This article originally appeared in TidBITS on 2013-07-10 at 4:34 p.m.
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Explaining the Apple Ebook Price Fixing Suit

by Adam C. Engst

By now, you’ve undoubtedly heard the news that U.S. District Judge Denise Cote has ruled against Apple in the antitrust suit filed against the company by the U.S. Department of Justice and 33 states, saying that Apple conspired with five major publishers to raise the retail prices of ebooks. Apple has announced that it will appeal [1], denying any wrongdoing. Initially, the next trial was supposed to set damages, but I imagine that will be set aside until the appeal is decided, first at the 2nd Circuit Court of Appeals, and then the Supreme Court if necessary.

Cote’s 160-page opinion [2] is remarkably well-written and is a fascinating read, at least if you’re interested in the chronology and minutiae of this case. I’ve read the entire thing, and have found it far more compelling than the soap opera media coverage of the trial, which took place from 3 June 2013 through 20 June 2013. It also clarifies numerous points and questions that came up during and since the trial. Rather than attempt to summarize the entire opinion, I’m going to focus on answering questions surrounding it, based on what Judge Cote wrote.

If you have other queries that I haven’t addressed here, please ask them in the comments, and I’ll do my best to answer them.

Where did this situation come from?

There are two key factors that led to this suit. Most important was Amazon’s pricing of bestselling ebooks at $9.99, even when that was below the price Amazon paid publishers for those titles. The publishers hated Amazon’s pricing structure because they feared it would change reader perceptions about what a book ought to cost, they were worried that cheap ebook sales would cut into expensive hardcover sales, and they were concerned that the rise of inexpensive ebooks would further damage the brick-and-mortar bookstores that served as alternatives to Amazon. In 2009, Amazon controlled 90 percent of the ebook market, due to the success of the Kindle and to its lowballing of prices, so the publishers were looking for solutions to what was called “the Amazon problem.”

The second factor was the introduction of the iPad in January 2010, and Apple’s desire to open a bookstore for ebooks along the lines of the iTunes Store. In June 2009, the book industry as a whole was estimated to be $35 to $42 billion in size, with trade books — books distributed to the general public — comprising $12.5 billion of that. Although trade ebooks were only $100 million or so at that time, predictions put the ebook market size at $1 billion by 2010. So Apple wanted in, and went to the Big Six publishers to negotiate an agreement to resell their books.

The publishers saw working with Apple as a chance — perhaps the only chance, an idea emphasized by Apple in the negotiations — to fight back against Amazon, with the publishers desperate for any means to raise ebook prices and Apple standing as one of the few companies with enough clout to compete against Amazon, thanks to the iPad hardware and the hundreds of millions of iTunes accounts.

How do pricing models fit into the equation?

Traditionally, books are sold via “wholesale” pricing, which means that the publisher sets a cover price for a book, and bookstores pay a negotiated wholesale price, usually about 50 percent of the cover price. The bookstore then sets the price wherever it likes. For instance, a $30 hardcover might sell for $15 to bookstores, and the bookstores might sell it for $25, advertising the $5 discount from the cover price. (As an aside, many author royalty agreements pay a percentage of the wholesale price, so if an author gets a 10 percent royalty, she’ll earn $1.50 on that $30 book.)

Amazon was exploiting the wholesale model by paying more for some ebooks than it was selling them for, the classic loss-leader approach. For every bestselling ebook Amazon sold for $9.99, the company might have lost $3 to $4. So, although the publishers were incredibly unhappy with the $9.99 price, they were still making the same amount as they would have had Amazon sold the book for $19.99.

When Apple first approached the publishers, it was assuming that it would purchase ebooks on a wholesale model, as the company does for music, TV shows, and movies sold in the iTunes Store. However, several of the publishers suggested that Apple instead adopt an agency model for ebook distribution, and after initially rejecting the idea, Apple became enamored of it.

In an “agency” model, publishers set the prices that retailers will sell books for, and then take a set percentage of those prices. Apple is no stranger to the agency model, since that’s exactly what’s used for the App Store and Mac App Store, where developers set their prices and take 70 percent from each sale, leaving 30 percent for Apple.

So what’s the problem with the agency model?

Nothing, inherently. Retailers tend not to like the agency model because it gives publishers control over pricing, something retailers prefer to manage on their own. But it’s important to note that there is nothing illegal about the agency model.

Apple’s legal woes instead stem from how the agency model ended up being applied more broadly, thanks to two other contractual requirements: pricing tiers with caps and a most-favored-nation (MFN) clause.

