The Linked World: Working Paper Series

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1 The Lnked World: Workng Paper Seres Impact of ICT on Producton of Goods and Servces: Who Captures the Benefts of ICT? The Case of Dgtal Books By By Janet Hao (The Conference Board) and Randall Wess (The Conference Board) About The Lnked World Project Informaton and communcaton technology (ICT) has decsvely establshed tself as a general purpose technology one that affects an entre economy. Over the past four decades, ICT has spurred dramatc changes that wll contnue for the foreseeable future. Harder to predct, though, s the exact nature of those changes, and how they wll play out across socetes n our economes, our cultural relatonshps and the way human bengs nteract. Ths noton formed the basc motvaton for embarkng on the study, whch the Telefónca Foundaton agreed to underwrte n The purpose of The Lnked World: How ICT Is Transformng Socetes, Cultures, and Economes s to take stock of our knowledge on what the economc, socal, and cultural mpacts of ICT wll be. How has t evolved, how much have we been able to quantfy or to evaluate n a qualtatve sense, and what does t mean for the challenges and opportuntes ahead? The Lnked World: How ICT Is Transformng Socetes, Cultures, and Economes s the result of a two-year global research project led by The Conference Board and underwrtten by the Telefónca Foundaton. Ths workng paper s one of a global seres that forms the bass of the book The Lnked World: How ICT Is Transformng Socetes, Cultures, and Economes publshed by the Telefónca Foundaton and Artel Press. For more nformaton about ths project, ncludng vdeo summares and onlne forums please go to: 1

2 Impact of ICT on Producton of Goods and Servces: Who Captures the Benefts of ICT? The Case of Dgtal Books By Janet Hao (The Conference Board) and Randall Wess (The Conference Board) 1. Introducton 2. Industry, Data and Methodology 2.1. The Book Publshng and Retalng Industry 2.2. Data and Summary Statstcs 2.3. Methodology 3. Benchmark Estmaton of Consumer and Producer Surplus 3.1. Prce Reducton Due to Dgtal Books 3.2. Sales Increase Due to Prce Reducton Increased Consumer and Producer Surplus 4. Current Dvson of Benefts 4.1. Publshers 4.2. Retalers 4.3. Consumers 5. Concluson 2

3 1. Introducton: The development of dgtal technology and the expanson of broadband have sgnfcantly changed the book publshng and retalng ndustry. Brck-and-mortar bookstores used to be the major retalers n the 500-year-old book ndustry. By 2003, though, Internet retalers accounted for 12.7% of sales of new books and 67% of sales of used books n the US (Rappaport, 2004 and Wyatt, 2005). The latest major dgtal development n the book ndustry s the emergence of dgtal books. From 2002 to 2009 the sales of dgtal books grew by 71.0% annually on average from $7.3 mllon to $313 mllon n the US (Fgure 1, Assocaton of Amercan Publshers (AAP), 2009). The sale of dgtal books grew much more rapdly after Amazon ntroduced ts Kndle dgtal book reader n late Based on AAP s data, Forrester (2009) projected that 2010 sales wll exceed $500 mllon. In contrast, sales of paperback mass market paperbacks dropped by 2.2% annually, from $1,217 mllon to $1,042 mllon, durng the 2002 to 2009 perod (AAP, 2009). Dvson of benefts from nnovaton Dgtal books provde an excellent opportunty to examne who benefts from a new technology. Frst, ICT creates gans to be dvded among customers, wrters, publshng houses and retalers, lowerng the producton costs of books by about 27%, the amount of prntng, bndng and other drect costs (HM Publshng Corporaton, 2005). Second, ICT allows new busness models to evolve and changes the market power of dfferent players. The dstrbuton of market power determnes how players dvde the benefts. It s mportant to evaluate how advances n technology change the dstrbuton of benefts and losses. From the perspectve of an ndvdual frm, understandng such factors s the key to remanng compettve.. A frm that does not explot new technologes to cut costs, reaches a larger consumer base, and mproves productve effcency rsks losng ts market share and fallng behnd ts compettors. From the perspectve of a socal planner or polcymaker, such an evaluaton s mportant n understandng the balance between welfare maxmzaton and beneft dstrbuton. Understandng ths dstrbuton s pvotal n gaugng the potental economc and poltcal constrants on these new technologes n the future. Teece (1986) revews many cases n whch the creators of technology nnovatons dd not beneft from those nnovatons 1, and concludes that three elements determne who beneft from nnovatons: approprate regme, complementary assets, and the domnant desgn paradgm. Approprate regme s the busness and legal envronment that determnes how dffcult t s for a frm to protect ts nnovaton n the form of a patent or a trade secret. Complementary assets determne how benefts are dvded along the supply chan. Supplers of 1 For example, Electrcal Muscal Industres (EMI) created the EM1 CAT scanner, the greatest breakthrough of radology snce the dscovery of X-rays. EMI lost market share of the CAT scanner wthn sx years and dropped out of that busness two years later. 3

