How Apple Conspired with Publishers to Raise Prices for eBooks

On July 10, 2013, Apple Inc. was found guilty of conspiring to restrain trade in violation of Section 1 of the Sherman Anti-Trust Act. That section criminalizes agreements among competitors at the same level of market structure to fix prices. Although Apple is not a publisher, it was instrumental in bringing together Penguin, Simon & Schuster, HarperCollins, Hachette and Macmillan, and helping them to execute a price-fixing scheme that they believed would serve their long-term mutual economic interests. Without Apple, the five publishers could not have raised ebook prices across the board and eliminated price competition for ebooks practically overnight.

What is curious about the case is not whether Apple and the publishers were guilty — their’s was a classic price-fixing conspiracy — but why five of the six biggest publishers in the U.S. did it at all.

The background of the case is the pricing of ebooks by Amazon, which launched the Kindle in 2007. Until February of 2010, Amazon bought ebooks much the same as it bought physical books: at a wholesale price set by the publisher, which also established a suggested retail list price (“SRLP”), but gave the retailer discretion to set the actual selling price. In the Kindle’s first two years, many publishers set the wholesale price for e-books about 20% lower than the equivalent physical book, reflecting, at least in part, the lower cost of distributing ebooks. (With ebooks not only are there no printing costs. There are also no costs related to shipping, warehousing, inventory and inventory taxes, damaged shipments, faulty print runs, returns and pulping.) Since the typical hardcover bestseller had an SRLP of between $24 and $28, at $9.99 for an ebook, Amazon would either earn a nominal sum at the lower end, or lose a couple of dollars at the upper end.

From the moment Amazon began pricing new releases and New York Times Bestsellers at $9.99, the major publishers (the five mentioned above plus Random House, the largest of all) were very unhappy. They believed that the $10 price would lead consumers to think that the value of a book was $10 and balk at paying $24 to $28 for hardcovers, which at the time represented 95% of sales. In their first attempt to get Amazon to raise ebook prices, the publishers soon put the wholesale price of ebooks on parity with their physical counterparts.

The increase had no effect. Amazon continued to offer Bestsellers and new releases at $9.99, even though Amazon was losing money on most of those transactions. (For a hardcover with an SRLP of $26.00, Amazon paid $13 for the ebook, sold it at $9.99 and lost $3.01 on the sale.) The publishers, on the other hand, lost nothing, but still objected on the basis that it was too cheap. In addition, they feared that Amazon, which had 90% of the ebook market at that point, would use its market position to demand lower wholesale prices for ebooks once Amazon tired of offering ebooks as loss leaders. The publishers also thought that the $9.99 price would add to the continuing demise of bricks-and-mortar bookstores[1] and even the death of the hardcover. (In retrospect, predictions of the demise of the hardcover were premature.

[2]Amazon established the $9.99 price, and in general tried to keep ebook prices low, for several reasons, one of which was the direct result of the publishers requiring “digital”. First, Amazon was already heavily discounting many of the hardcovers, earning just a few dollars over the wholesale price. Purchasing an ebook for the same price as a hardcover, even a discounted one, was an unattractive prospect to consumers, particularly given that digital rights management (“DRM”), a regime imposed by publishers, prevented consumers from even lending an ebook, let alone selling it in the used book market when they were done with it or holding onto it for its value as a “First Edition.” DRM made ebooks worthless as commodities. $9.99 was thus, at least arguably, a sensible price. Second, since ebooks at that point accounted for no more than five percent of the market, Amazon wanted to gain loyal customers, which was as easy as selling them a Kindle and offering them as much content as possible at the lowest prices — content, not incidentally, that due to DRM could only be read on the Kindle and (later) its apps. Third, while Amazon would take a loss on the digital versions of Bestsellers and new releases, it benefited when Kindle owners became more invested in their devices and therefore more likely to purchase other (and more) ebooks, not to mention other products from Amazon.

