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.

Publishing also has relatively high barriers of entry. You need a great deal of investment for marketing, advances, printing, overhead, etc. Now, that could theoretically change for e-books, if e-book distributors decide to sell even amateurs' books and not rely solely on publishing houses. But even then, barriers to entry exist, since you have to actually have written a book, which takes many productive hours, the opportunity cost of which is income you could have made in another job.

From a broader economic standpoint, it's also pretty unlikely that the price equals marginal cost relationship holds up very often in the real world. For a great essay on this topic, check out this one by James DeLong from back in 2003. He explains that the relationship is particularly shaky in investment-intensive products, like those involving intellectual property or pharmaceuticals. When the vast, vast majority of cost involved in creating a product is upfront, how could a producer ever hope to break even if it charges customers only the small price each additional end product costs to produce?

So where does this lead e-books? As I said, they should definitely be cheaper than regular books. After all, their production cost is lower, since you don't need to produce a physical book. But that price difference should just consist of however much it costs to print, bind and ship the book. As I said, that's probably only a dollar or two per copy. The rest of the price, most of which likely accounts for the high up-front cost and investment required to find books that turn out to be big sellers, should remain intact.

Note: There's one other argument that I hear from time to time that could apply to e-book pricing which really bothers me. It's usually applied to music or movies. The narrative goes, "Well, people just pirate the stuff and get it for free these days online anyway, so you can't possibly charge much for it, because no one will pay it." Really? So since I can walk into a grocery store and quietly slip an orange into my jacket pocket, its price should be low too? How about a little memory stick from Best Buy? What if I could sneak behind a jewelry counter and steal a diamond ring? Should products really be priced based on how easy they are to steal? Of course not. Just because someone can easily obtain a product illegally doesn't imply the price should be low.