bestsellers were not available for over two months on Kindle as Publishers could not come to an agreement regarding price structure with Amazon. Amazon as a result lost its market leader status , and began to dig its heels after this phenomenon, it tried to portray itself as a messiah of the common folk trying to bring books to people at an affordable price, but really was concerned about its falling game plans of eating into the profits of other vendors. After a lengthy battle with almost all publishing houses and suffering losses running into millions Amazon finally relented and let the $9.99 model fall, and with it lost the pole position in eBook race. EBook sales dipped in total, but in revenue due to higher prices the turnover increased. Apple constantly increased its market share, no matter the title, the MFN Clause ensured that it was available on iTunes at the most competitive price of the market. Even after a total decline in sale volumes, publishers did not flinch as they now had at least an option to do some price management to increase profits and avail other platforms for their sale promotion. Hardcovers also began to see some traction, as the gap between the pulp and the digital files began to shrink. But most importantly Apple’s greed led to some opening of market which had been till now the playground of a sole ruler. This vice of Mr. Jobs gave him profits and might have been incorrigible but was he the sole culprit?

Is Apple the only one to blame?

Many trade analysts do not solely blame Apple for the fiasco as Amazon’s predatory pricing was also not beneficial for the sector and for industrial competitiveness. But as the United States Trial Court in its judgement observed, if Amazon was indulging in predatory pricing then the justified remedy for the Publishing Houses was to bring it to proper authorities rather than engaging in anti-competitive practices themselves. But Mr. Jobs was never known to be a subtle spectator of his industry he went ahead with the move and orchestrated a plan with so many moving pieces which changed an entire sector worldwide and had effect on multiple industries from electronic sales, publishing, ecommerce, gadgets and even disturbed the piracy markets all over the world. From being a leviathan in eBook markets sitting atop the throne as the sole ruler in times to come for eBook distribution Amazon was thrusted into the jungles of open competition, thanks to shrewd planning and careful orchestration by Steve Jobs. The actions may be unscrupulous if seen in black and white but besides his wardrobe Mr. Jobs never dabble in these colors, he was an artist in grey master in finding loopholes and solutions to make an enterprise work, and his creativity maybe saved an entire sector from being captured by one enterprise, as we read about his strategy in his biography available on Amazon at a price of $16 not $9.99.

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