The pricing tiers with caps were designed to prevent Apple from being embarrassed with unrealistically high prices — Apple’s executives knew the company would be ridiculed if iBookstore prices were far higher than Amazon’s. Although the details varied throughout the negotiations, Apple ultimately succeeded in setting two basic price tiers of $12.99 and $14.99, with the first for new release hardcovers priced between $25 and $27.50, and the second for new releases priced between $27.51 and $30. There were also $16.99 and $19.99 tiers for new releases priced higher than that, by $5 increments.

The second key factor was the MFN clause, which stated that if any ebook retailer charged less than Apple was charging in the iBookstore, Apple could match it, regardless of what price the publisher had set. So, if Amazon had some bestseller for $9.99, Apple could also sell it for $9.99, even if the book would otherwise have fallen into the $14.99 tier.

Before coming up with the MFN clause, Apple had initially suggested that the publishers all adopt the agency model for all ebook retailers across the board. Apple’s goal in doing this was to avoid price competition with Amazon, since under the agency model, the publishers would likely set the same price everywhere. Although the publishers weren’t upset by this (they were less happy with the price tiers and 30 percent fee), Apple switched to using the MFN clause because it solved the price competition problem more elegantly, encouraging rather than requiring the publishers to move other ebook retailers to the agency model.

Why was this? Without across-the-board agency pricing, the MFN clause meant that publishers would earn far less money any time another ebook retailer lowballed a price and Apple matched it. The only rational reaction for the publishers was to move all retailers to agency pricing, so the same book was for sale at the same price everywhere.

An open question is why Apple was so interested in eliminating price competition. There’s some indication that Apple didn’t want to compete with Amazon’s loss-leader strategy, but Apple’s cash hoard would certainly have enabled it to win a price war with Amazon, which doesn’t have nearly Apple’s resources.

How this is an antitrust violation?

Again, there is nothing inherently illegal with the agency model, price tiers, or an MFN clause. And there isn’t even anything wrong with combining them in negotiation with a single company. The problem comes when they’re combined in negotiation with six publishers that between them control nearly 50 percent of the book market, and over 90 percent of the New York Times bestsellers.

After five of the Big Six publishers signed Apple’s deal, they immediately went to Amazon to switch their wholesale pricing agreements to the agency model. Amazon was understandably upset about this, due to the loss of pricing control, but had no choice but to accept in the end. Subsequently, the publishers also negotiated an agency model with Google, which was similarly unhappy.

Once the agency model was in place, ebook prices from those publishers rose immediately. Roughly two weeks after the move, prices at Amazon rose 14.2 percent for new releases, 42.7 percent for New York Times bestsellers, and 18.6 percent overall. Publishers raised prices for their hardcovers as well, to bump them into higher price tiers, and increased prices for their backlist books, older titles that sell relatively few copies each, but which form the long tail of book sales.

Simultaneously, and in a win for the basic economic rule that higher prices result in lower sales, the number of sales dropped by 12 to 17 percent per publisher. In short, customers bought fewer books and paid more per book.

In Judge Cote’s opinion, the combination of Apple working with all the publishers simultaneously to fix ebook prices in such a way as to cause them to rise was where Apple violated the Sherman Antitrust Act [3]. Whether the 2nd Circuit Court of Appeals upholds or strikes down Cote’s ruling remains to be seen.

Do publishers and authors earn more money because of these higher prices?

That’s one of the counterintuitive aspects of this situation. Yes, customers paid more — as noted, prices rose nearly 19 percent per book overall after the agency model went into effect.

But publishers earned less per book, with some predicting the overall drop in earnings would be as much as 17 percent. Here’s why. Consider a $29.99 hardcover that Apple would sell for $14.99. The publisher would earn 70 percent of that, or roughly $10.50. But under the wholesale model, the publisher might have sold that book to Amazon for as much as $15. Plus, because publishers were earning less, they also allowed fewer promotions that would have reduced prices for customers.

Since author royalties generally track with publisher earnings, most authors presumably earned less as well, though the specifics undoubtedly varied by contract.

Ironically, the agency model probably caused Amazon to earn more than it was earning under the wholesale model, since it could no longer sell ebooks as loss leaders. But just as the publishers didn’t agree to the agency model in order to earn more money, Amazon wasn’t utilizing the wholesale model because it wanted to earn less. In both cases, the issue was control over pricing.

Isn’t Amazon really the bad guy in this case?

In a word, yes — Amazon started the snowball rolling by selling ebooks as loss leaders. But you shouldn’t be irritated that the judge is somehow letting Amazon off the hook. Amazon isn’t on any hook here — this case is purely about whether Apple’s activities in negotiating agency model contracts with price tiers and MFN clauses with the major publishers is a violation of antitrust law.

