Winning the Hardware Software Game Winning the Hardware-Software Game - 2nd Edition

Using Game Theory to Optimize the Pace of New Technology Adoption
  • How do you encourage speedier adoption of your product or service?
  • How do you increase the value your product or service creates for your customers?
  • How do you extract more of the value created by your product or service for yourself?

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The e-Book Pricing Battle

The following is a brief history of the e-book pricing battle that has been taking place. The passage quotes heavily from three articles:

“Publishers, Amazon in Flux in e-Book Pricing Fray” by Phil Wahba and Alexandria Sage, Reuters  

“Amazon Looking Foolish in e-Book Flap” by Therese Poletti, MarketWatch

“Cost of an E-Book Will Be Going Up” by Motoko Rich and Brad Stone, NYT

Being first to market, Amazon established a $9.99 e-book pricing model.

Amazon was first on the market with an electronic book (e-book) reader (e-reader), the Kindle.  Being first to market and having a large market presence together provided Amazon with enough leverage vis-à-vis publishers as to be able to establish a low, fixed sales price of $9.99 for all sales of e-books to Kindle users. This single, low, fixed price for all books is analogous to Steve Job’s iTunes music store pricing model, which initially sold all songs for 99 cents each.

Understand, though, that Amazon pays publishers about half the list price for books.  So if the list price of a new release hardback is $27.50, then Amazon loses about $4 on each $9.99 title it sells.  Why sell books below cost? Amazon has been trying to quickly build a dominant position around its sprawling e-bookstore and tying the Kindle to that store. It sells its e-books as loss-leaders, according to Wall Street analysts. Its tactic has been to head off Apple's anticipated entry into the e-book market by offering digital best-selling books at very low prices, propelling its Kindle reader to dominate the market.

Apple’s entry into the e-book market with its iPad e-reader has decreased Amazon’s market power.

Now Apple is entering the e-book market with its iPad.  In contrast to Amazon’s fixed, low price of $9.99 for all titles, Apple negotiated with publishers to sell e-books for its iPads at higher sales prices, ranging from $12.99 to $14.99 per title.

The emergence of a potentially strong distribution alternative in the form of Apple's iPad has given publishers the much-needed leverage to demand a change in the low, fixed-price book model Amazon has been using for the Kindle.  Publishers have feared that low e-book prices will generally devalue books and additionally cannibalize sales of its higher margin hardcover books.

Book publishers are now transitioning to an “agency model” for e-books.

The agency model transfers the retail pricing power to the publisher and gives a fixed cut to retailers.  More specifically, the publisher establishes the price for each e-book, and the distributor (Amazon or Apple) takes a 30% distribution fee.

The increase in e-book prices from $9.99 to $12.99 - $14.99 has caused a backlash from current Kindle users.

Just what e-books are worth is a matter of debate.  Some e-book buyers say that since publishers do not have to pay to print, store or distribute e-books, they should be much cheaper than print book.  However, publishers argue that printing and distribution represents a small proportion of the total cost of making a book.  To consumers who do not pay much attention to the economics of publishing, though, such arguments are trumped by the fact that e-books have been available for $9.99 for more than a year.

With higher e-book prices users of e-readers may instead either resort to piracy and/or forgoing reading altogether in favor of other activities.

The e-Book Game

The dynamics of the battle between e-reader manufacturers, e-book publishers, and consumers is a game: the players in the game are the manufacturers, publishers, and consumers, and each player’s payoff (profits) is affected by the actions taken by the other players.  Let’s consider the incentives faced by each player to address some of the key points of contention described in the history above:

  • As long as publishers are getting paid the same amount, why do they care what price Amazon charges for e-books?
  • Why would Amazon price e-books below cost?
  • Why would Apple price e-books above Amazon, risking a competitive disadvantage?
  • What should the price of e-books be?
  • Will higher price of e-books lead to increased piracy and/or lower use of e-readers?

ebook_game

Publishers of e-Books

As long as publishers are getting paid the same amount, why do they care what price Amazon charges for e-books?

Clearly, the prices that consumers currently pay for products affect the short-term profitabilities of both the manufacturers who make products, as well as the distributors or retailers who sell them – the higher the price, the greater the profit.  However, the prices consumers currently pay also affect the potential long-term profitability of manufacturers and retailers, because they constrict the prices consumers will be willing to pay in the future for those same (or similar) products.  This is the idea behind reference prices.

The following passage on reference prices was taken from Branding Strategy Insider:

People often compare a product’s price to a “reference price” that they maintain in their minds for the product or product category in question.  A “reference price” is the price that people expect or deem to be reasonable for a certain type of product.

