Book Pricing: The Economics of Diversifying Markets
Happy Labor Day! In honor of no work (nevermind the fact that I do something similar to the below assessment as part of my job) and no school (for the back-to-school crowd), I’m dusting off some econ today.
I’ve seen quite a few posts lately regarding the cost of e-books. Why, many bloggers have been asking, do e-books still cost us readers so much when we don’t have the obvious recurring costs required to make a tangible product? I’ve seen several comments in related discussions about the costs incurred by the publishers: you have to reformat the books into multiple e-book formats, and that obviously costs something. Is it enough to offset the ink, paper (etc), and shipping costs of a tangible book? I honestly don’t know. Quite frankly, I see it as being a bit of moot point.
Truthfully, this is something driven by nothing more than basic economics and the nature of substitutes goods. Basically, a substitute good is anything that can be used/purchased instead of another item. For example, someone who wants to buy some new music could either download an mp3 or buy a CD. In this case, the mp3 file and the CD are substitutes for each other.
Put in the context of the book market today, you could consider an e-book and a physical book to be almost perfect substitutes. A perfect substitute is simply a more specific substitute—with a perfect substitute, the consumer would get the exact same value out of good y as they get out of good x, but possibly at a different price. Wikipedia uses an example of CD brands. With book types, there are some advantages/disadvantages of e-books versus physical books that cause people to have preferences, but let’s ignore that for the moment for the sake of using math in later examples.
If a physical book has a significantly higher price than an e-book, the tendency of all rational consumers is to switch to buying e-books. The previous demand of physical books will be reduced, and the demand of e-books will increase. For those of you familiar with supply and demand curves, this causes a shift of the demand curves (as opposed to movement along the curves). Thus, basic economics (and really, common sense), tells us that if publishing companies set their e-book prices sufficiently low, there would be significantly reduced demand for physical books.
Now let’s jump back to the point of view of the publishers, rather than the consumers. Publishers today are now facing a concept called market cannibalization. Basically, by selling more e-books, their sales numbers of physical books suffer. The way they choose to set pricing for e-books vs. paperbacks vs. hardcovers will determine how much market cannibalization they are faced with. If handled properly, this can be a great way for a company to diversify their products and allow them to reach a broader market than they had before. However, if handled poorly, a company can greatly suffer and potentially lose their footing in the market altogether. This is particularly important for some of the smaller, less established publishers (and is why you are now seeing more and more companies publishing only in e-book format and no physical copies).
So how does this directly affect the price of e-books? Let’s work through an example.
If you (a publisher) price an e-book at $1.99 compared to a paperback at $7.99, you will surely make lots of sales on the e-book, but you will make minimal sales on the paperback. But if your profit margin is only $0.99/e-book compared to $2.49/paperback, you’re going to want to sell more paperbacks. Even if more people in total buy the book, the publisher will want to maximize their paperback sales.
Let’s use specific numbers and pretend we have a super small market:
- Currently there are only paperbacks available and priced at $10/paperback (just to make the math easy)
- Let’s say there are 1,000 consumers and 1,000 non-consumers (curse you non-readers; you must come to the dark side).
- The publisher’s profit is ~$2/book sold (and let’s say that the fixed costs are minimal relative to the e-book).
- Thus, their total profit = $2*1,000 = $2,000.
Now let’s introduce an e-book. The publisher now has a decision to make. They can either price this e-book significantly cheaper and try to get more readers (please come to the dark side?), or they can price it at the same price as the paperback. In the real world there are obviously more options, but working through these two examples will illustrate what’s going on well enough.
Let’s say it costs the publisher a fixed cost of $150 to do all the formatting, etc, and that there is minimal recurring cost (cost/e-book sold). That means that if they price the e-book at $1, they need to get 150 new readers to cover the costs, and >150 readers will be profitable. So let’s use that scenario and see the results.
- They sell the e-book at $1, and all of the paperback readers switch to buying e-books, and some of the non-readers decide they can afford it now. Let’s say all 200 people buy the book.
- That means the revenue of the e-book is now $1*2,000 = $2,000.
- But the publisher has incurred the fixed costs, so their true profit is only $1,850.
Compare that to the profit from the paperback sales up above. With this scenario, the publisher would choose to not sell e-books at all because they make more money off of the paperbacks.
But what if they sell the e-book at $10, the same price as the paperbacks?
- First, we can safely assume that no new readers will start buying books, because they likely wouldn’t be willing to pay $10 now if they weren’t before.
- But some of your paperback readers will probably like the idea of having an e-book instead of a paperback, so they’ll switch. Let’s say 25% of the readers switch to e-books.
- Now the company’s profit off of paperbacks = $2*750 = $1,500.
- Their revenue off of the e-books = $10*250 = $2,500. Thus, their e-book profit = $2,500-$150 = $2,350.
- Thus, their total profit between paperback and e-book = $1,500 + $2,350 = $2,850.
That’s looking pretty good compared to the $2,000 we were making with just paperbacks. Yeah, we lost some of our paperback readers, but because we set the pricing high enough for the e-book to make up for it, we’re actually make more money. If you’re in a really geeky mood, you can lay this example out with a few equations and solve for the optimal price (making a few assumptions on what the demand quantity would actually be), but I’m not going to go quite that far.
Obviously, I’m using made-up numbers. I don’t have much of an idea on what the profit margin/paperback is, but I suspect it’s somewhere around 20%-30% at minimum. And I honestly have no idea how much it costs to format the e-books in all of the necessary ways (it’s almost certainly more than $150, but it’s also almost certainly spread over more than just 250 purchases).
These examples may seem extreme, but it’s exactly the kind of analysis that has resulted in the e-book prices lining up the way they have so far. Obviously the real world’s situation is a lot more complex, but market cannibalization is a very real “problem” (again, not necessarily a problem if handled correctly) that publishers need to consider. I, personally, would rather pay higher prices for e-books than see the entire publishing market collapse (yes it’s hyperbolic; I’m allowed some drama in my life) under a shift in demand that they weren’t prepared for—baby steps while they’re testing the waters to see how the market will respond are completely understandable. Besides, there’s still a tender place in my heart reserved for paperback and hardcovers, and I don’t want to see them go away just yet.