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.

DVD vs. VHS sales: Market Cannibalization example from TeleRead.com

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.

Read more about Substitute Goods.

Read more about Market Cannibalization.

 TeleRead gives a few more examples of market cannibalization that the e-book vs. paperback book might be following.

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Posted on September 1, 2014, in Miscellaneous and tagged , , , , , , . Bookmark the permalink. 10 Comments.

  1. Fantastic discussion, and I love how you explained it. I will link this to next weeks Sunday Post. While I will not pay the price of hardcover for an ebook I do buy plenty of new releases at higher costs than paperback.

    • There’s a part of me (that part of me that looks at my budget every other week and cries) that doesn’t like paying for highly priced e-books, but in several instances it’s worth it—instant gratification, potential to share with my parents/friends who live across the country, etc. Thanks for stopping by!

  2. This is a great post, Liza.I am one who really hates e-book prices over $10 and even over $8–especially when the price stays there after several years. I sometimes see the paper copy of the book for a lower price than the e-book!

    I just read e-books these days (love the format) so I usually wait for the price to come down, look for a digital copy at my library or I don’t read the book. I have perhaps five authors I will pay more than $10 for their book. I also don’t get any review copies from publishers so I don’t have the option of getting high priced books that way.

    This post did make me see the issue from a different point-of-view, but I still find $8+ e-book prices just too high to pay every day.

    • I totally agree, and I personally will hardly pay even that much for an ebook. Even though I kind of understand where the publishers are coming from, I still have a hard time clicking the ‘buy’ button unless I’m really, really, really impatient. I’ll buy them on occassion, but usually I’ll just go to the bookstore and buy the physical book if the ebook price is that high. I tend to switch between formats frequently, and even though I like ebooks well enough, nothing beats that good ol’ book smell in the evening 😉

      It’s interesting to see where people set their thresholds. Did you know that Amazon recommends pricing all ebooks at $9.99 in order to supposedly maximize sales? They argue that if your paperback is priced at $14.99, a $9.99 ebook will get 1.74 times more sales, thus yielding a significantly higher revenue. $9.99 seems pretty steep to me, and I also wonder why they used $14.99 as standard paperback instead of the more common format at $6.99-$8.99.

      Then there’s another push to have all ebooks under $4, which is altogether a much more drastic low-price proposal that I think could drastically influence the ebook vs physical book sales. I have a post going up with some commentary on that tomorrow 🙂

      Thanks for commenting!

  3. Great discussion of the economics, Liza! A couple of points:

    Many of the costs associated with producing an ebook are identical to the costs of producing the paperback (or hardcover), so they carry over from one version to the other: editing, cover design (usually), marketing, and maybe a few others. The only additional costs for adding an ebook version are formatting and (hopefully) proofreading each new format for formatting errors, the cost of new ISBN for the ePub and Kindle versions, and whatever costs are associated with placing the ebook in various e-tailers’ stores. Those are costs a lot of readers don’t think of, and they’re small in relation to the initial costs of producing and marketing the book, but they do have to be taken into account — which you did; you covered that with the additional $150 for the ebook in your example.

    On the other hand, there are costs associated with physical books that don’t apply to ebooks: printing, storage, and shipping the book to retailers are obvious ones, but there are also returns – all the physical copies that don’t sell. Retailers send unsold hardcovers back to the publisher; paperbacks have the front cover stripped off and are trashed, while the covers are sent back for credit/refund. Unsold hardcovers are often marked down and sold at bargain prices later (as “remainders”) in order to mitigate the loss, but publishers expect to print more copies than they sell for most titles, and that loss is presumably figured in to their pricing. Unsold books are simply not an issue when it comes to ebooks, because each buyer receives a copy of an electronic file.

    You said that an ebook is an almost perfect substitute for the physical book, but I think it’s less than that. As I’ve argued a few times on my blog, when you buy a physical book, you own it. When you “buy” an ebook, you have a license to read the book in that particular format on your device or devices. But because of the nature of DRM and the law which makes it illegal to remove DRM, you can’t legally do any of the following: resell the ebook after you’ve read it, give it away, lend it to someone (except in a few limited circumstances and only if the publisher agrees), or even convert the file format so it works on a different device (for example, if you bought an ePub copy, then replace your ePub reader with a Kindle, you can’t legally convert the ePub file to a mobi or AZW3 file that your Kindle can read, so you’ve essentially lost the book.) To my mind, all that adds up to not really owning the ebook, and thus reduces its value relative to the physical copy. That difference is usually reflected in lower pricing for ebooks relative to hardcovers, when the book first comes out, but it’s often not reflected in paperback vs. ebook prices.

    As someone who enjoys re-reading a book I really liked, often multiple times over the years, the potential drawbacks of purchasing an ebook are considerable. I recently switched from ePub to Kindle, leaving me with well over 200 books I bought but can’t legally read on my Kindle. Why, then, should I pay as much for an ebook as I would for the comparable paperback? The answer is, I rarely do. I wait for them to go on sale. There are only a handful of authors whose ebooks I will buy when they first come out, and those are in genres where I’ve pretty much stopped buying paperbacks due to lack of shelf space.

