Thursday, August 30, 2012

Why is it okay for you to set your own price but not for Apple or a publisher?

Setting your own price for your books seems like the most logical thing in the world. The $0.99 and $2.99 book price points are widely-used by authors to make money, and the free promotion days are like gold. But the Department of Justice has sued Apple and the e-book publishers for making this possible.

Why are these companies being charged with a criminal offence for doing something that thousands of authors now do every day?

It's not illegal for a manufacturer to let the world know what it thinks is the right price for its products. If it was, commercials for products as widely-varied as cars and fast food would be illegal. Every day Drew Carey hosts an hour of The Price is Right and the whole premise of that show is based on there being a standard price of goods, but Drew Carey isn't a retailer. Even print books have their prices printed right on the front or back covers. So that's not the issue.

The pricing suggestions I mentioned above are exactly that: suggestions. You may be familiar with the acronym "MSRP". It's short for Manufacturer's Suggested Retail Price. Pretty much every company that makes a product has an MSRP for it, because that's how manufacturers figure out how much to charge their own customers: the retailers.

Let's use books as our example (and note that I'm massively oversimplifying it). Amazon orders hundreds of thousands of different books every year. It would be a nightmare to have to specify in every contract with all the various publishers exactly how much it will pay for each individual title. So instead they agree that the price is a discount off MSRP. An example may help.

  • Let's assume that Amazon has a discount of 50% off MSRP. So for books where the MSRP is $20, Amazon would pay the publisher $10 for each copy. So far, so good.
  • Amazon can now charge whatever price it wants. It can charge $15. It can charge $25. And unless it makes a regular pattern of selling a company's goods below its cost of acquisition (called "loss-leadering") or does a couple of other things that can be questionable sometimes, Amazon has full discretion here.
  • Because the price is a percentage of MSRP and not the actual sales price the publisher gets the exact same $10 no matter what actual price Amazon charges. And that's the way it works for many consumer goods.

Or at least that's the way it worked before agency pricing. Under agency pricing the retailers are effectively saying they're not buying the book, they are effectively acting as an intermediary service to introduce sellers (the publishers) to buyers (the consumers). One technical aspect of agency law is that the agent isn't acting on its own behalf, it's acting on behalf of the principal. And so if a retailer is acting as an agent there shouldn't be a problem with letting the publisher, who is the principal, set the price.

Aside: this might seem pretty simple and you might wonder why no one thought of it before. I don't actually know but if you made me guess I'd think it's because this model only really works online. If a physical retailer like Walmart or Best Buy acts as an agent then the manufacturer still owns the inventory sitting on the retailer's shelves. That means the manufacturer might have to file sales and other tax returns in all of those states. But online retailers don't necessarily create those same issues, which makes agency pricing more possible.

So this could be a pretty compelling element to a defense by Apple or the publishers: that if there's nothing illegal about setting an MSRP, and there's nothing illegal about acting as an agent, then how can it be illegal to create agency pricing and allow publishers and authors to set their own prices?

That argument has a lot of surface appeal, but at the end of the day I think it's not going to succeed.

Taking a page from the music industry, Apple put something called a "most favored nations" clause into its contracts (often abbreviated to "MFN"). Under a typical MFN clause, if a record label lets Retailer A pay $5 for an album then it has to charge $5 to Retailer B.

But Apple's version of the MFN was different: it required the publishers to drop their pricing on iTunes to the lowest price offered for their e-books by any other retailer. Using my example, Apple's MFN would trigger if a publisher's book was sold by Amazon for $9.99 but Apple's price through agency pricing was $12.99: the publisher would have to reduce its iTunes price to $9.99.

This would incentivize the publishers either to force Amazon to accept an agency pricing model (so the publishers could price-match upwards) or to pull their e-books from Amazon. And with the iTunes base of customers, for the first time pulling their books was a meaningful option for e-book publishers. As far as the DOJ is concerned this shows Apple's real intent: it didn't want agency pricing for its own sake or because it thought agency pricing was a good model. It wanted agency pricing only if there wouldn't be any downside. And for the publishers, the DOJ thinks it shows that they were conspiring to keep prices high.

By no means are these slam-dunk arguments. Something legal doesn't become illegal just because you have a bad intent. If it's legal to have agency pricing, then it's legal to do it even if you want to raise prices. What's not legal is to conspire with respect to prices and then take steps to put that into effect. This is what the DOJ will have to prove in order to win its case. (This is also why despite some of the outcry this case won't actually affect people like indie authors or small publishing houses that want to use the agency model: they didn't conspire around pricing so their use of the agency model isn't illegal.)

But this answer leads to the another possible defense the publishers and Apple could raise. I'll go into that in more detail in the next post. For now, ask one question: is the DOJ actually arguing that publishers are legally obligated to sell e-books to Amazon?

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