By the end of 2009, just about the time that Apple came courting, Macmillan, Simon & Schuster, Hachette, and HarperCollins were so fed up with Amazon’s ebook pricing that they had either begun delaying ebook releases or announced their intention to do so. The theory behind the delay, called “windowing,” was that consumers would be forced into buying the more expensive hardcover edition (rather than wait for the ebook) and Amazon would raise its ebook prices out of desperation. In practice, however, the publishers only ended up losing money. In fact, Penguin refused to join the other publishers after an internal study revealed that when release of an ebook was delayed, its sales never recovered — that is, the customers who would have purchased the ebook didn’t buy the hardcover and didn’t return to buy the ebook when it finally became available. Penguin was right.

In November 2009, Steve Jobs authorized Eddy Cue (“Cue”), Senior Vice President of Internet Software and Services at Apple, to pursue the opening of a dedicated Apple ebookstore simultaneously with the launch of the iPad, set for January 27, 2010. At his initial meetings with publishers in December, Cue assured the publishers that Apple was in favor of higher consumer prices for ebooks if that’s what the publishers wanted, specifically $12.99 and $14.99. (HarperCollins wanted even higher prices, but Apple wouldn’t hear of it.) Apple had a number of demands, however. First, Cue made it clear that Apple would not compete with Amazon or anyone else on prices for ebooks. Second, it would not tolerate windowing, because it would interfere with the growth of the ebook market. Third, Apple would only launch its store if it got all six major publishers to sign on. (Random House eventually decided to bow out, but Apple went ahead with the other five.) Fourth, Apple would not pay the publishers’ then-current wholesale prices for ebooks — generally $13 to $15, but as high as $17.50 — because Apple believed those prices were too high. (Of course, these were the prices that Amazon was already paying the publishers.)

After discussing various proposals, Apple and the publishers settled on the “agency” model of sales, where the publishers, not the retailer, would set the retail list price — i.e., it would no longer be a “suggested” price, but a mandatory one – and ebooksellers would earn a percentage as a sales agent. It was then, however, that the real negotiations began. The issues were essentially three-fold: Apple’s commission, what retail prices the publishers would set, and how the publishers would deal with Amazon and every other ebook seller.

Apple negotiated aggressively. It insisted on a 30% commission, the same commission it was getting in its App Store, and never budged from that. As for pricing, Apple was unwilling to accept retail prices that it thought would be embarrassing. After a two weeks of back and forth, during which the publishers were in daily contact with each other, Apple sent the publishers its terms: when a Bestseller was listed at $30.00 or less, the ebook price could not exceed $12.99; when the Bestseller was listed above $30.00 and up to $35.00, the ebook price couldn’t exceed $14.99. For all other new releases, the $12.99 ebook price would apply to physical books with list prices between $25.01 and $27.50, and the $14.99 ebook price would apply to physical books with list prices between $27.51 and $30.00.

In addition, knowing that the agency model would fail unless every other ebookseller were forced to accept it, Apple insisted on a “most favored nations” clause (“MFN”) under which the publishers guaranteed that their retail price at the Apple store for any given ebook was equal to the lowest selling price on the Internet for the same ebook. In other words, if Amazon continued selling ebooks at $9.99, the publishers would have to set a $9.99 price for the Apple store and Apple would still be entitled to its 30% commission. As one of Cue’s colleagues at Apple in Britain noted, following a conversation with Cue (and ascribing these words to him), “any decent MFN forces the model.” With the MFN, moving Amazon and everyone else to the same pricing structure as Apple was a fait accompli.

In January of 2010, the publishers were claiming that Apple was their savior, but the irony of the deal they made with Apple is that consumers would pay more money for Bestsellers and new releases while the publishers would earn less. Under the wholesale arrangement with Amazon as it then existed, the publishers received about 50% of the hardcover list price, i.e., they received $13 for a book priced at $26, even if Amazon only sold it for $9.99. Under the Apple “agency” arrangement, the publishers would earn just 70% of the ebook selling price. That meant that a $12.99 ebook (which applied to a bestseller whose physical counterpart had an SRLP of under $30.00), earned the publishers $9.01, whereas the publisher might have received as much as $15 from Amazon (i.e., 50% of $30.00).

