Does Agency Pricing Lead to Higher Book Prices?

According to a March 9 story in the Wall Street Journal, The U.S. Department of Justice is considering suing Apple and five large US publishers for allegedly colluding to raise the price of ebooks.

At the heart of the issue, I suspect, is concern over the agency pricing model. Agency pricing allows the publisher (or the indie author) to set the retail price of their book.

Although Smashwords is not a party to this potential lawsuit, I felt it was important that the DoJ investigators hear the Smashwords side of the story, because any decisions they make could have significant ramifications for our 40,000 authors and publishers, and for our retailers and customers.

Yesterday I had an hour-long conference call with the DoJ. My goal was to express why I think it's critically important that the DoJ not take any actions to weaken or dismantle agency pricing for ebooks.

Even before the DoJ investigation, I understood that detractors of the agency model believed that agency would lead to higher prices for consumers.

Ever since we adopted the agency model, however, I had faith that in a free market ecosystem where the supply of product (ebooks) exceeds the demand, that suppliers (authors and publishers) would use price as a competitive tool, and this would naturally lead to lower prices.

I preparation for the DoJ call, I decided to dig up the data to prove whether my pie-in-the-sky supply-and-demand hunch was correct or incorrect. I asked Henry on our engineering team to sift through our log files to reconstruct as much pricing data as possible regarding our books at the Apple iBookstore.

We shared hard data with the DoJ yesterday that we've never shared with anyone. I'll share this data with you now.

As background, Smashwords is one of several authorized aggregators supplying ebooks to the Apple iBookstore. On day one of the iPad's launch, we had about 2,200 books in the iBookstore, and our catalog there has grown steadily ever since.

Henry was able to assemble a complete data set going back to October 2010. We created once-a-month snapshots of the Smashwords catalog at the Apple iBookstore between October 2010 and March 2012. Our data captures the average price of our titles in the iBookstore, and the number of titles listed.

I'm sharing four data sets. The first data set, above at left, shows the number of Smashwords titles for sale in the Apple iBookstore. As you can see, the numbers have grown steadily. I'm not aware of any other agency pricing study that worked against such a large body of data.

In the next data set, we plotted the percentage of books priced at FREE by our authors and publishers. As you can see from the chart, the number grew from 8.45% in October 2010 to 9.60% this month.

Why would authors and publishers give away complete books when they have the power to price at a price? The reason is because FREE is a powerful marketing tool for platform building, and for introducing new readers to an author's backlist.

This data indicates a slow but steady increase in the adoption of FREE.

For you statistics geeks out there, the data represents a statistically significant trend with a tau of 0.516 and a 2-sided pvalue of .00313. For you non-stat-geeks, a positive tau number indicates an upward sloping trend, and the pvalue represents the statistical odds that the trend is invalid. A 2-sided pvalue of .00313 indicates that the odds of this trend not being statistically significant is only 3 in 1,000.

In the next chart, I aggregate all books, both FREE books and priced books, to calculate the average price of the books in the catalog.

The downward sloping trend is pronounced. The tau is -.948, indicating a downward trend, and the 2-sided pvalue is .000000049141. So, if I'm counting my zeros correctly, that's less than a 1 in 100 million chance that this trend is not statistically significant.

Dizzy yet?

In plain English, we've seen the average price of books in our catalog drop from $4.16 in October 2010 to $2.97 today.

In the next data set, we removed the free titles to identify the true average price for priced books in our catalog at Apple.

This statistically significant data set carries a tau of -0.908 and a 2-sided pvalue of 0.00000017217. This confirms that even if you remove FREE books, the average price of priced books is declining. The tau indicates 1 in one million chance that the indicated trend is incorrect.

In plain English, the average prices have dropped 25% from $4.55 in October 2010 to $3.41 today.

Back in 2009, I blogged at the Huffington Post that the time had come for publishers to price ebooks at $4.00. That day arrived for Smashwords authors and publishers a year ago.

