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Price Fixing, Razor Blades, and Steve Jobs’ Bad Idea

What the DOJ has on Apple and publishers.

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Price Fixing, Razor Blades, and Steve Jobs’ Bad Idea
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Shaylin Clark reported here on the Department of Justice suit against Apple, and five major publishing houses over price-fixing allegations. Three of the five publishing houses have agreed to settle out of court. Clark summed up the basics of the suit:

The government is seeking to nullify the agreements between Apple and the five publishers that instituted an agency model of e-book sales. Under the agency model, publishers set the price of e-books, and the retailer gets 30% of the price. Under the previous wholesale model, e-books were sold in the same way as physical books: the books are sold to the retailer by the publisher, and the retailer is allowed to set whatever price they choose. This model caused concern for publishers because Amazon was selling e-books at or below wholesale in order to drive sales of their Kindle e-reader, a practice which Barnes & Noble also adopted when they released their own Nook e-reader. The government alleges that by adopting the agency model, Apple and the publishers colluded to raise e-book prices. Once the agency model agreements with Apple were in place, the publishers were able to strong-arm Amazon and Barnes & Noble into similar agreements.

Sounds cut and dried enough. But it has led some to ask a few basic questions about how anti-trust works and what is and is not allowed in open market competition in the United States. Amazon is the king of the hill in the e-book market. It seems counter-intuitive that the DOJ would sue to quell competition in that market.

The key to understanding it all comes down to understanding two things: price-fixing and “freebie marketing”.

I met a guy once who told me that every gas station owner in our town met at a particular restaurant weekly to agree on gas prices for the week. Since gas was consistent around town, it was all a matter of what was convenient for the buyer, not a price-comparison issue. Not sure if that story is true, but if so, that is price-fixing. And, it’s illegal as can be.

In the 1950s, heavy equipment manufacturers like General Electric and Westinghouse would meet in public places like golf courses to discuss how they would price their products. They agreed to rotate bids for government projects so everyone got a taste. It went on for years until the Tennessee Valley Authority realized that bids that had been submitted as sealed and secret were actually identical, down to the last dollar. In the end, almost 50 executives paid large fines and several people spent a month or more in jail for the conspiracy. Before it was all uncovered and stopped, the price-fixing system had hosed taxpayers out of $175 million dollars a year in 1050s dollars.

In the mid-1990s, Archer Daniels Midland and 4 other foreign companies colluded to raise the price of the animal feed additive lysine. Their international cartel was exposed when an employee told an FBI agent about it in the context of a completely separate matter, fearing it would be found out anyway. The resultant investigation led to the first DOJ prosecution of that scale in 40 years. ADM was also found to be conspiring to fix prices in the citrus market. Hundreds of millions of dollars in fines were assessed. But, over a nine month period, the lysine price-fixing scheme had managed to raise prices on farmers 70%.

In the case of Apple and the publishing houses, the DOJ says that their “agency model” is a price-fixing scheme. The deal was actually the brainchild of Steve Jobs. In his biography, Jobs explains the genesis of the model:

“We told the publishers, ‘We’ll go to the agency model, where you set the price, and we get our 30 percent. And yes, the customer pays a little more, but that’s what you want anyway.”

Let’s pause here and look at the other term we said needed to be explained: “freebie marketing”, sometimes called the razor-and-blades business model.

This marketing scheme is based on the idea of selling one item at a low price, even below cost or free, but making profit on a complementary item. Examples of these pairings include printers and ink cartridges, cell phones and service contracts, game consoles and games, and yes, razor handles and blades. In each of these cases, many of the sellers of these items take a loss on the initial purchase in order to make money on the second item in the pair.

This is what Amazon had been doing. They had been selling their e-books for less than it costs them to get them wholesale, never going above the $9.99 mark they had set for themselves. But, in doing so, they grabbed the lion’s share of the market and gotten their Kindles spread far and wide. They are the default choice in e-readers today, in part because of the price points they set.

Amazon has other things they can put through those Kindles, including independently-published books that cost them almost nothing to carry. Last year, one of these independent authors outsold every traditionally-published author in the Kindle store. We interviewed him here about his success in Q4, 2011.

In order to be able to compete with Amazon in the e-book market, Apple needed to find a way to control pricing better. So they instituted the “agency model” as Jobs described it above.

So far, none of this really amounts to price fixing. It is a different way to sell something, but not illegal. However, for this whole thing to work, the publishers had to get other retailers, including Amazon, to go along with the model, which let them set the prices. The DOJ says that things went one step further, which makes all the difference in the world. This was in the way that they went about constructing their plans. These were competitors talking amongst themselves about how to best get Amazon to raise prices. A particular price point may not have been set, but the agreement to a particular scheme to raise prices overall was. According to the suit:

The Defendants’ conspiracy to limit e-book price competition came together as the Publisher Defendants were jointly devising schemes to limit Amazon’s ability to discount e- books… Together, Apple and the Publisher Defendants reached an agreement whereby retail price competition would cease (which all the conspirators desired), retail e-book prices would increase significantly (which the Publisher Defendants desired), and Apple would be guaranteed a 30 percent “commission” on each e-book it sold (which Apple desired).

Phrases like “jointly devising” are the damning parts of the whole thing. If proven, they are the smoking gun that proves the charge. And, keep in mind, three of the defendants have already settled in this matter

Some are saying that Apple did no price setting. Apple maintains that they are merely the “agent” in the model. But, the suit alleges that Apple is complicit because the agency model was their idea in the first place. And, to top it all off, it had to be implemented industry-wide or Apple would not play ball. Again, according to the biography, Jobs said:

“We also asked for a guarantee that if anybody else is selling the books cheaper than we are, then we can sell them at the lower price too.”

The DOJ suit puts it this way:

Apple facilitated the Publisher Defendants’ collective effort to end retail price competition by coordinating their transition to an agency model across all retailers. Apple clearly understood that its participation in this scheme would result in higher prices to consumers… Over three days in January 2010, each Publisher Defendant entered into a functionally identical agency contract with Apple that would go into effect simultaneously in April 2010 and “chang[e] the industry permanently.”

The simultaneous adoption of contracts, the identical structure of those contracts, and the fact that it was all built upon competitors putting their heads together to beat back a single entity is what is going to make this suit very heard to beat for Apple and the remaining publisher defendants.

Penguin, one of the holdout defendants in the case, released a statement from its CEO John Makinson which denies any collusion with other publishers as he outlines two reasons they are not settling with the DOJ:

“The first [reason] is that we have done nothing wrong. The decisions that we took, many them of them costly and difficult, were taken by Penguin alone… The second, and equally powerful, reason for our decision to place this matter in the hands of a court is that we believed then, as we do now, that the agency model is the one that offers consumers the prospect of an open and competitive market for e-books… we reasoned that the prevention of a monopoly in the supply of e-books had to be in the best interests, not just of Penguin, but of consumers, authors and booksellers as well.”

Since HarperCollins, Simon & Schuster and Hachette Book Group have already settled, Amazon has wasted no time in announcing victory. They released a one-sentence statement:

“This is a big win for Kindle owners, and we look forward to being allowed to lower prices on more Kindle books.”

Price Fixing, Razor Blades, and Steve Jobs’ Bad Idea
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