Some of the publishers predicted that with the agency model, they would lose about 17% of their e-book gross revenue, resulting in significant losses in the millions of dollars, but they still believed they would be better off in the long term. HarperCollins concluded that the economics of the deal were “terrible” for the company and its authors, but felt that “the strategic value” of Apple creating an ebookstore was “very high.” Apple must have been laughing all the way to the bank. It had gotten five major publishers to accept less for their ebooks than Amazon was paying, while forcing consumers to pay higher prices. At the same time, Apple created for itself a no-risk “level playing field” for entering the ebook market without any threat of competition with Amazon or anyone else. It was already set to launch the iPad. Now it would compete against the Kindle, rather than the prices of ebooks that Amazon offered for it.

Moving Amazon to an agency deal and thereby fixing prices was only possible by the publishers acting in concert with each other, and Apple was their prime mover. The effects of the deal were immediate. Within two weeks of Amazon moving to the agency model, the average per unit e-book retail price increased by 14.2% for new releases, 42.7% for Bestsellers and 18.6% across all of the five publishers’ ebooks. As Apple had anticipated, the publishers also instituted price increases for their backlist ebooks, even though these weren’t actually governed by the price tier regimen negotiated by Apple. In addition, the five publishers also raised the prices of some of their new release hardcovers so that the ebook version would move into a higher price tier. The result of the price increases was, not surprisingly, lost sales. Thus, as the Court found, “consumers suffered in a variety of ways from this scheme to eliminate retail price competition and to raise e-book prices. Some consumers had to pay more for e-books; others bought a cheaper e-book rather than the one they preferred to purchase; and it can be assumed that still others deferred a purchase altogether rather than pay the higher price.”

If there was any question whether Apple knew what it was doing by forcing the publishers to agree to the MFN, Steve Jobs clarified it when he spoke to his biographer, Walter Isaacson, the day after the iPad was launched:

Amazon screwed it up. It paid the wholesale price for some books, but started selling them below cost at $9.99. The publishers hated that -– they thought it would trash their ability to sell hardcover books at $28. So before Apple even got on the scene, some booksellers were starting to withhold books from Amazon. So we told the publishers, “We’ll go to the agency model, where you set the price, and we get our 30%, and yes, the customer pays a little more, but that’s what you want anyway.” But we also asked for a guarantee that if anybody else is selling the books cheaper than we are, then we can sell them at the lower price too. So they went to Amazon and said, “You’re going to sign an agency contract or we’re not going to give you the books. Although Apple attempted to defend itself as the hero that went to battle against Amazon.com and established “competition” in the ebook marketplace, nothing could be further from the truth. As the factual findings in the case make clear, Apple’s efforts were intended to reduce competition and they succeeded in doing so. Apple’s vision of “competition” in the ebook market was not lower ebook prices for consumers, but offering a better device which consumers could use to access the same ebooks at the same prices.

The high prices that resulted from the scheme were ameliorated somewhat once the five publishers pleaded guilty and agreed with the U.S. Department of Justice not to prohibit retailers from setting the sale price for ebooks. But Amazon’s low prices may not have endured anyway: for obvious economic reasons, predatory pricing is only a short-term strategy. In any case, Amazon’s practice was probably legal under U.S. law as controlled by Supreme Court precedent. Selling under cost becomes illegal only if
the scheme alleged would cause a rise in prices above a competitive level sufficient to compensate for the amounts expended on the predation, including the time value of the money invested in it. Evidence of below cost pricing is not alone sufficient to permit an inference of probable recoupment and injury to competition. The determination requires an estimate of the alleged predation’s cost and a close analysis of both the scheme alleged and the relevant market’s structure and conditions. Although not easy to establish, these prerequisites are essential components of real market injury.[3]
Since Amazon showed no sign of ever wanting to raise prices, it would probably not have satisfied the test, even if it was arguably recouping its loss through customer loyalty.