The $3.41 is a really interesting number, for a couple reasons: 1) It shows that authors and publishers, left to their own free will, are pricing their books lower in this highly competitive market. Sure, they could all try to fleece customers by pricing their books at $29.99, but customers won't let them. 2) $3.41 is remarkably close to the average price paid for Smashwords books purchased at Barnes & Noble during the last 30 days. The B&N number: $3.16. I looked at every Smashwords book sold at Barnes & Noble between February 28 and March 27, then calculated the average price. This means Smashwords authors are pricing their books close to what customers want to pay. The median price (represents the midpoint, where an equal number of books sold at lower prices and and equal number sold at higher prices) was $2.99. The weighted average price (all priced book sales divided by number of units purchased) was $2.59.


We had a good conversation with the DoJ. They were very interested to learn about our business, and learn about the underlying dynamics of the retail distribution ecosystem from the perspective of indie authors and small publishers.

I explained how when Smashwords first began distributing ebooks to retailers in 2009, our retailer contracts were under the traditional wholesale model. After Apple introduced the agency model in early 2010, we found ourselves managing dual, incompatible pricing systems. Apple priced at agency, and our other retailers continued to discount.

As I explained to the DoJ, Apple was aware that our other retailers were underpricing them, not just because we were juggling wholesale and agency, but because Apple prices in $.99 tiers. As we explained to Apple two years ago and to the DoJ yesterday, if a Smashwords author priced a book at $1.25, we'd bump the price at Apple up to $1.99 rather than price lower than what the author wanted.

The DoJ asked me if Apple ever balked at the knowledge that other retailers were selling our same books for less, and my answer was no. Not once in our two year relationship with Apple have they ever complained about a Smashwords-distributed title priced lower at one of their competitors. They've never price-matched any of our books if they found it lower elsewhere. I really don't think they care.

For our other large retailers - Barnes & Noble, Sony and Kobo - I can think of less than five instances combined where any of them tried to price-match books because they found them priced lower elsewhere.

There's only one retailer that has made it a practice to strictly enforce most-favored-nation pricing upon its authors and publishers, and they're the retailer that forced us to move all of our wholesale retailers to the agency model. As I mentioned in my initial blog post here, our move to agency in 2010 was necessitated by Amazon's automated price matching.

At the time, when Sony or B&N discounted a $2.99 book by a mere 5%, Amazon price-matched the book which dropped the author from a 70% royalty rate at Amazon to 35% (Some time after October 2010, I believe Amazon stopped dropping the royalty rate upon price-matching). At the time, our bestselling authors were understandably upset, because the downgrade was costing some of them thousands of dollars in lost income. It caused some of them to remove their books from all retailers except Amazon out of fear of such punishment. Keep in mind, in mid 2010, Amazon controlled 80-90% of the US ebook market, so such policies put authors in a tough bind.

In mid-2010, with our authors angry over the discounting, and with them removing books from distribution (as a distributor, we care about this on multiple levels!), we started asking our retailers to move us to agency terms so our authors could control their pricing. At first, they all said no. None of them were fans of the agency model at that time. I think all of them felt as if the model had been shoved down their throats by the ultimatums of the Big 5 publishers (who viewed Apple and its agency model as their white knight counterbalance to Amazon).

In November 2010, Kobo moved us to agency, and then the next month Barnes & Noble and Sony gave us agency terms as well. I think they all moved us to agency because they realized that their discounting was causing indie authors to remove their books and sell only on Amazon.

Over the last two years, my appreciation for the agency model has grown as I've come to fully understand its benefits for our authors, publishers, retailers and customers. Here's why I support agency:

• Agency puts the authors and publishers in control over their retail price and their promotions. This gives authors and publishers the freedom to coordinate promotions across all retailers for reasons decided by the author or publisher.
• Publishers earn 60-70% of the retail list price as their earnings, vs. 35-50% under the traditional wholesale pricing model. This gives authors and publishers the freedom (should they choose to exercise it) to price their books lower, yet still earn the same or more income from the sale of each unit. This allows our authors to compete more effectively against the books of Big 6 publishers, who price their books on the high end. Lower prices make books more affordable and more accessible to more potential customers, leading to a virtuous cycle of higher unit sales at higher profit levels which leads to more earnings for our authors and publishers.
• Agency provides our retailer partners a fair, predictable commission of 30%. These retailers are investing millions of dollars - sometimes hundreds of millions of dollars - to attract more readers to more books. They earn every penny. We want them all to build profitable businesses selling indie ebooks.
• Agency creates a level playing field for all ebook retailers. It prevents deep-pocketed retailers or device-makers from using predatory pricing practices to sell books at below cost in an attempt to bleed their competitors' finances dry, or in attempt to snuff out new competitors before smaller startups gain a foothold in the market.
• Agency forces retailers to compete on customer experience rather than price. Retailers who win will be those who do the best job of attracting customers to their store, and who offer the best algorithms to match readers with books they'll enjoy reading.
• Agency forces authors and publishers to be wholly accountable to their customers. If the author or publisher prices their book too high, the market will respond by purchasing lower cost alternatives.

