Amazon vs. Macmillan: It's all about control

Geoffrey Manne —  7 February 2010

The Amazon vs. Macmillan controversy has been beaten to a pulp in the blogosphere.  See Megan McArdle, John Scalzi, Joshua Gans, Virginia Postrel, Lynne Kiesling, Lynne Kielsing and Lynne Kiesling, among others.  Pulp or no (get it? It’s a book/e-book pun), I haven’t seen anyone hit squarely on what I think is the crux of the issue: control rights.

Amazon is an interesting hybrid, sometimes acting as a platform, sometimes acting as a direct merchant.  In its capacity as a platform, Amazon facilitates sales of goods from other merchants to Amazon’s customers through its website.  Amazon itself doesn’t actually sell these goods (because it never actually owns them), although it operates the system that enables these sales and takes a cut.  In its capacity as a merchant, Amazon purchases goods from suppliers and sells them directly to its customers.

The Kindle makes the merchant/platform distinction even more muddled for Amazon, and the distinction is at the core of the issue.

Basically, the difference between a merchant and a platform, as suggested above, is in the degree of control an intermediary exerts over pricing and other terms of sale, and the extent to which it bears risk.  The more control, the more merchant-like; the less control, the more platform-like (Thus the Gap is a merchant; eBay is a platform).  Background economic conditions determine which model (or where on the continuum between them) is more efficient for a given intermediary or market.  As these conditions change, the optimal degree of control may change, as well.  At the same time, suppliers or intermediaries may choose to assert or deny control in response to changing economic conditions–and this choice may not be optimal.  To my thinking, this is what is going on in the book/e-book market.

Steven Pearlstein in the WaPo hints at the issue:

While markets have their flaws, over the long run they are good at executing these technological transformations. My guess is that in the not-so-distant future, best-selling authors such as John Grisham and Malcolm Gladwell — along with unknown authors peddling their first books — will publish their own works, contracting with independent editors and marketers and selling directly to consumers as much as possible. Other authors will turn to smaller, more specialized publishing houses that will offer smaller advances but bigger royalties and will be built, as they once were, around great editors. Publishers will sell their books through competing online distributors and traditional hard-copy bookstores, the latter of which will continue to exist not only as places to browse and socialize, but also as places to have printed on demand. Backlists will be infinite, pricing will be dynamic, and more copies of more books will be read and sold.

From Amazon’s point of view, this possible future is probably a quite likely one (in part because it can help to hasten its arrival), and one which does not necessarily bode well for its merchant-like business model (on which see, e.g., Charlie Martin).  But this future is a goldmine for its platform model, particularly to the extent that Amazon’s Kindle offers a widespread and attractive platform to readers and authors alike.

When it comes to selling physical books directly, Amazon has, and is used to, full control over the terms of sale.  When it comes to selling e-books, however, Amazon is not really a merchant–but it’s not (yet) exactly a platform, either.  Most obviously, there is no physical inventory for Amazon to purchase with e-books, and whether it actually purchases e-books at the time of sale to resell in each transaction (even at a predetermined price) or simply facilitates a transaction between publisher and purchaser at the time of sale, Amazon bears the same extent of inventory risk: zero. Very platform-like.  But the terms of contracts with publishers complicate matters.  Under the Amazon-negotiated pricing scheme, Amazon does, indeed, buy the e-book and re-sell it.  Although this entails no inventory risk, it does mean that Amazon bears “pricing risk” (if that’s a term) just as a merchant does, and it is stuck with the price it negotiated with publishers, no matter the price at which it actually sells its e-books.

There are other nuances.  Important among these, use of e-books purchased through Amazon requires that buyers own a Kindle (just as use of Xbox video games generally requires owners to have purchased an Xbox).  If not enough buyers own Kindles, there is little value (and some cost) to publishers in participating in the e-book market through Amazon; likewise, if not enough publishers sell e-books through Amazon, there is little value to consumers in buying a Kindle.  Again, very platform-like.  But books will be written, published and marketed regardless (or maybe almost regardless) of the number of Kindle owners, and book buyers will buy the same books (or maybe almost the same books) whether they own Kindles or not–and some Kindle owners will buy physical books even though they own Kindles.  The point is that the indirect network effects (or economies of scale–a debate for another day) that one expects in platform markets and that one sees in, say, the video game market (the more Xbox owners, the more Xbox game developers there will be and thus the more Xbox owners there will be) are severely attenuated in the e-book market currently because of the overwhelming demand for physical versions of the same books.