Several factors affect reference prices:

• Memory of past prices

• Frame of reference (compared to competitive prices, pre-sale prices, manufacturer’s suggested prices, channel-specific prices, marked prices before discounts, substitute product prices, etc.)  -- Creating the most advantageous (and believable) competitive frame of reference is essential to achieving a price premium

• Prices of other products on the same shelf, in the same catalog, or in the same product line -- The addition of a more premium priced product typically increases sales of other lower-priced products in the same product line

• The way the price is presented – for instance, absolute number versus per quart, per pound, per hour of use, per application, for the result achieved, etc.; also four simple payments of $69.95 versus $279.80; for automobiles: total purchase price versus monthly loan payment versus monthly lease payment

• The order in which people see a range of prices – like when a realtor uses the trick of showing the poorest value house first.

In the case of e-books, publishers were afraid that by continuing to charge $9.99 for e-books, Amazon would reduce consumers’ reference prices for books.  If this happened, it would decrease the price consumers would be willing to pay in the future for all books.

Manufacturers of e-Readers

Why would Amazon price e-books below cost?

Three strategies come to mind that involve below-cost pricing.  The first is Amazon could be using e-books as loss leaders.  Loss leaders are products sold by retailers at less-than-profitable prices.  The very low prices of the loss leaders attract customers to the retailer's store, where the customers may then purchase other, higher-margin products.  However, in the case of e-books, it is unlikely Amazon is using them as a loss leader. Kindle users who are attracted to Amazon by low e-book prices are bound to buy more e-books, rather than other, higher margin books or other Amazon products.  In this case below-cost-pricing would simply generate losses for Amazon.

The second strategy that involves below-cost-pricing is the razor and blades model, now probably better recognized as the printer and ink model.  Applied to the Amazon situation, this would mean Amazon is selling e-books at very low prices in order to encourage sales of high-margin Kindle e-readers, where the high profits generated from sales of e-readers would more than compensate for the losses associated with sales of e-books.  It is doubtful that Amazon is using the razor and blades model, though.  Properly applied, the model would entail losing money on the system component that is purchased by system users one time (that is, the hardware component), while making up for the losses on sales of components that are purchased repeatedly (that is, the consumables component).  In other words, if Amazon were using the razor and blades model, it would sell the e-readers at low prices, and it would sell the e-books at high prices, which is exactly the opposite of what it is doing.

This leaves the low introductory pricing model, which makes perfect sense here.  Applied to the Amazon situation, this entails offering e-books for sale at low prices during some limited initial offering period, so as to encourage user adoption of Amazon’s e-book/e-reader system.  This strategy is particularly effective, since the system being adopted involves network effects: the generation of an initial base of installed Kindle users will attract more suppliers of e-books for the Kindle, which will lead new users to subsequently adopt the Amazon’s e-book/e-reader system.   Once a large enough base of users has committed to Amazon’s system, Amazon will then be able to increase the price of e-books to more “reasonable” levels.  At reasonable e-book prices, the base of Kindle users will still buy e-books at the higher prices, because it will be cheaper than switching to a different e-book/e-reader system (such as an Apple iPad), and the network effects (increasingly large availability of e-books for the increasingly large base of Kindle users) will continue to attract new users to adopt Amazon’s system. 

Why would Apple price e-books above Amazon, risking a competitive disadvantage?

A blog entry by Lima Al Azzeh offers this reasoning for Apple’s pricing strategy:

Apple’s decision to introduce variable pricing in the digital books industry was a well-learned lesson they applied from negotiations with major record labels over iTunes prices last year.

In April 2009 Apple announced that they were going to vary the prices of songs, moving away from the 99-cent standard, after negotiations with four major record labels. The price of more popular songs rose to $1.29, while the price of “oldies but goodies” were dropped to 69 cents…

Though Apple agreed to the terms of variable pricing, they did so in exchange for the rights to sell songs that are stripped of copy protection software. Removing DRM (Digital Restrictions Management) from iTunes songs would allow consumers to freely move their songs between PCs and other digital devices. In negotiating this exchange, Apple was able to leverage the strength of their brand to ensure that customers would continue to use iTunes as their primary resource for downloading music, despite rising costs.

Based on the fact that Apple immediately employed the variable pricing strategy when it came to digital books, one can safely assume that they’ve learned their lesson. Not only that, but in agreeing to this system from the beginning, Apple has created an alliance with major book publishers by showing that they too have a vested interest in protecting the interests of, what Scott Westerfeld of The Guardian so elegantly described as, an “ancient industry with many arcane traditions that's in a state of technological flux”.