As I explained to the DoJ, I think it's fallacy to believe that agency pricing leads to higher prices. That's like blaming cars for drunk driving accidents. The driver behind the wheel is responsible. If the Big 6 publishers are pricing their books too high (and I think they are), blame the publishers.

It's also fallacy to believe that somehow the wholesale pricing model is the savior and enabler of low prices. Under the wholesale model, the publisher has always set the price at which they'll sell the book to the bookstore, typically a 50% discount to the suggested list price. The $30 front list hardcover you purchase earns the publisher $15, or less. If the publisher decides they need to earn $18.00 on each copy sold, they'll set the suggested list price to $36.00. If you agree that under normal circumstances, most retailers will not consistently sell all their books at below cost, then it's reasonable to conclude that even under wholesale, publishers already control the minimum price all customers, on average, will pay.

It's worth noting that when the Big 5 publishers moved to agency, many of them started earning less per book than they had previously earned under the wholesale model. Pricing control was more important to them.

Analyzing the Short and Long Term Impacts

A return to the wholesale pricing model for ebooks would lead to the following short term affects:

• Indie author and publisher "royalty rates" (earnings) would drop to 35-50% of the retail price.
• Retailers would discount ebooks, and customers would begin migrating to retailers with the lowest prices. In the online realm, the cheaper book is only a click away. Online price checking web sites and apps make it easy for customers to always find the lowest price.
• Authors and publishers, in an attempt to recoup lost earnings, would at first increase prices. For example, if it's important to a Smashwords author that they earn $3.00 per copy sold, under agency they'd price the book at $5.00. Under wholesale, they'd need to price the book at $7.00, 40% higher. Yes, a return to wholesale could increase prices for customers.

A return to the wholesale pricing model could lead to the following long term affects:

• In the battle for market share, price wars will break out, and some retailers will begin pricing books below cost. Other retailers would be forced to match the prices or risk losing customers. If the price wars persisted, only two or three major ebook retailers would likely have the financial stamina to endure: Apple, Amazon and Google
• Barnes & Noble, which now controls about 28% of the US market, would probably run out of cash and suffer the safe fate as Borders.
• Smaller independent ebook retailers such as the Diesel eBook Store, BooksOnBoard and others, would be probably be forced out of business.
• Formation of new ebook retailers, both here in the US and internationally, would dry up to a trickle, further limiting the number of companies in the business of promoting reading.
• With less competition, retailers would stop discounting, and prices would rise as retailers capture the full 50% margin enabled by the wholesale model.
• With retailing power consolidated in the hands of one or two powerful retailers, authors and publishers could lose control over their distribution options and could be forced to make concessions on royalty rates, or forced to pay co-op dollars or listing fees.

I'm not suggesting that any of these retailers harbor nefarious intentions. They're simply trying maximize profit on behalf of their shareholders within the environments they operate. As much as I love our friends at Apple, and as much as I hope to be great friends someday with Amazon, I don't want there to be only two bookstores standing when the post-DoJ dust settles. That would be horrible for everyone, and I don't think it would even be good for Apple and Amazon.

I think if those of us - including the DoJ, authors, publishers, retailers, distributors, readers - who have the power to promote policies and practices that lead to more bookstores and more reading, we have an obligation to do the right thing. I believe agency will lead to more reading, and wholesale will lead to less.

Ultimately, regardless of pricing model, customers will decide what they will and will not pay.

Here's the big question: Who should decide what customers should pay? Proponents of the wholesale model believe that publishers make poor pricing decisions, and retailers make smarter decisions. If we're talking about big publishers, I agree with the retailers. Big publishers are pricing their books too high.

If we're talking about the indie authors and small presses, I think indies are more savvy about pricing than big publishers. The data above supports this. They're closer to their customers. With nearly 100,000 Smashwords books to choose from at Barnes & Noble, customers are voting for $2.99 as the median price and our books are priced very near that.

