Jun 8, 2013

Apple, Amazon & The Economics of Price Fixing

There is this interesting case thats going on in US now. It started as US Govt vs Apple. It is now more and more looking like Apple vs Amazon. The key underlying point highlighted by US govt is that Apple forced a change in pricing policy of ebooks which resulted in an increase of prices across the industry.

Circa 2009 December, Amazon ruled the roost in ebook industry with a market share of about 90% - monopolistic by any standards. They had a peculiar pricing policy at that time. Regardless of the book, you would end up paying $9.99 as the price. From Amazon's perspective, it was a clear ploy to capture the market. Obviously, publishers did not like a distributor setting the pricing policy. In other words, it was an unstable monopoly. And such markets are ripe for disruptive innovations.

Enter Steve Jobs with iPad, the wonderful product that has kept me hooked on ever after that. One of the lesser noticed things that Apple did at that time was to enter into a different kind of pricing policy. Jobs' proposition to the publishers was - Price your books at whatever price you want. Just give me a 30% cut on every sale made throiugh iTunes store. But would anyone buy a book through iTunes if it was selling at significantly lower level through the Amazon Kindle store ? Apple had a way to cover up that problem as well. The contract with publishers had this ingenously defined MFN clause . In a nutshell, it meant that the price in Apple iTunes store had to match the lowest price that is offered across any other platform ( read Amazon ) . This had an immediate impact. Amazon's monopoly collapsed. Publishers moved from a distributor driven pricing into an agency or publisher driven pricing. This obviously resulted in higher prices for ebooks. And this is the point on which the entire lawsuit is on. But does US Govt really have a case ?

In economics, there is this concept of Consumer & Producer surplus . Though predominatly explained in the context of quantity based pricing , it is equally applicable in this case as well. A lower price results in more consumer surplus ( or benefit to the consumer. Because in reality, he may be willing to pay higher ) . A higher price results in more producer surplus . Governments typically champion people's cause. And rightfully so in many cases. Because in subsistence related things like drinking water , which people may be willing to pay anything , keeping a low price helps. In a lot of legal & policy making discussions, the cause of consumer surplus is championed and producer surplus is often pictured as a villian. But is that the right way always ?

Producer surplus has a value. It incentivized producers to produce more in terms of quality and quantity. An artificially lower price obfuscates market signals. In the publishing industry context, the artificially low $9.99 prices did not give good signals to the publishers as to whether a book was really doing good in terms of content or price. It was really a barrier to a publisher to know the true taste of a consumer.

Take a look at other industries..

If a medical insurance chain mandates same hospital costs for all hospitals for a unique kind of treatment, as a consumer how would you know which is the best hospital and which one is not ? Identical charges would not foster in quality in treatment. Hospitals giving better quality of treatment would not be able to incentivize doctors or provide better treatment facilities if charges are identical

If a ticketing distributor or Govt mandates same price for tickets from place A to place B for all airlines , how would you know which one is serving you better. Airlines which have a better product offering should be able to charge higher based on the consumer demand. In a regulated pricing regime owing to monopoly of distributor or because of govt regulations, the artificially low pricing leaves passengers under-served

Giving those signals is the real value of producer surplus. It spurs producers to innovate , incentivize and serve consumers better. And I would say, this case against Apple is going collapse like a frail structure of playing cards sooner or later. At worst, for Amazon, this will change as a case against them for abusing the monopoly power in the pre-iPad era to dictate an artificially low pricing.