Amazon vs. Apple: What Should E-Book Prices Be?

Amazon has backed down from its weekend dispute with Macmillan, agreeing to charge the publisher's higher prices for Kindle editions rather than its preferred $9.99. But the long-term questions about e-book pricing remain.

Amazon still calls Macmillan's prices--generally $12.99 to $14.99 for new books--"needlessly high." Apple, meanwhile, has made deals with publishers like the one Macmillan demanded from Amazon: higher prices for books, with Apple keeping a percentage of sales.

Who, in fact, has the better strategy? To maximize revenue, what should prices for e-books look like?

The common intuition is that e-books should be cheap because they aren't physical--no printing, no shipping. Ah, say contrarians, printing and shipping make up only a tiny fraction of a book's costs. E-books aren't really cheap.

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 other side of the equation is consumer response: How many more copies will people buy if the price goes down? Or, in economic lingo, what is the price elasticity of demand? Book publishers talk (and often act) as though book buyers aren't particularly price sensitive. The Borders and Barnes & Noble coupons in my email suggest otherwise. So does what little academic research exists on the subject. In a paper looking at people buying physical books using a shopbot, economists Erik Brynjolfsson, Astrid Andrea Dick, and Michael D. Smith found very large elasticities: A 1 percent drop in price increased units sold by 7 percent to 10 percent.

Of course, people who use shopbots are likely to be more price sensitive than average. But there's anecdotal evidence that prices matter a lot for e-books. As The New York Times reported recently, most of the books on the Kindle bestseller list are being given away for free. And comments on various discussion threads among Kindle users suggest that many are bargain hunters looking for a good, cheap read rather than a specific title.

Rather than cut prices for everyone, Macmillan hopes to be able to price discriminate, so that eager readers pay more than casual ones. It's a reasonable strategy. But the publisher seems to envision a traditional method of dividing the market: charging more for brand-new titles and lowering prices over time. That approach works for paperbacks, which come out roughly a year after hardback editions. But paperbacks are, of course, physically inferior to hardbacks, while e-books are all the same. Discriminating by publication date works only for titles that are fashion items--you want to talk about Game Change this week, not in six months--or blockbusters with impatient fans (the latest Twilight installment). Most books fall into neither category.

If lower book prices would generate more revenue, why, then, has Apple so willingly adopted higher prices? Here it's worth considering the difference between Amazon's books-plus-reader system and Apple's.

As many commentators have noted, Amazon is not just selling e-books. It's also selling the Kindle. To encourage sales of its device, the company has even been willing to sell Kindle editions for less than the wholesale price it pays for them. It's presumably maximizing profit on the whole system, not just each individual title.

Apple, too, is a system seller, and a device company to boot. But it doesn't have to sell a single book for the iPad to succeed. Books are just one app among many. If you're one of those old-fashioned people who read books without pictures, you can download a novel between watching videos, playing games, visiting websites, or looking at photos--all the things the visually oriented iPad was really designed for. The iPad is exciting not as a way to sell or read books as they currently exist but as a tool for reinventing them as multimedia. The book angle also helps generate good press, since journalists are desperate for any evidence that writing will pay in the future.

Apple doesn't need to maximize book sales. It simply needs to keep publishers happy enough to maintain an impressive sounding inventory of titles while waiting for entirely new forms of publishing to develop. After all, as Steve Jobs famously put it, "people don't read anymore."