Are retailers better at pricing than indie authors? My guess is yes, simply because retailers have real-time access to store-wide data. But this gap in intelligence is rapidly decreasing. Indie authors are getting faster access to information, and there's even greater opportunity ahead for distributors such as Smashwords to start sharing more information with both authors and our retail partners. Such information sharing will help better align the interests of authors and retailers, and the end result will be pricing that is more responsive to the needs of customers.

Who Should Control Pricing?

In the end, I think authors and publishers should have the freedom to decide their pricing.

I have no idea how the DoJ will lean in their rumored lawsuit. I also don't know the negotiation plans of the publishers and Apple. The DoJ declined to share any details of their investigation with me.

I trust now that whatever decision the DoJ makes, they'll make it with the full knowledge of how it will impact indie authors. As I expressed to the DoJ, indies are the future of publishing.

Smashwords Puts Authors and Publishers in Control of Pricing

Our authors and publishers spoke (and some wrote, screamed, begged and politely asked), and we listened.

Effective today, all Smashwords retailers are pricing Smashwords books at the price set by the author or publisher. No more discounting.

It also means we have significantly increased the royalties we pay our authors and publishers.

To summarize how we got here, and what it means to Smashwords authors, publishers and readers, let's take a stroll down memory lane to review how books have traditionally been priced, distributed and sold.

For most of the last several decades, the book industry worked under a wholesale pricing model. A publisher would ship their books to a distributor or wholesaler, who would then sell the books to brick and mortar bookstores. In advance, the publishers and their supply chain partners would work out a discount schedule in which the retailer would purchase the book for some percentage off of the suggested retail price.

For example, a retail bookstore might purchase books from the wholesaler/distributor for 50% off of list price, which means the retailer would pay $15 for each $30 list price book they sell. The retailer could then set the price. Most retailers, taking advantage of their close proximity to the customer and their understanding of consumer behavior, had the ability to discount the book to such a price that they could achieve their objective.

For example, if a retailer's objective was to maximize the per-copy profit, they might sell the book at list price (when I was Brazil in October, I learned some airport bookstores sell print books for more than the list price). If the retailer wanted to maximize their overall profits, they might sell the book at a discount and make up the difference in increased volume. If a retailer wanted to attract buyers into their store, they might even sell the book at below cost.

To the author and the publisher, the discounting didn't make a difference, because the author and publisher were paid a fixed percentage of the suggested list price. Retailers liked this pricing model because it gave them the flexibility and freedom to use price to help serve their customers and serve their bottom line. Everyone was happy.

Then ebooks came on the scene, and the pricing of ebooks followed the same general wholesale model, only rather than shipping physical copies of a dead-tree book to a warehouse or distributor, the publishers or their distributors would ship a single digital copy of the book to the retailer, and the retailer would make digital copies each time they sold one.

Retailers, responding to customers who expected to pay less for ebooks than print books, started aggressively discounting. Many publishers dreaded such discounting for fear it would devalue books, or would cannibalize print book sales. Then Amazon, in an effort to serve their customers, started selling many best-seller ebooks for under $9.99 - for less than what Amazon had to pay the publisher for the book.

An ebook price war broke out, and other ebook retailers tried to match Amazon's price.

Now remember, in the print world, publishers didn't care too much if a retailer discounted the book, since the publisher is paid based on a predetermined discount off of list. Publishers also understood that if the retailers couldn't sell through their inventory of books, those books would be returned to the publisher for a full refund. So the discounting double-benefited the publishers.

You might think the publishers would have been happy that Amazon and other retailers were pricing books at below cost. The low costs drove up demand, helped accelerate the growth of the ebook market, and helped the publishers sell more books.

But no, the big New York publishers were not pleased. They feared that Amazon and other retailers, by pricing their books under $10.00, were devaluing books and setting an inappropriate customer expectation that ebooks should be priced at $9.99 or less. Publishers feared Amazon was exerting too much control over prices, and further feared that some day Amazon would come back to publishers and demand greater discounts, thereby permanently lowering the publisher's list prices and profits.

