The best thing for books is more power to Amazon

Aaron Pressman Yahoo Finance
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Amazon.com founder and CEO Jeff Bezos in June 2014

Amazon (AMZN) used to set the prices people paid for ebooks, but, thanks to an illegal price fixing conspiracy, they lost most of that power to publishers. Almost everyone -- probably even the big publishers -- would be better off if they got it back.

Part of what’s made Amazon a success is its sophisticated pricing system, which automatically raise and lower prices on millions of items throughout the day. Prices change in response to varying levels of interest from buyers, competitors' prices and other factors. And the bottom line for consumers is great prices on most products, while sellers tout Amazon as their most profitable outlet.

Back before the major publishers plotted to take control of ebook prices in 2010, those same systems helped stimulate massive demand, sparking a multi-billion dollar market that more than made up for shrinking print book sales. The fact seems utterly lost on the industry today, as Hachette holds out against Amazon for higher ebook prices and some best selling authors protest the company’s tactics in full-page newspaper advertisements.

True, Amazon didn’t use dynamic pricing for every ebook. Best sellers and some new issues were priced at a fixed $9.99 as the same kind of loss leader strategy commonly found at the end of every super market aisle in the country. But the vast majority of ebooks were not fixed at $9.99, but rather at ever-varying prices set to stimulate the most sales.

Unfortunately, under the new model publishers forced into play, the book industry took control away from Amazon’s smart algorithms and ebooks were set at fixed prices, almost all at either $12.99 or $14.99. After Random House, the largest publisher of all, switched to so-called agency pricing plan in 2011, ebook sales growth slowed dramatically.

And even after regulators broke up the conspiracy to some degree, ebook prices are still pretty static. The price for the ebook of Hillary Clinton's "Hard Choices" has been more or less stuck at $14.99 at Amazon and competitors Apple (AAPL) and Barnes & Noble (BKS) since it came out.

A lose-lose situation

Ironically, not only do consumers pay more, but publishers – and authors – profit less.

As revealed in the price fixing trial last year, the two price bands were negotiated between Apple and publishers with no testing. And the prices don’t end up bringing in the most revenue – each sale may bring in more, but the higher price results in a fewer number of sales that more than offsets the higher prices, explains Rafi Mohammed, a top pricing strategy consultant.

“The agency model – a retail price assigned by publishers – precludes Amazon from setting the most profitable price,” he says. “Generally speaking, Amazon has found that lower than publisher suggested prices are the most profitable.”

That was the point of Amazon’s recent blog post revealing some data about ebook sales at different prices. The company found that on average an ebook priced at $9.99 sold 1.74 times as many copies as an ebook priced at $14.99.

The greater number of copies sold more than offset the lower sticker price, generating more revenue for publishers and authors. And since there is almost no additional cost to selling one more copy – or 10,000 more – of an ebook, additional sales revenue is highly profitable.

Publishers and their allies quickly attacked the number, but their math made little sense. They worried: What's to stop Amazon from pushing ebook prices down to $6.99, then $1.99 and so on until there was no money for authors left at all?

They seemed to ignore the most basic principle of the Amazon pricing system: finding the price that generates the most total revenue.

The system would only price an ebook at $6.99 instead of $9.99 if that attracted a massive increase in sales volume to offset the lower price. At $6.99, ebook sales would have to increase by more than 1.4 times to exceed the revenue of the $9.99 price, or 2.1 times overall to beat the $14.99 ebook’s total revenue. And if that was the case, then publishers and authors ought to cheer the overall increase.

Amazon’s interest isn’t in the lowest possible price – it’s in maximizing the total sales revenue from each book.

Some like to lump Amazon in with tech firms like Apple and Google (GOOGL) and imply that book selling isn’t a top priority. But unlike Apple, which makes money from selling hardware, and Google’s ad-based sales, almost all of Amazon's revenue is generated from sales of actual stuff made by others, stuff like ebooks. 

Set aside the conspiracy theories that Amazon sold ebooks at a loss to build a monopoly. The company’s ebook business has always generated a profit overall and the intention was to maximize sales, not become the evil overlord of publishing. (The fact that Amazon runs its established business units at a profit may come as a surprise to those who only pay attention to the company’s quarterly reports on Wall Street, where Amazon is seemingly always just breaking even or reporting losses. But Bezos reinvests all profits from older areas, like books, into newer, higher-growth areas, like cloud computing.)

Amazon's better track record

It’s also worth diverging from the economics and looking at history to decide who's in a better position to control ebook prices. Not only has publishers’ insistence on high prices stifled sales recently, it also helped keep the market from even taking off in the years before Amazon’s Kindle.

Sony (SNE), Microsoft (MSFT) and others tried to beat Amazon to the ebook game, but set prices even higher than hardcovers, giving consumers no incentive to try the new format. Bezos and company actually kept their $9.99 price a secret from publishers before introducing the Kindle.

The copyright industries overall have a horrendous track record navigating digital transitions. Hollywood initially resisted the shift from video cassette tapes, and the dominant rental model, to DVDs, with their emphasis on sales at much lower retail prices. But within a few years, DVD sales exploded and total revenue was much higher.

There is one legitimate question about Amazon’s analysis: It doesn’t include the likelihood that lower priced ebooks cannibalize some print book sales. Although sales of print books are less profitable than ebook sales, authors receive a much higher royalty rate from print (which may explain some of their pique at Amazon’s tactics), and print bookstores are an effective means of helping readers discover new books.

Several studies have attempted to quantify ebook cannibalization. Two recent analyses, one in 2012 and one in 2013, found that while there was some substitution of ebook buying, mostly for top print best sellers, ebooks did more to expand the overall market by surfacing more older titles along with ebook-only (generally self-published) books.

And that really should be the bottom line in this age of endless apps, YouTube videos and Instagram feeds available on every phone in every pocket. Reading was in decline before the Kindle came on the scene and ebooks have been exactly the kind of digital boost the industry desperately needed.

Now it’s time to get the market growing again by putting pricing back in the hands of the experts.

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