Does Apple
Apple’’s agency model raise
eBook prices?
Øystein Foros, Hans Jarle Kind, Greg Shaffer, 14 November 2013
Apple, Amazon and Google are the major downstream firms in the markets for
eBooks and apps. Apple uses the so-called ‘agency’ business model to
regulate the vertical relationship in the value chain.
With this model:
•
Apple does not pay any unit wholesale prices; instead there is a split, such that the
upstream content providers receive 70% of the sales revenue and Apple 30%.
•
This 70/30 revenue split is used no matter how large the upstream firms are –
Macmillan does not obtain a better deal than a small, insignificant publisher.
•
More importantly, the agency model delegates retail pricing to upstream firms.
This resale price maintenance aspect of the model is highly controversial, and
competition authorities and others fear that it raises retail prices.
In the eBook market, US antitrust authorities further conjecture that the rapid
industry-wide adoption of the agency model after Apple entered the industry
was an outcome of tacit collusion among Apple and five major publishers (see
e.g. Manne 2013 and Bobelian 2013). It has also been claimed that Amazon
de facto was forced by major eBook publishers to change from the traditional
wholesale model to the agency model.
While it is obvious that tacit collusion among upstream firms might increase
retail prices, it is less clear whether resale pricing per se is anti-competitive in
the industries where Apple operates. Indeed, Apple does not always prefer
resale prices (though it always uses the 70/30 revenue split). One illustration of
this is that when Apple entered the music industry with iTunes, Steve Jobs
dictated a retail price of 99 cents per song, leaving no room for the music
publishers to influence the price.
In Foros, Kind and Shaffer (2013) we raise the questions of:
•
Why powerful firms like Apple cede control of retail pricing to content providers.
•
What determines whether we will actually see an industry-wide adoption of the
agency model (e.g., that both Apple and Amazon voluntarily will use the agency
model for eBooks).
•
What the role is for most-favoured nation clauses (MFN) in an industry where one
or more downstream firms have adopted the agency model.
Why cede control of retail pricing to content providers?
Content providers are often better informed than retailers about the market
potential for their products. In such cases, there might be efficiency gains from
letting content providers determine retail prices (Foros, Kind and Hagen 2009).
By the same token, more autonomy to content providers may stimulate
entrepreneurship and innovation.
In Foros, Kind and Shaffer (2013) we intentionally abstract from asymmetric
information, and fix the number and the quality of the products offered in the
market. We set up a model with upstream and downstream competition, as
illustrated in Figure 1. For given revenue shares (e.g. the 70/30 rule), we
compare the outcome when the downstream firms (platforms like Apple,
Amazon and Google) decide retail prices, to a setting where retail prices are
decided by the upstream firms (content providers). The latter setting is the
agency model.
Figure 1. Upstream firms are content providers like publishers for eBooks and
developers of applications in app stores. The downstream firms are platforms
like Apple, Google and Amazon
Public debate often gives the impression that resale pricing eliminates
competition. This, of course, is incorrect. What resale pricing does do is to shift
competition from the downstream level to the upstream level. A reasonable
conjecture is, therefore, that the agency model tends to raise prices if and only
if the competitive pressure is weaker upstream than downstream. This is
formally proved in Foros, Kind and Shaffer (2013). Thus, other things equal,
one would expect downstream firms to prefer the agency model when
upstream competitive pressure is relatively weak.
In Apple’s App Store and Google’s Google Play there are evidently a large
number of small and competing upstream firms (developers of apps). Resale
pricing is, therefore, likely to reduce prices – a claim which is consistent with
widespread complaints from app developers that low prices push down profits
(Boudreau 2012). Consequently, it is hard to argue that ceding control of retail
pricing to content providers by platforms like Apple and Google is an
anti-competitive act. The motivation for imposing resale prices is presumably
to stimulate entrepreneurship, rather than to increase prices.
So what about the eBook market, does the resale pricing mechanism raise
prices there? Unlike the app market, in the eBook market we can, to some
extent, compare prices with and without such resale pricing. Before Apple
entered the market with the iBook store, downstream firms were responsible
for determining retail prices, both for printed and digital books. After Apple's
entry, however, there was a rapid industry-wide transition to the agency model
during the spring of 2010. And prices did increase!
The US Department of Justice (DOJ) claims that Apple's motivation for using
resale pricing was to stop the low prices set by Amazon for eBooks, described
by publishers as "the $9.99 problem". Compared to the apps market, the
upstream eBook market consists of a relatively small number of publishers.