When Apple came on the scene in April 2010 with a new pricing model known as "agency," one in which the publisher set the price and Apple, acting as a sales agent, would not discount, five of the big six New York publishers jumped for glee. Finally, they thought, Apple would be their savior - their counterbalance - to Amazon's increasing influence in the ebook business. Publishers also appreciated that Apple would pay them 70% of the list price, as opposed to the traditional 50% or less that they earned under the conventional wholesale pricing model.

So the five big New York Publishers - now known as the Agency Five or A5 - put a gun to the heads of all the major ebook retailers, and basically told them, "you need to either switch us to the agency model April 1 or we're going to stop allowing you to sell our books." As you might imagine, the retailers were not pleased. First, no one appreciates threats, especially from suppliers who are supposed to be your partners. And second, if you take away a retailer's ability to control the price, you make it difficult for retailers to do what they do best, which is to use price as a tool to sell more product and make customers happy.

Amid this awkward shift to agency for the A5, the A5 also gave second shrift to the smaller independent ebook retailers, even though a thriving ecosystem of indie ebook retailers would assist the A5's master plan of creating a counterbalance to Amazon. Due to logistical problems, contractual holdups, tax collection requirements and prioritization, the small indie ebook retailers were not allowed to switch immediately to agency, which meant that the indie retailers lost access to most of the best-selling books in April. I'm told more than one indie retailer went out of business after the virtual rug was pulled out from underneath them when they could no longer sell these books.

The move to agency also created conflict within the supply chain, and it created challenges for Smashwords authors too. Prior to the advent of agency, three our original retailers - Barnes & Noble, Sony and Kobo - were under the traditional wholesale retailer model. Previously, most Smashwords authors and publishers didn't care that their books were discounted, because the discounting only helped sell more ebooks, which benefited authors, publishers and readers.

But then around July, Amazon increased their royalty rates for direct publishers to match the Apple 70%. For the authors who chose to work directly with Amazon, they had to agree that their books would not be sold elsewhere for less, and if Amazon discovered the book priced elsewhere for less, they had the right to discount the author's book to price-match the competition.

This is when the proverbial fertilizer hit the fan for some Smashwords authors who publish direct with Amazon via DTP and then use Smashwords for all the non-Amazon retailers. I recall receiving one especially frantic email from a Smashwords author on disability retirement who was faced with the prospect of seeing his Amazon sales slashed due to discounting at our retailers. This author, like some other panicked authors who had been selling at Amazon for a long time, decided to remove their books from Smashwords retailers. This, to me, was an especially disconcerting trend, because these authors were hurting themselves by removing their books from important retailers like B&N, Sony and Kobo. Some of these authors even removed their books from our Apple channel, or unpublished their books at Smashwords altogether, even though Smashwords and Apple have never discounted. When someone yells "FIRE," it's tough to think straight. Matters weren't helped when some authors, clearly talented on the imagination front but lacking hard details, jumped to erroneous conclusions in online message boards, which further fueled more panicked responses.

When an author pulls a book from retail, it destroys their sales rank, they lose all their reviews, and they deny themselves the opportunity to reach new readers. In other words, no author in their right mind should ever remove a book from retail.

On the other hand, it's difficult to maintain your right mind when your friends are panicking too, and you're suffering real measurable harm when an auto-pricing robot cuts the price of your book at the largest retailer - a retailer said to control 70% or more of the ebook market. Remember, Amazon had every right to do these price corrections - and the authors agreed to this when they signed the Amazon contract - though it did create a situation where some authors felt forced to take actions to preserve their sales at Amazon. Some of these authors eventually waded back in, or tried to compensate for the expected discounting by raising prices at Smashwords, or raising prices across the board.

The obvious solution to me, given the impossibility of managing two incompatible pricing models, was to give our authors and publishers complete control over the price of their books. We've always done this for sales at Smashwords.com, our small retail operation, but I knew it would be a bigger challenge to move our retailers to the agency model, or something agency-like. Needless to say, none of our retailers were too keen to do this when I first started requesting this in June. I can't blame them for their hesitation, because the agency model creates all kinds of complexity and expense for the retailer to administer. I imagine many were still smarting from the insult of being forced to do it in the first place by the A5.

Today, however, I'm pleased to report that Kobo, Barnes & Noble and Sony have transitioned all Smashwords books to the new model. I'm also pleased to report that unlike the tactics used by the Agency 5, we did not put a gun to the head of our retailers. No shots fired, no threats made. In the end, I think each retail partner decided on their own that what is best for Smashwords authors and publishers is also what's best for them and their customers in the long term.