Now, both of these points are discussed in different ways by many of the commentators I pointed to on this issue.  Obviously the nature of the contracts between Amazon and publishers is central to the story (in fact, it is the story), and everyone has discussed the issue.  Several folks have also pointed out that e-books compete with physical books, usually to mention that publishers are interested in price discrimination (on which Kiesling and Postrel are particularly good).

But I think viewed in the light of the choice of business model it is clear that the issue is control.  The question is the extent to which Amazon should act more like a platform or more like a merchant, and this distinction is determined by the amount of control it has.  As a merchant, Amazon expects–and everyone benefits from it having–a lot of control, with both its attendant costs and benefits, over the terms of sale of its products.  As a platform, Amazon is willing to cede control over the terms of sale and just manage the platform.

When publishers assert that they want more control over e-book prices they are pushing Amazon toward a platform model for e-books.  The problem is that because book publishers do not internalize the benefits conferred on other publishers from a wider use of Amazon’s platform, their pricing incentives may be inefficient.  As others have noted, publishers probably want to engage in pricing and price discrimination that will maximize their revenue.  But this control may not be optimal for the platform at this nascent stage.

And that’s really the twist.  Amazon is not ready to be a platform in this business.  The economic conditions are not yet right and it is clearly making a lot of money selling physical books directly to its users.  The Kindle is not ubiquitous and demand for electronic versions of books is not very significant–and thus Amazon does not want to take on the full platform development and distribution risk.  Where seller control over price usually entails a distribution of inventory risk away from suppliers and toward sellers, supplier control over price correspondingly distributes platform development risk toward sellers.  Under the old system Amazon was able to encourage the distribution of the platform (the Kindle) through loss-leader pricing on e-books, ensuring that publishers shared somewhat in the costs of platform distribution (from selling correspondingly fewer physical books) and allowing Amazon to subsidize Kindle sales in a way that helped to encourage consumer familiarity with e-books.  Under the new system it does not have that ability and can only subsidize Kindle use by reducing the price of Kindles–which impedes Amazon from engaging in effective price discrimination for the Kindle, does not tie the subsidy to increased use, and will make widespread distribution of the device more expensive and more risky for Amazon.

Many of the commentators (see especially Scalzi and Kiesling) are angered by Amazon’s conduct in the affair, and see in it reason to shift their loyalty from Amazon to its competitors (or at least they did before Amazon capitulated).  I see it quite differently.  To me the affair was a dispute over control rights allocated by contract.  Amazon is willing to pay more for control–to act, in other words, like a merchant re-selling publishers’ books.  It wants this control because it wants to sell e-books at a lower price than publishers want in an effort to sell more Kindles and encourage e-book use (and, incidentally, sell fewer physical books).  At this stage in this market what is needed is not more incentive for publishers to develop more inventory, but more incentive for Amazon to develop its platform.  To the extent that Amazon must now bear more of the risk and cost associated with the transition to e-books, the transition will likely occur more slowly.  Amazon’s effort to maintain pricing control by playing hardball with Macmillan in the physical book market was appropriate and gutsy.  And we would have been better off if it had succeeded.

I don’t think there’s anything to be “done” about the state of affairs other than for Amazon and publishers including Macmillan to continue negotiating.  But I will note one thing (seconding Joshua Gans):  It is almost certainly the case that Amazon capitulated in its dispute with Macmillan because of fear of drawing antitrust litigation.  If so, I think this would be most unfortunate, and it would represent antitrust enforcement placing an inefficient thumb on the bargaining power scale.  Perhaps we shouldn’t be so quick to reject the idea of false positives . . . .

Important Hat Tip.  When I started writing this post I hadn’t yet seen this article by Andrei Hagiu (Hagiu, Andrei (2007) “Merchant or Two-Sided Platform?,” Review of Network Economics: Vol. 6: Iss. 2, Article 3) (embarrassingly enough, as it was published in 2007).  But my thinking here maps significantly onto Andrei’s and I re-wrote some of the post, particularly reflecting some of his terminology, once I did read it in the middle of drafting the post.  It strikes me as an extremely important article in the two-sided markets literature, and I highly recommend it to everyone interested in the topic.  To the extent that I say what he says, he says it better; and to the extent that we diverge, he is probably correct and I am probably wrong.

Geoffrey Manne

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