Nonetheless, it is not obvious that the competitive pressure is weaker
upstream than downstream in this market either, since there are only two
major platforms selling eBooks on a global scale – Apple and Amazon (and
you cannot readily read an “Apple book” on an Amazon tablet).
So why did prices rise? Presumably because the publishers wanted to protect
the profit they earn on printed books. If printed books and eBooks are
substitutes, a shift to the agency model might increase prices even if it should
be true that eBook upstream competition is tougher than eBook downstream
competition. It is thus not resale pricing which leads to price inflation, but rather
the fact that the pricing decisions are transferred to firms which have
incentives to compete more softly due to the existence of lucrative
neighbouring markets with (imperfect) substitutes (see also Abhiskek et al
2013). In the same way, a key motivation behind Amazon’s low-price strategy
for eBooks was to increase the sale of their complementary Kindle eBook
reader (see Gaudin and White 2013). Jobs’ resistance to endorse Amazon’s
low prices indicates that Apple’s analogue motivation (promote sales of iPads)
was weaker.
What determines when platforms will adopt the agency
model?
During the spring of 2010 there was a rapid industry-wide adoption of the
agency model in the eBook market. The US antitrust authorities’ conjecture
was that Apple and major publishers pressured Amazon into adopting the
agency model. However, Foros, Kind and Shaffer (2013) show that
industry-wide adoption of the agency model may arise in equilibrium if this
raises industry profits, i.e. if the competitive pressure is lower at the upstream
level than at the downstream level. There is one important caveat, though –the
downstream firms have incentives to unilaterally deviate from the agency
model if upstream competition is sufficiently weak. This might appear as a
paradox, since it is precisely when upstream competition is weak that the
industry gains from using resale pricing are particularly large. The problem is
that the high resale prices give each downstream firm incentive to undercut the
rival in order to steal business.
So is there anything Steve Jobs could have done to prevent such a prisoner’s
dilemma situation? This is where the Most Favoured Nation (MFN) might enter
the picture.
What is the role of Apple
Apple’’s MFN clause?
When Apple entered the eBook market, it included a retail MFN in its contracts.
This MFN clause means that the publishers cannot set higher retail prices at
Apple than the retail prices at other downstream firms, regardless of whether
the latters' prices are controlled by the publishers (e.g., the publishers are not
allowed to set Apple's prices higher than Amazon's prices even if Amazon
controls its own prices).
Johnson (2013 a, b) shows that the MFN clause does not affect prices if the
agency model is adopted industry-wide. The reason is that retail prices are
then solely determined by the competitive pressure upstream. Interestingly,
though, Johnson (op cit) shows that an MFN clause increases the bargaining
power of the downstream firms, such that they can demand a higher revenue
share. This might help to explain why Apple is able to capture 30% of the sales
revenue also in the eBook market, even though the average upstream firm in
this market is larger, and has a greater bargaining power over Apple than has
the average app developer. But since Apple uses the 70/30 rule in all markets,
the company’s reputation would possibly allow it to demand 30% in any case.
In Foros, Kind and Shaffer (2013) we, thus, hold the downstream firms’
revenue shares fixed, and consider a case where upstream competition is so
weak that the prisoner’s dilemma situation described above arises. We
subsequently show how MFN might ensure that even if the rival firm (e.g.,
Amazon) does not adopt the agency model, equilibrium prices will be the same
as they would be if both firms adopted the agency model. This has the
interesting implication that it was unnecessary to 'force'Amazon to delegate
the pricing decisions to the publishers. With Apple’s MFN, there was simply no
reason for Amazon not to adopt the agency model.
References
Abhishek, V, K Jerath and Z J Zhang (2012), “To Platform Sell or Resell?
Channel Structures in Electronic Retailing”, working paper.
Bobelian, M (2013), “DOJ's Victory Over Apple May Turn Out To Be A Pyrrhic
One”, Forbes.
Boudreau, K J (2012), “Let a Thousand Flowers Bloom? An Early Look at
Large Numbers of Software App Developers and Patterns of
Innovation”, Organization Science, forthcoming.
Department of Justice (DOJ) (2012), “US v. Apple”, Inc. et al, April 11, 2012.
Foros, Ø, H J Kind and G Shaffer (2013), “Turning the Page for Business
Formats for Digital Platforms: Does Apple’s Agency Model Soften
Competition?”, CESifo Working Paper Series No. 4362.