Apple and Amazon E-Book Most Favored Nation Clauses

Josh Wright —  3 August 2010

Connecticut AG Richard Blumenthal has reportedly contacted Apple and Amazon concerning their pricing arrangements with publishers (WSJ, CNN):

Mr. Blumenthal said he has sent letters to Amazon and Apple asking them to “meet with his office” to address his concerns that agreements in place may restrict rivals from offering cheaper e-books. For instance, he said, “both Amazon and Apple have reached agreements with the largest e-book publishers that ensure both will receive the best prices for e-books over any competitors.”

A “most favored nation” (MFN) clause is a contractual agreement between a supplier and a customer that requires the supplier to sell to the customer on pricing terms at least as favorable as the pricing terms on which that supplier sells to other customers.  They are common both in the retail distribution of a number of products, as well as health care, and in long-term contracts.  Apple and Amazon are also moving to the so-called “agency” model for an increasing number of titles.  Under that distribution model,  the publisher sets it own retail prices and the publisher and retailer (Apple, Amazon) negotiate a split of the revenues (in this case, reportedly 70 percent to the publisher).

With respect to the MFNs, Blumenthal also noted the following in his statement:

“These agreements among publishers, Amazon and Apple appear to have already resulted in uniform prices for many of the most popular e-books—potentially depriving consumers of competitive prices,” said Mr. Blumenthal in a prepared statement.”

Of course, parallel pricing activity merely raises the classic antitrust cartel identification problem, i.e. both collusive and competitive pricing can look uniform (in the limit, think of the simple perfect competition model in which all sellers price at marginal cost).  The anticompetitive theory concerning MFNs is that they can facilitate tacit collusion by increasing the cost of targeted discounts aimed at attracting new business (since a discount to one must be given to all) (see Salop, 1986).  On the other hand, MFNs can also create efficiencies, and thus, lower prices.  For example, in a market with search costs where uninformed buyers can avoid those costs and “free-ride” on the bargaining effort of the informed buyers by bargaining for MFNs.  MFNs can also increase pricing flexibility in long-term economic relationships while constraining opportunism (see Crocker & Lyon) and facilitate entry of new products by guaranteeing the original entrant that subsequent entrants do not free-ride on his creation of the market and bargain for lower input prices.  One can think of this as compensating the original entrant for bearing the risk of innovation.

In the meantime, e-book sales are apparently on the rise:

Electronic book sales have been rapidly heating up. The Association of American Publishers said that e-book sales at 13 reporting publishers grew 163% from a year earlier to $29.3 million in May. The category accounted for 8.5% of the total trade books market through the end of May, compared to 2.9% for the same period in 2009.

The standard antitrust approach would require the Connecticut AG to demonstrate under a rule of reason analysis that the clauses facilitated collusion and that any economic harms outweighed the efficiencies of the MFN.  The dramatic increase in output in the market is, of course, not dispositive as a matter of antitrust economics because, for example, one is always free to argue that output would have increased more but for the agreements.  But if the facts are that output continues to increase at the same pace or faster with the MFN clauses in effect, it does not help the AG’s case.