Amazon vs. Hachette: We’ve seen this movie before

The Mail & Guardian’s CTO, Alistair Fairweather, has a terrific piece out this week in which he puts his finger squarely on the real source of the publishing industry’s problems with Amazon:

Publishers still treat Amazon as though its market power was simply given to it on a plate, rather than earned by consistently pleasing millions of customers for nearly two decades. They complain about the inflexibility of its e-books platform, and about Amazon taking too much of their revenues, but none of them have come up with an alternative.

If publishers believe that Amazon is bad for authors and readers, then they should put their money where their mouths are. They should start a competing platform and launch their own device. If they really are better then readers will flock to their offering.

The occasion for Fairweather’s column was an earlier post by Amazon on its corporate blog in which the retailer laid out in detail for the first time its position in its ongoing dispute with Hachette:

It’s…important to understand that e-books are highly price-elastic. This means that when the price goes up, customers buy much less. We’ve quantified the price elasticity of e-books from repeated measurements across many titles. For every copy an e-book would sell at $14.99, it would sell 1.74 copies if priced at $9.99. So, for example, if customers would buy 100,000 copies of a particular e-book at $14.99, then customers would buy 174,000 copies of that same e-book at $9.99. Total revenue at $14.99 would be $1,499,000. Total revenue at $9.99 is $1,738,000.

One suspects Fairweather’s thoughts were also aimed at other commentators, such as Farhad Manjoo in the New York Times, and Carolyn Kellogg in the LA Times, who mustered armies of straw men in their own postings on Amazon’s comments to contest claims Amazon doesn’t actually make.

To understand the essential truth of Fairweather’s analysis, compare the publishing industry’s collision with digital books to the movie industry’s more successful format transition from VHS to DVD. The most critical and telling aspect of that earlier transition was that it was led by the Hollywood studios themselves, in particular Warner Bros., rather than by any particular retailer or technology company.

At the time, the home video market was based largely on one or two-night rentals of VHS cassettes (80+ percent of revenue), which were sold by the studios to retailers at prices that grew over a decade from around $50 per cassette to upwards of $100 per cassette. Those peculiar economics were driven initially by the awkward cost structure of prerecorded cassettes, which could be mass produced only by a very cumbersome, real-time process, consumed a lot of materials and contained multiple moving parts prone to breaking. Later, wholesale prices rose as the studios sought to grab a bigger slice of the money being spent by consumers at the video rental counter.

Even with sky-high wholesale prices, however, retailers still captured roughly 70 percent of consumer spending in the rental market, while the retail base itself became highly concentrated under a handful of large chains. At its peak, Blockbuster Video had a bigger market share than Amazon has now, giving it enormous leverage with the studios.

Worse, the peculiar economics of the business all but guaranteed that there would not be enough copies of popular titles to satisfy manifest demand when it was at its peak, leaving the bulk of potential customers dissatisfied and forcing consumer dollars to chase less popular titles.

The DVD format was conceived expressly to transition the video business from a rental market to a “sell-through” market. By involving themselves directly in the development of the technical standard that became DVD, the studios were able to directly influence their cost structure. DVDs could be pressed at high speed, for pennies per disc in volume and were easier to transport, store, ship and display. The lower unit costs meant retail prices could be lowered, making movie purchases attractive to consumers and flipping the old economics of the business on its head, to where the studios were now capturing 70 percent of the consumer dollar.

At first, even some studios were skeptical. Long accustomed to the high per-unit profit margins they earned from VHS cassettes, some were wary of trading lower prices (and margins) for more volume, convinced that demand was relatively inelastic (sound familiar?). Eventually, however, even the skeptical studios figured out that pricing power was more important to their long-term profitability than any particular price.

One critical way that pricing power was achieved and maintained was through studio control of the DRM system that was used on all commercial DVDs. Through their involvement in the development of the DVD technical standard, the studios gained control of the licensing agency that oversaw the Content Scramble System (CSS), which all DVD drive and player makers needed to license if they wanted their players to be compatible with Hollywood’s DVDs.

As it turned out, CSS was quickly cracked, leading to much mockery of the system and of DRM generally. But the criticism missed the main point: By controlling the standard, the studios were able to dictate the design of DVD drives and players — by including design criteria in the CSS license — ensuring universal compatibility among all DVD players and all DVDs.

That universal compatibility turned DVD movies into a true commodity, which could be sold in any type of retail outlet, not just those set up to rent out and take back cassettes. The result was an explosion in the number of retail outlets offering movies at a reasonable price, leading to a huge increase in the volume of movies sold and an enormous windfall for the studios. Large retailers like Walmart eventually accumulated substantial market share, but the much more diverse retail base ensured that no one retailer could set wholesale prices — and thus studio margins — for the entire category.

Contrast that experience with the ebook market. Instead of controlling the platform by which their ebooks would be sold, the publishers left the way open for Amazon to develop its own technical standard. The publishers then compounded their error by agreeing to let Amazon use a proprietary DRM on Kindle books, which tied them to a device only Amazon could legally make and effectively excluded all other booksellers from the market.

The result: Publishers are now being forced to accept Amazon’s terms, instead of the other way around.

What the studios accomplished in the DVD market did not come easily. It took vision and genuine industry leadership, supplied in the studios’ case primarily by the then-head of Warner Bros.’ home video division, Warren Lieberfarb, who managed to step on quite a few toes, often repeatedly, along the way and left more than a few noses out of joint. But what’s happening in the ebook business today is no more inevitable than what happened in the DVD market two decades ago. It’s just happening in reverse.