How Do You Like Them Apples?

The US DOJ has filed suit against Apple (AAPL) and some book publishers over their agreement to replace the existing wholesale model for ebooks with an “agency model.” Under the old model, publishers would charge a wholesale price to a retailer, and the retailer would choose its own price. Under the agency model, the publishers would set the retail price, and the agent/retailer (e.g., Apple) would receive a fixed margin (30 percent).

I am inherently more skeptical about antitrust actions involving vertical restrictions, although there is an element of horizontal coordination here. Normally, you would expect that wholesalers/manufacturers would love retailers who sell for very low margins, and would resist guaranteeing a pretty fat margin, as lower margins downstream increase the derived demand at the wholesale level. So why would publishers want higher margins downstream? That suggests that there was some sort of inefficiency associated with the wholesale model that the agency model was intended to correct.

The agency model is, in essence, a resale price maintenance strategy. Once upon a time these were per se illegal, but scholarship pioneered by my thesis advisor Lester Telser revolutionized understanding of this practice, and led to RPM being evaluated on a rule of reason basis.

Telser argued that free rider problems could undermine the incentives of retailers to provide information and special services that increased the demand for a wholesaler’s product: a consumer could go to a retailer that provided the information/service, then go to a cut price retailer that didn’t when actually purchasing. Due to the discount retailer’s cut rate price, the information/service providing retailer wouldn’t get any return from supplying these (costly) services, so few or no services would be offered. This would reduce the demand for the wholesaler’s product. Wholesalers/manufacturers would have an incentive to guarantee a retail margin to prevent undercutting by free riders.

I don’t know enough about book publishing to opine whether resellers provide services or information that is subject to free riding.

In any event, publishers didn’t seem to be focusing on that issue. It was Amazon’s (AMZN) dominant position as a retailer that seemed to be the reason for changing the model.

Time permitting, I give this some more thought. Several questions suggest to me that this will be a challenge for the DOJ. In particular, what were the publishers getting from Apple (and potentially other resellers adopting the model) that would make it worthwhile to guarantee the resellers a fat margin? Why didn’t the publishers love the fact that Amazon was willing to sell at very low margin? These two questions suggest this is not a garden variety horizontal price fixing case, and that the conduct (and contracts) at issue were designed to address a free rider problem or other source of distortion. How does Amazon’s potential monopsony power affect the analysis? What are the implications of the high fixed cost-zero marginal cost nature of epublishing? Specifically, when combined with the potential for monopsony power downstream, could finding the agency model illegal have adverse dynamic implications (fewer books published, for instance)?

A lot of complicated issues here, and lurid tales of secretive dinners in London tell me zip about the economics. My (rebuttable) presumption is that vertical restrictions usually have efficiency purposes. The nature of the agreement with Apple shares similarities with other efficiency enhancing vertical restrictions, and doesn’t make a lot of sense as a means of facilitating collusion among publishers. To persuade me (not that that matters in the scheme of things) the government would have to explain why colluding publishers would use this form of agreement, and why they would want to guarantee retailers a big margin.

I am sure the defendants’ lawyers will make every effort to make this into a vertical restrictions case instead of a price fixing case. They seem to have considerable material to work with.

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About Craig Pirrong 238 Articles

Affiliation: University of Houston

Dr Pirrong is Professor of Finance, and Energy Markets Director for the Global Energy Management Institute at the Bauer College of Business of the University of Houston. He was previously Watson Family Professor of Commodity and Financial Risk Management at Oklahoma State University, and a faculty member at the University of Michigan, the University of Chicago, and Washington University.

Professor Pirrong's research focuses on the organization of financial exchanges, derivatives clearing, competition between exchanges, commodity markets, derivatives market manipulation, the relation between market fundamentals and commodity price dynamics, and the implications of this relation for the pricing of commodity derivatives. He has published 30 articles in professional publications, is the author of three books, and has consulted widely, primarily on commodity and market manipulation-related issues.

He holds a Ph.D. in business economics from the University of Chicago.

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