Performance Management Solutions

In this second blog on the subject of Amazon, I am interested in the company’s behaviour as exhibited by its pricing model. (Alasdair White, September 2011)

The objective of all business is to generate revenue and, by controlling costs, to make a profit. To do this they have to sell products to end users at a sufficient price to generate a margin (net revenue) – this is derived by taking the selling price and deducting the cost of purchase or manufacture. In any value chain, each party makes the same set of calculations and they ‘set’ the selling price – usually by taking the their cost price and adding a margin. The next party in the value chain then takes this as the ‘cost price’ to which they add a margin and so on.

In the case of books (in any format), the producer of the book (‘the publisher’) is generally expected to establish an end-user price – often called the Recommended Retail Price, or the Recommended Sale Price. This will be based on market research to determine what similar books are selling at and is thus market-driven. The bookseller then negotiates a ‘trade discount’, this is deducted from the RRP, and the result becomes the price at which the bookseller buys the book. This is, technically, a ‘wholesale pricing model’ and leaves the retailer with the flexibility of setting the final sale price to suit their market. In a robust and diversified retail market, this encourages competitive behaviour and is good for all parties.

However, in a new and fragile market, such as that for ebooks, which represents under 7% of the total book market in the US and is estimated to be under 0.5% of the world market, the current model is thought to distort by allowing dominant retailers – especially Amazon – to sell ebooks at huge discounts in an effort to capture or protect their market share, but such very heavy discounting can be seen as anti-competitive behaviour by a market-dominant party. Publishers claim that this undermines their ability to sell their books through ‘normal’ bookselling channels. (By which, I assume, they mean that sales of books in other formats are being under-mined – especially if the ebook is also offered in a print format.) This sort of thing was, of course, a potential contributory factor to the demise of Borders as a high street bookseller. And let’s be absolutely clear about this – this problem is not confined to the USA, it is becoming an issue in Europe as well.

So, in an effort to protect the print-format market, the publishers and the retailers (mainly Amazon, Barnes & Noble and the other online retailers, including those in the UK) have come up with something called ‘the agency model’ in which the publishers ‘set’ (or ‘fix’) the retail price claiming that this will allow the development of the ebook market in a protected environment. While I can see how this helps publishers who issue the same title in both print and ebook formats (and thus, by extension, the authors), I cannot see how this is in the interests of the retailer or the consumer – it is, plainly and simply, ‘price fixing’ which is an anti-competitive behaviour. By agreeing with the publishers to adopt the ‘agency model’, Amazon, Barnes & Noble and Apple, to name but three, appear guilty of collusion and I am obviously not the only person to think this: the EU’s Competition Directorate and the Office of Fair Trading in the UK have both launched investigations as to the legality of the model.

Why have Amazon and the others agreed to collude with the publishers in the ‘agency model? Well, given that 40% of Amazon’s revenues come from book sales in general, they are rather dependent on the publishers as a source of supply and to get Amazon to agree to their new ‘agency model’ the publishers simply threatened to withdraw all their titles from Amazon’s list! Amazon capitulated in short order – they held out for a week, I believe, but then folded.

Amazon almost certainly decided that since the publishers really only wanted to operate the ‘agency model’ for ebooks, it was in Amazon’s own enlightened self-interest to agree simply because their interest in ebooks was to supply content for their Kindle reader on which there is a far higher margin. (see earlier blog)

Having been forced to concede to the publishers’ demands, Amazon has set about making the best of a bad job and has developed a two pronged approach: to vertically integrate, and to maximise their control over the ‘agency model’. The vertical integration strategy gives them a high level of control over the entire book value chain and psychologically leverages the authors’ desire to be published, while the maximisation of control of the ‘agency model’ is achieved through price banding to ensure that the majority of ebooks are priced at the most advantageous price as determined by Amazon.

Their vertical integration strategy encourages authors to convert their manuscripts to the MOBI format that is used by the Kindle reader (indeed, the only major e-reader to use it). This conversion is either done by the Kindle Direct publisher platform or the file can be converted elsewhere and simply made available to Kindle. The file is then loaded using the Kindle Direct publisher platform and the publisher has to enter various data, including the list prices (as per the ‘agency model’). The publisher then has no further control over the process except to monitor the prices. Kindle pays when it is ready – either by cheque or by bank transfer to a US bank account (no international transfers and no use of PayPal). Kindle will enter into NO discussions about prices, money or exchange rates and their decisions are final – there is no negotiation on anything. In this way, Kindle has virtual control over everything in the value chain except the original creation process (the authoring) – at the same time, Kindle also exerts non-negotiable control over the ‘agency model’. Which ever way this is viewed, the Amazon/Kindle strategy is an attempt to dominate the market and, as such, is broadly anti-competitive – however, Amazon/Kindle is such a dominate player, it is very difficult to see how this can be changed while the collusion with the publishers is still in existence.

In the next blog, I will outline a case study example of Amazon Kindle and its pricing model, which shows clearly how, as ‘elephant in the room’, Amazon/Kindle behaves in a strange, arbitrary, and restrictive manner towards those who supply it with content to sell and it can’t be ignored.