    • Thanks for taking the time to respond with that. Great comments, and some things I hadn’t thought of.

      The costs of unsold books is something I considered after I published this, and it’s a very valid consideration. I will say it kind of works on both sides of the cheap or not ebooks—yes, ebooks don’t add have unsold inventory adding costs, but if they draw a significant enough portion of sales away from physical copies (ie, more than was anticipated by the publishers), they might actually cause an increased inventory cost to the physical books. Since physical book pricing is fairly locked in, I could easily see publishers trying to make up for that with ebooks, be that right, wrong, or indifferent.

      I hadn’t considered the nature of DRM with ebooks, so thank you for bringing that up. It certainly does play a major role in this discussion, and I’m actually a little embarrassed that I didn’t think of it sooner. I’ve never had to switch formatting to transfer from one device to another, but that is a good consideration. I think there are some workarounds to that problem, but as you mention, they’re not legal. I may do some more thinking/research on this topic and make a follow-up post in the future. Thanks for bringing it to my attention! 🙂

      • Mmm, you make a good point about unsold books – that an ebook version could potentially increase the number of unsold physical books. I hadn’t thought of that, but you’re absolutely right.

        As for DRM, yes, there are fairly simple ways to get around it. Since I’ve written on the subject before, I’ve done some research. There are tools to remove it, and file-type conversion tools, some for sale and others free. It’s not legal, but there are a number of otherwise law-abiding citizens doing it. It could potentially open one up to a lawsuit or even criminal prosecution, although it’s hard to see why a publishing company would do so if the person was doing so strictly for his/her own use, and not sharing the files (the latter, of course, would be piracy.)

        It puzzles me that file conversion for your own use is illegal, when rulings on cases involving music clearly went the other way. Back in the vinyl records and cassette tapes days, the music industry tried to prevent people from making cassettes of their vinyl albums. I don’t remember the case names, but I think it went clear to the Supreme Court, and the decision was that you could make a copy for your own personal use, but you couldn’t distribute it. That’s why you can now rip your CDs to MP3 for your personal use, and it’s legal. I’ve wondered why a similar case hasn’t been fought over ebooks and the right to convert the files for personal use. But of course, the Supreme Court is a bit more conservative now, and more on the side of big business. It would be interesting to see it play out.

      • Hmm, that’s really interesting. I would think that a Supreme Court ruling regarding DRM for personal use in the music industry would certainly set a precedent in the digital books industry. Even if the new Court would have different views now and is on the side of big business (which I absolutely don’t doubt even though I haven’t paid much attention), I would expect most courts to follow that precedent. In fairness, we have plenty of historical examples where the Supreme Court gave a different ruling years later, but there was generally a big hubub about the upset, and good reasoning behind it. It would be very interesting to see if that happens here.

        I understand concerns about mass distribution and enabling blackmarket sales—any economist would be mindful of that. But let’s be honest: ebooks have way less to worry about there than music/movies do—there’s a generally smaller audience, and I think it’s fair to say that a lot more of us care about the authors we read (and want to continue being able to read them). And just from a personal-use digital library management, programs like Calibre are about ten times more useful if you can copy your ebooks and let it do the rest of the work.

      • Agreed on both counts. And I love Calibre; I used it for my ePub books, and now I download my Kindle books into it — if there’s ever a glitch at Amazon, or they decide to take the book down for some reason, I’ll still have a copy. Calibre can actually catalog DRMed books and load them onto your ereader; you just can’t open the book within Calibre or convert it to another file format without removing the DRM. (And for those who are so inclined, there are Calibre plugins that will do the DRM removal for you, but they’re not sanctioned by Calibre’s developer.)

        There are publishers who routinely publish without DRM. Baen Books is one, and I gather Tor has been moving in that direction. They haven’t seen a noticeable rise in piracy or drop in sales as a result, which argues in favor of your point that most book lovers, or at least most sci-fi and fantasy readers, prefer to keep the authors they love in business!

      • My mother is obsessed with Calibre. I’m fairly certain she’s discovered most of its uses. Since we by and large have the same ebooks, I let her do her thing and don’t really worry about it, so I haven’t played around with it as much as I otherwise would have. (I started too, but our digital family library is probably in the tens of thousands by now, so I’ve honestly avoided it like the plague. I basically decide I want to read a book and check there for it first before I buy it (unless I just straight up want a physical copy. If I started a series in paperback/hardcover, I usually stick with it no matter what).

        The stats nerd in me just decided she wanted to get the data on piracy rates with and without DRM for music, movies, and ebooks. That sounds like so much fun! Too bad most of this kind of info is proprietary. Working with pre-manipulated data is so much less fun …

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