Virginia Postrel of The Atlantic offers this insight:

As many commentators have noted, Amazon is not just selling e-books. It's also selling the Kindle. To encourage sales of its device, the company has even been willing to sell Kindle editions for less than the wholesale price it pays for them. It's presumably maximizing profit on the whole system, not just each individual title.

Apple, too, is a system seller, and a device company to boot. But it doesn't have to sell a single book for the iPad to succeed. Books are just one app among many... The iPad is exciting not as a way to sell or read books as they currently exist but as a tool for reinventing them as multimedia. The book angle also helps generate good press, since journalists are desperate for any evidence that writing will pay in the future.

Apple doesn't need to maximize book sales. It simply needs to keep publishers happy enough to maintain an impressive sounding inventory of titles while waiting for entirely new forms of publishing to develop. After all, as Steve Jobs famously put it, "people don't read anymore."

Consumers

What should the price of e-books be?

I was trying to think about how to best phrase this question, when I realized that there are several variations on the question, each of which has a vastly different answer:

  • What is the value of e-books? Or, equivalently, what are e-books worth?

The value of e-books has to do with the advantages that e-books offer over their alternatives.  The primary advantages of e-books are their immediate availability (you can download them on your e-reader without having to go to the store or wait for the arrival of a mail order), their compactness (you can fit an “unlimited” number of e-books on your e-reader), and their durability (they don’t wear like hardcopy books do).

  • What price will consumers pay for e-books?

The price consumers will pay for e-books has to do primarily with the price of available alternatives (hardcopy books) and the attitudes of consumers: many users believe that all content, digital content in particular, should be free.  These users will not be apt to pay much if anything for e-books and will probably end up pirating them.  Others will use a reference price concept (the concept of references prices is discussed above in the section on Publishers).

In the reference price case, the illusion that e-books should be priced below hardcopy books “since publishers do not have to pay to print, store or distribute e-books” could be overcome either by stressing the added value of e-books (discussed in the bullet point above), or by trying to educate people as to the large up-front costs associated with the production of books.  Given the difficulties many suppliers of IP-intensive products have had in this area (pharmaceutical companies in particular), I’d say good luck in this latter endeavor.

  • What is a fair price for e-books?

A fair price for e-books would consider both fairness to consumers, which would consider the price of available alternatives (hardcopy books), as well as fairness to suppliers, which would consider the costs of supplying e-books.

Again, if suppliers are unable to educate readers as to the large up-front costs associated with the production of e-books, the price of e-books will probably end up being less than, perhaps significantly so, the price of hardcopy books.

  • What is a sustainable price for e-books?

A sustainable price for e-books would entail one that consumers would be willing to pay over the long run, AND one that would cover the total costs of supply (including development costs).

I think e-books will eventually end up being sold in subscription form, like Netflix.  In the case of movies, the revenues movie makers generate from Netflix is not enough to recover the large costs of making movies.  Rather, the costs are recovered mostly through ticket sales, sales of associated merchandise and sponsorships, and to an increasingly lesser extent, sales of DVDs.

In this case of e-books, publishers must be able to recover the up-front costs associated with bringing new books to market.  If e-books end up being sold through subscription form, then publishers will still have to rely on hard-copy sales of books (and/or sales of movie rights) to recover their costs.  In other words, the greater the extent to which readers adopt e-books in place of hardcopy books, the more difficult it will be for publishers to recover their costs. 

Will higher price of e-books lead to increased piracy and/or lower use of e-readers?

There is most likely a certain segment of the population who will never pay for e-books, but who will gladly take them for free.  Furthermore, the fact that digital documents are so easy to steal (relatively speaking) in and of itself will lead to a good amount of piracy of e-books.

The Law of Demand says that if the price of anything is raised it will always lead to fewer sales.  So in this sense, the use of e-readers will naturally be less when e-books are priced at $9.99 than when they are priced at $12.99 - $14.99.  However, taking a big picture view, it’s still way too early in the adoption lifecycle of e-reader/e-book systems to definitively say that an increase in the price of e-books from $9.99 to $12.99 - $14.99 will have a significant detrimental impact on long-term sales of e-reader/e-book systems.  In fact, I would bet that the pricing of e-books will go through a lot of changes before it eventually settles into a steady state pricing model, and I think e-readers in some form or other will eventually prove to be a very successful technology.  There’s just too much potential for classroom use, personal use, business use, and so on.

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