That’s not to say that Amazon couldn’t be brought up on antitrust charges for predatory pricing [4], but that would be an entirely separate case. Indeed, Judge Cote even addresses this:

If Apple is suggesting that Amazon was engaging in illegal, monopolistic practices, and that Apple’s combination with the Publisher Defendants to deprive a monopolist of some of its market power is pro-competitive and healthy for our economy, it is wrong. This trial has not been the occasion to decide whether Amazon’s choice to sell NYT Bestsellers or other New Releases as loss leaders was an unfair trade practice or in any other way a violation of law. If it was, however, the remedy for illegal conduct is a complaint lodged with the proper law enforcement offices or a civil suit or both.

Nor should you interpret Amazon’s role in this case to mean that Apple was somehow riding in on a white horse to save the day for customers. First, the agreements that Apple negotiated with the publishers caused ebook prices to rise, which is one of the things antitrust law is aimed at preventing. Second, although it’s easy to say that the iBookstore increased competition in the ebook market by providing an alternative to Amazon, Apple’s agency model and MFN clause ensured that the publishers would charge the same price everywhere, entirely eliminating competition on price. That in turn would likely have made it significantly harder for any new companies to enter the ebook retailing market and compete with Apple and Amazon.

What happened with the publishers?

Initially the U.S. Department of Justice filed this lawsuit against Apple and five of the Big Six publishers (Random House didn’t agree to the initial iBookstore contracts). Over time, though, all five publishers settled with the Department of Justice [5], basically agreeing to terminate existing contracts with Apple and other ebook retailers, and renegotiate contracts that don’t prevent retailers from discounting ebook prices. However, retailers are not allowed to discount below the point of breaking even on a publisher’s works overall. In other words, Amazon can still discount titles below cost, but not to the extent of losing money on a particular publisher’s titles in their entirety.

From a practical standpoint, ebook retailers have gained price control again, and ebook prices have vacillated, dropping initially, then rising slowly. Plus, Amazon has started raising prices [6] for scholarly and small-press books.

Does this decision have any effect on the App Store or other Apple businesses?

For the moment, definitely not, since Apple is appealing the decision. A subsequent trial was to be scheduled to assess damages, but there was no hint in the opinion that Apple’s actions in this particular case are in any way related to its other businesses.

So the fact that the App Store and Mac App Store rely on the agency model, and that Apple has an MFN clause in one of its music agreements (which used a wholesale model) are simply unrelated for now.

Wasn’t the judge biased against Apple from the start?

Much was made of the fact that Judge Cote said before the trial: “I believe that the government will be able to show at trial direct evidence that Apple knowingly participated in and facilitated a conspiracy to raise prices of e-books, and that the circumstantial evidence in this case, including the terms of the agreements, will confirm that.”

What’s now clear is that this wasn’t the gaffe it was made out to be. In accordance with the court’s procedures for non-jury trials, much of the information was submitted during the pre-trial phase. Judge Cote had prepared a draft opinion based on those materials, and the parties to the case understood that the final decision would incorporate both the pre-trial information and the evidence that came out during the trial.

So, as the opinion states in footnote 2: “Consistent with these procedures, and with the expectation that the Court had already prepared a draft opinion, the parties jointly asked the Court for its preliminary views on the merits at the final pretrial conference held on May 23, 2013.” Hence Judge Cote’s statement.

What does Apple’s appeal hinge on?

After working through the chronology of the case, Judge Cote examines the six major arguments that Apple raised in its defense. In each case, she dismisses Apple’s position, of course, but Apple’s lawyers will undoubtedly be digging into her reasoning in their appeal.

Not being a lawyer, I’m uncomfortable analyzing the strength or weakness of each argument, or of Judge Cote’s counter-claims, but Philip Elmer-DeWitt, writing for CNN Money [7], runs through each argument, laying out which he believes are the strongest and weakest.

Regardless, it’s now a matter for the 2nd Circuit Court of Appeals to decide!

[1]: http://tech.fortune.cnn.com/2013/07/10/apple-ebook-antitrust-ruling/
[2]: http://www.nysd.uscourts.gov/cases/show.php?db=special&id=306
[3]: http://en.wikipedia.org/wiki/Sherman_Antitrust_Act
[4]: http://en.wikipedia.org/wiki/Predatory_pricing
[5]: http://www.justice.gov/opa/pr/2012/April/12-at-457.html
[6]: http://www.nytimes.com/2013/07/05/business/as-competition-wanes-amazon-cuts-back-its-discounts.html
[7]: http://tech.fortune.cnn.com/2013/07/10/apple-ebook-verdict-appeal/