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On Ebook Pricing and Sunk Costs

April 13, 2012

Guest Post by Teresa Oswald

The Department of Justice has finally brought a suit against several major book publishers after threatening to do so for months. The suit attempts to address the charges of collusion to fix prices between the major publishers as a result of Apple’s entry into the market as an ebook distributor and its subsequent push to switch to an agency model of pricing its books.

I think there is a lot of misunderstanding about the basic economic principles surrounding this issue, namely that sunk costs keep cropping up as a reason for the high prices. Hopefully this post will explain why that reasoning is fallacious.

The Sunk Cost Fallacy
Simply put, sunk costs are costs that an actor has already paid and cannot get back. A good example of a sunk cost is dollars put into a research and development branch of a company. Once research has been completed, a company is free to attempt to monetize the results, but the work already finished cannot be undone. For book publishing, sunk costs include all the costs of writing, editing, and promoting the book. Once a book is written, it cannot be un-written by selling the words off one by one. Everything is already paid for. If the book flops, the sunk costs might not be recouped, and if the book sells well, the publisher makes the money back.

The Sunk Cost Fallacy is when an actor feels as though he must do something to make up for the sunk costs, even if those actions won’t help. In other words, if someone says “I should never have started this, but it’s too late to quit now,” they are likely caught in this trap.

Customer Perception and Marginal Costs
Sunk costs do not magic away the laws of supply and demand. Publishers should not ask ‘what price should I set to recoup my losses?’ but rather ‘what price should I set to maximize my profits?’ In order to choose a good price, publishers must consider the public’s perception of how valuable ebooks are.

The reality of the situation is that most consumers do not believe ebooks should cost more than paperbacks. To the average consumer, the marginal costs of a book are the most visible. When you buy a book, you get a thing that you can hold in your hands, but digital goods are far less tangible. A similar thing has happened in the music industry; consumers might pay $15 for a CD, but are only willing to pay $1 for a digital copy of a song, which translates into about $10-$12 if a person purchases every track in an album.

For printed books, customers can see the paper in their hands and feel its weight. Clearly, it cost money to print the book and ship it to the store. In this case, even if the marginal cost of the book is low and the majority of the cost of a book is in sunk costs, because the marginal costs are the most visible to the consumer, the consumer believes it should have a visible effect on the price. In other words, a person can see the difference between a paperback and a digital book. Since it’s easy to see there is a difference in the product, there should be a difference in the price. Right or wrong, this perception is well-entrenched and is not about to change any time soon.

What This Means for the Industry
In my opinion, the publishing industry as a whole is caught in the sunk cost trap. Publishers believe that they must sell books for a certain price regardless of medium to recoup the sunk costs, when in reality they should price the books at the price that consumers are willing to pay. Publishers do not need high prices to see high profits. Publishers need to find the price point that will earn them the most profit. This means finding out what people are willing to pay and selling at that price.

Consumers expect ebooks to cost less than paperbacks. Regardless of whether or not ebooks actually do cost less to make, this means consumers are not willing to pay as much for ebooks as they are for physical copies of the book. Though it is hard to find the exact right price for the most sales, it is clear that insisting on $14.99 prices for ebooks is a silly way to maximize profits.

In conclusion, publishers need to stop thinking about sunk costs when setting prices. The sunk costs have absolutely no bearing on what people are willing to pay, because people do not care about how much publishers spent to make something. The only thing people care about is how much they are willing to pay to get what publishers have to offer.

Further Reading:
Steam’s video game pricing strategy
DOJ Lawsuit over ebook pricing.
B+N is the big loser – they would have made lots of money selling a cheaper substitute to the ebook – the book.
Libertarian take on the whole event.

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