Earlier this week, Virginia Postrel wrote a post addressing the e-book price war brewing between Amazon and Apple. She argued that e-books should be very, very cheap. In fact, I agree with Postrel that e-books should certainly be less expensive than paper books. But I don't buy into the argument that their pricing should approach zero just because the marginal cost of e-books is practically zero.
In her post, Postrel made the following seemingly uncontroversial argument:
Like publishers themselves apparently, these wise guys are using the wrong cost figures. To calculate the cost of a copy, they're loading on fixed "pre-production" costs like the editor's salary and the publisher's rent. They're including the marketing budget. But these are fixed costs. They don't change when you produce another copy. They may be important when deciding whether to publish a book at all, but once the money has been spent they're irrelevant to what you charge for a given copy. Optimal pricing should be based on the marginal cost of that incremental copy. Cover that incremental cost, and selling one more copy is profitable. The common intuition that e-books should be cheap reflects this basic microeconomics: Producing and delivering another e-copy costs next to nothing.
The notion that price should equal marginal cost is common economic theory. You probably learned it in Econ 101 -- I know I did. But it's largely misunderstood when people attempt to apply it in the real world. It shouldn't apply to e-books.
There are a few ways to understand why this assertion is false. The first is just to witness the actual book market. What's the marginal cost of a regular, paper book? I'm not sure, but since paper, printing and glue are pretty cheap these days, it's maybe a dollar or two, max. Yet, even paperbacks are rarely less than $5. So it's pretty obvious that marginal cost does not, in fact, equal price in publishing.
The reason why should be examined on a broader economic level. In fact, in the real world, marginal cost rarely equals price, and it rarely should. In economics, the only time that relationship is really supposed to hold up is within perfect competition. For a market to be perfectly competitive it has to have a number of attributes. Since my economics text book isn't with me today, let's turn to Investopedia for those conditions, which it does a decent job of providing:
1. All firms sell an identical product.
2. All firms are price takers.
3. All firms have a relatively small market share.
4. Buyers know the nature of the product being sold and the prices charged by each firm.
5. The industry is characterized by freedom of entry and exit.
I'm not sure that more than one or two of those conditions hold up in the book market, but a few in particular jump out at me as not applicable to publishing: #1 and #5.
All book publishers sell pretty similarly constructed books: they tend to have similar bindings, pages and covers. But they're hardly identical products. Few would honestly be indifferent to reading the memoir of Sarah Palin versus that of Ted Kennedy. And this speaks to one of the unusual attributes of publishing: the great uncertainty whether a book will be a hit. For publishers to stay in business the winners often subsidize the losers, since it's so difficult to predict which books will turn out to sell millions of copies.