Currently ebooks account for about 20% of publishers’ revenues, compared to 15% in 2011 and 5% in 2009-2010. 2012 ebook sales in fiction rose 42% (over 2011), while nonfiction and audiobooks saw increases of 22% each. For children’s and young adults’ ebooks, sales increased some 117%. Hardcovers did slightly better in 2012 than 2011.[4]

Apple’s prediction of immediate dominance in the ebook market never came to pass, despite the fact that Apple has sold some 84 million iPads, vastly more devices than have been sold by Kindle. Amazon has about 50-60% of the ebook market, while Apple has 10-20%. This is probably because Kindle owners are readers, while iPad owners prefer to use their iPads for other things. It isn’t the verdict against Apple that “ensures that Amazon will remain on top for the foreseeable future,” as Matt Buchanan claimed in a recent article in the New Yorker.[5] What predicts Amazon’s continued dominance is that it has built up a business based on books in every available format and has fostered a literary culture led by readers.

Although a serious competitor, Apple was never the savior the publishers were looking for. Indeed, it is rather strange to view Amazon as the bully and Apple as the good guy. After all, it was Apple, not Amazon, which cost publishers — and authors — millions of dollars in lost income by paying publishers less for their ebooks than Amazon was willing to pay.

Endnotes.

[1]Amazon and other online booksellers also aggressively discounted physical books, a practice with which bricks-and-mortar booksellers could not compete, given the increased costs of maintaining a bookstore. While Amazon can be blamed for exploiting the efficiencies of online bookselling, there were other factors that led to the demise of bookstores, one of which was noted by Ken Auletta in the New Yorker on April 26, 2010, just as Apple’s conspiracy with the five publishers was unfolding:
Amazon had a profound effect on publishers’ business, creating a place where customers could reliably find books that were no longer being promoted in stores. Backlist books—those which sell reliably over time—are vital to publishing houses. At Random House, more than fifty per cent of revenue is generated from books like “The Prophet” and “Mastering the Art of French Cooking,” which provide steady profits that allow editors to make more adventurous gambles on new books. With Amazon, “people could find backlists,” David Young, of Hachette, said. “You were no longer hoping and praying that you would find that spine on a shelf.” Carolyn Reidy said that in a three-month period online vendors typically sell copies of twenty-five hundred Simon & Schuster titles that bookstores don’t stock.
Auletta, Ken. “Publish or Perish: Can the iPad topple the Kindle, and save the book business?” New Yorker, April 26, 2010
http://www.newyorker.com/reporting/2010/04/26/100426fa_fact_auletta

[Mr. Auletta’s article is fascinating because at the time he wrote it he was unaware of the conspiracy to raise and fix prices. Many of the quotes from industry players really only make sense now, knowing how they acted behind the scenes.]

[2]Carr, Nicholas. “Don’t Burn Your Books—Print Is Here to Stay.” WSJ, January 5, 2013. http://online.wsj.com/article/SB10001424127887323874204578219563353697002.html

[3]Brooke Group Ltd. v. Brown & Williamson Tobacco Corp. (92-466), 509 U.S. 209 (1993). http://www.law.cornell.edu/supct/html/92-466.ZS.html

[4]Bosman, Julie. “E-Book Sales a Boon to Publishers in 2012.” New York Times, May 15, 2013. http://www.nytimes.com/2013/05/15/business/media/e-book-sales-a-boon-to-publishers-in-2012.html?_r=0

[5]Buchanan, Matt. “The E-Book Conspiracy Comes to a Close.” New Yorker, July 11, 2013. http://www.newyorker.com/online/blogs/elements/2013/07/apple-amazon-ebook-antitrust-court-ruling.html