Possibly I have a different view of our retailers than the view from the large publishers. I see our retailers as true partners. Our mission at Smashwords is to help our authors and publishers connect with readers. One of ways we accomplish this is by supporting our retail partners because they more than anyone know how to connect readers with books.

Every once in a while I'll see people suggest authors should only sell their ebooks direct on their own websites, as if all intermediaries between the author and the reader are to be excised. Those folks are smoking opium. Smart authors put their books at retailers who can put their books in front of customers.

So effective immediately, all our retailers are on the same page. Like with our other agency retailers Apple and Diesel, we now pay our authors and publishers 60% of the author/publisher-determined list price for books sold at Kobo, Barnes & Noble and Sony. Simple.

Well, mostly simple. Here are some additional fine print details of interest to Smashwords authors and publishers:

This change means that for sales at B&N and Sony, we have significantly increased our royalty rates. Previously, we paid 42.5% of your suggested list price. The new 60% represents a 42% increase (42.5*1.42=60). At Kobo, we've increased our rate from 46.75% list to 60% list for most sales, a 28% increase. At Kobo, the new royalty rate applies for books priced between $.99 and $12.99, and only for dollar-denominated sales. We can no longer ship books to B&N that carry the price "Reader Sets the Price," so if you're one of the very few authors with this price setting, and you want distribution to B&N, then please change your price asap to $.99 or higher. All three have the freedom to price match if the same book is sold elsewhere for less. Make sure your prices at Smashwords are the same as elsewhere. Click to your Smashwords Dashboard's Channel Manager for summarized details.

With this change comes new responsibility for authors and publishers to price their books at a level customers want to pay. Here, I think indie authors and small publishers do a much better job than the big publishers. Already, the average book at Smashwords is priced under $5.00. At $5.00, a Smashwords author earns $3.00 profit for every book sold at retail. Large publishers can't compete against that (a traditional mass market paperback sold for $8.00 earns the author about 40 cents), which is one of the reasons I firmly believe the future of publishing lies in the hands of indie authors and small publishers, and in the years ahead we'll see more and more big-name authors go indie. They can earn more money per sale while serving their readers with a lower cost product. It's a win-win for the author and reader.

If you'd like to learn more about the agency model, Mike Shatzkin did a good post on it a few days ago at his Idealogical blog in which he concluded agency pricing represents the most significant event in 2010 for the publishing industry. Click here to access it.

If you'd like to learn about the transition to agency from the perspective of an indie ebook retailer, Kelley Allen over at Diesel has been posting a fascinating blow by blow as the events unfolded from April through today. She thinks the agency model will eventually be good for indie retailers and customers in the long term, though the path to here was fraught with much pain. Some links from the Diesel blog:

April: Most of the posts on this page deal with agency. Start at the bottom first for a chronological blow by blow: http://blog.diesel-ebooks.com/?m=201004

May:
Jilted (this caused quite a stir): http://blog.diesel-ebooks.com/?p=124

Day 43, Landing Harper Collins: http://blog.diesel-ebooks.com/?p=137

Day 45 days, they got Penguin: http://blog.diesel-ebooks.com/?p=130

June:
Mobi announces that they are no long selling Agency
http://blog.diesel-ebooks.com/?p=161
http://blog.diesel-ebooks.com/?p=179

July:
Diesel inteviewed by Kat Meyer of O'Reilly about Agency
http://blog.diesel-ebooks.com/?p=201

September:
Day 153: Hachette back up http://blog.diesel-ebooks.com/?p=368

October:
S&S back up http://blog.diesel-ebooks.com/?p=520

Nov:
Kelley Allen's recap of her latest thoughts on agency
http://blog.diesel-ebooks.com/?p=704

My sincere thanks to Smashwords authors, publishers and especially our retail partners for their support in helping us navigate these exciting times.

If you're not yet using Smashwords as your ebook publishing and distribution platform, please join the over 10,000 indie authors and publishers who now collectively publish and distribute over 25,000 books at Smashwords. To learn more, visit How to Publish and Distribute Ebooks with Smashwords. Or, view the Introduction to Smashwords post on the Smashwords Blog.