Apple Should Win Its E-Book Appeal

On Monday Apple will ask the Second Circuit Court of Appeals in New York to overturn an antitrust verdict. U.S. v. Apple boils down to this: Amazon possessed a 90% market share in e-book sales, and Apple developed a method of carving into it, increasing competition. Nevertheless, federal Judge Denise Cote held that Apple violated the Sherman Act.
Apple’s appeal is important to more than the company. The Second Circuit has the opportunity to consider the appropriate antitrust rules governing competition between marketing platforms—an important legal and economic issue that Judge Cote ignored.
Here is the underlying history. When e-books were introduced in 2007, Amazon developed a distribution method, through its Kindle, that eventually gave it a dominant market position. The major book publishers licensed Amazon to distribute their e-books (as well as their hardcover and paperback books) on what is called the “wholesale model,” which is standard for selling print books.
The retailer pays the publisher a wholesale price for each book, then is free to determine the price at which the book sells to the public.
Amazon took advantage of this pricing freedom to sell e-books below cost, as loss leaders. A publisher might charge Amazon $13 for an e-book; Amazon would sell it for $9.99, absorbing the loss as part of a larger business strategy, most likely to sell more Kindles.
Although Amazon’s lower prices increased e-book sales, virtually all of the major publishers opposed the practice. They viewed Amazon’s low e-book prices as eating into the sale of print books, challenging the existence of book stores, and leading to a public devaluation of books.
The major book publishers tried to convince Amazon to raise e-book prices—unsuccessfully. They tried withholding the delivery of e-books for some period after the print edition was released. Amazon refused to budge.
Enter Apple. In 2009 the company was launching the iPad, which it could use to sell e-books. But to build a successful platform and compete against Amazon, Apple needed to gain licenses from a critical mass of the major publishers. To get them, Apple proposed to let publishers set the prices at which their e-books would be offered to the public, subject to some price limits and a general provision allowing Apple to match the lowest price any distributor charged for a given e-book. Apple took a 30% commission, identical to what it traditionally charged for apps at its AppStores.
Apple’s model would reduce revenues to publishers from e-book sales, but it would, crucially, let publishers better balance e-book prices against print prices.
After discussing Apple’s proposals among themselves, five of the six major book publishers (not including Random House) agreed to the terms in 2010. They took control of e-book pricing by adopting a different agreement with retailers, the “agency model.” The retailers would serve as the agent of the publishers, who set the price of their e-books for the public. This agreement eliminated Amazon’s $9.99 loss-leader practice.
In 2012 the Justice Department sued the five major publishers—Hachette, HarperCollins, Macmillan, Penguin Group and Simon & Schuster—and Apple, charging them with conspiring to raise the prices of e-books. The publishers settled but Apple refused, and last year, following a bench trial, Judge Cote ruled that Apple violated the Sherman Act.
Yet what Apple had coordinated was hardly a typical price-fixing conspiracy. The publishers had chosen Apple’s terms—including a cap on prices—even though the terms reduced the returns they would receive from e-book sales. The court entirely ignored what really mattered: the platform competition between Amazon and Apple.
The court sharply restricted from the trial any evidence about Amazon, including its retaliatory practices against publishers who challenged its pricing. In 2010 Amazon deleted the buy option for Macmillan’s e-books and print books. More recently Amazon delayed shipment of Hachette’s books. The court also did not consider the publishers’ desire to increase e-book prices to protect their core print book business.
In short, the court’s evidentiary rulings concealed the economic motivations driving the industry. All that mattered to Judge Cote was that the publishers’ new agency agreements meant that Amazon had to offer their e-books at non-subsidized, higher prices.
This is not sensible antitrust policy. Apple attempted to enhance competition, not restrain it—and the court’s decision protects Amazon’s 90% market share in e-book competition.
The issues raised by this case are substantially more complicated than Judge Cote allowed. The court should have examined the publishers’ interest in balancing e-book to print book sales by setting different prices for each of them. There is nothing anticompetitive about this, and this kind of balancing is routine. Food producers, for example, set prices for branded versus generic versions of a product.
Is it illegal for companies subject to a dominant marketer of their product—in this case Amazon—to meet and determine how to protect their interests? The court did acknowledge the legitimate fears of the publishers that to challenge Amazon’s policies alone would lead to Amazon’s retaliation, as it did with Macmillan and Hachette.
Now the Second Circuit has the opportunity to provide guidelines about how firms like Apple, interested in providing platform competition but needing a critical mass of producers to do so, can compete without running afoul of the antitrust laws.
What Apple and the major booksellers did to get a foothold in a market dominated by Amazon was not restraint of trade. It was competition, and progress.