4 generc assets usually gan less than supplers of specalzed assets. A domnant desgn paradgm emerges when an nnovaton s mature and s at a turnng pont when competton shfts from desgn to prce. Usng the analytcal structure of Teece (1986), Dedrck, Kraemer and Lnden (2010) examne two new products released n 2005, the Pod and the HP nc6230 notebook. They use teardown reports to examne the composton of each product, and use company fnancal statements to estmate the proft ganed from each composton. They argue that Apple captured a large share of the value of the Pod, whle HP captured a small share of the value of HP nc6230 notebook. In contrast to HP, Apple marketed Pod before a domnant desgn paradgm emerged for dgtal musc, controlled content delvery (Tunes Musc Store) and brand-specfc accessores (external devces usng Pod s dock connector), and nternally developed the hghly specalzed software of Pod and Tunes. Meda ndustry transformaton The mpact of technology on meda ndustres s not restrcted to the book publshng ndustry. The newspaper and magazne publshng, move, and musc ndustres are experencng tremendous transformaton. Tradtonally, the creaton, producton, and delvery of content n these ndustres ncluded most or all of the followng steps: (1) content creaton, (2) selecton and edtng, (3) bundlng of ndvdual peces nto a sutable format for dstrbuton, (4) applcaton of the content bundle to a delvery medum (e.g., prntng), (5) dssemnaton of a lst of avalable bundles (marketng), and (6) delvery to the consumer. In each ndustry, a dfferent pattern of enttes performed dfferent steps n the process. In the newspaper and magazne ndustres, publshng companes domnated all of these steps. In the musc and book publshng ndustres, wrters and performers (step 1) were typcally dstnct from publshers (steps 2, 3, and 4), who, n turn, were dstnct from retalers (steps 5 and 6). Dgtal technology and broadband have reduced costs and created new marketplace pressures at every step of ths process. Meda ndustres have also struggled (and contnue to struggle) wth technology s mpact on revenues from advertsers and from the end users of the content. In the frst phase of technology s mpact, onlne retalng substantally reduced the value created n steps 5 and 6, although t also created new opportuntes for retalers to control the format of content delvery (e.g., dgtal books that can be read only on a dedcated devce). As broadband became more prevalent, content creators could skp steps 2 and 3 entrely and apply step 4 by themselves at lttle cost, thus puttng pressure on the companes that tradtonally carred out steps 2 and 3. For example, n the musc ndustry onlne delvery of ndvdual tracks elmnated producton companes benefts from step 3 (bundlng tracks nto albums), leavng the value of ther other functons (recrutng and selectng talent, producton, dstrbuton, and marketng) subject to ncreasng competton. For magazne and newspaper publshers, book publshers, and musc producers, the ablty of ndvdual bloggers, authors, and muscans to delver content drectly to consumers leads to a drect marketplace measure of the value they create by recrutng, selectng, tranng, and edtng talent. Indeed, because of 4

5 vastly ncreased access and lowered costs, much of the content avalable onlne s created by users themselves. Objectve of ths study Addng surplus analyss to the methodology of Teece (1986) and Dedrck, Kraemer and Lnden (2010), ths paper analyzes from two perspectves how dfferent partes dvde the beneft of dgtal books n the US market. The frst s a benchmark estmaton of the outcome of a hypothetcal long-run equlbrum n whch dgtal books replace all paperback books. It measures the sze of the pe to be dvded among producers and consumers. A long-run estmate s necessary because the book market currently s n turmol, and short-run consumer and producer surplus can be sgnfcantly changed by random and temporary factors. We treat dgtal books n the same way as any new technology that lowers the costs of paperback books, and assume that dgtal books do not change the market power, as a group, of the varous players nvolved n supplyng books to consumers. Under these assumptons, we estmate that dgtal books wll ncrease consumer surplus by 16.6% of current book revenues and wll ncrease producer surplus by 13.4% of current book revenues. Usng the current market sze of $9.16 bllon for paperback trade and mass market books, dgtal books wll ncrease consumer surplus by $1.52 bllon and wll ncrease producer surplus by $1.19 bllon. The second perspectve does not provde a quanttatve estmate lke the frst. Rather, the second perspectve provdes a snapshot of what the market s at the moment and gves nsghts nto how the market may develop as dgtal books become more wdespread. We estmate that currently publshers have benefted as much as 13% of the lst prces of prnt books. Amazon has profted, on the average, the same from dgtal books as from prnt books, and n addton has made $73 to $213 from each Kndle dgtal reader. Although consumers pay less for dgtal books than prnt books, they have to pay a relatvely hgh, albet declnng, prce for dgtal readers lke Kndle. We argue that ths dvson of beneft wll change, f and after Amazon or other Internet retalers establsh the domnant desgn paradgm of dgtal books. Secton 2 of ths paper descrbes the data and methodology and gves an overvew of the book publshng and retalng ndustry. Secton 3 provdes the benchmark estmaton n the long run f dgtal books take over the book ndustry. Secton 4 analyzes how much publshers, retalers and consumers have benefted from dgtal books at the very begnnng of ths new trend. Secton 5 s the concluson. 2. Industry, Data and Methodology: 2.1. The Book Publshng and Retalng Industry: The major players n the book ndustry are wrters, publshers, wholesalers, retalers and consumers. The book ndustry has a hollow structure, wth a large number of small players and 5

6 a small number of large players. A small number of wrters account for a large porton of book sales. In 1994, for example, over 70 percent of total fcton sales were accounted for by just fve authors: John Grsham, Tom Clancy, Danelle Steel, Mchael Crchton, and Stephen Kng (Greco, 2005). The wrters are generally represented by lterary agents, who sharply ncrease the chances of publcaton but at a cost of about 15% of author s royaltes (Sorensen, 2007). The publshng ndustry has a large number of small publshng houses, a small number of large publshng houses and relatvely few md-szed publshng houses. Of roughly 2,600 publshers, 50 receve 80% of ndustry revenue (Hoover s ndustral profle 2 ). Larger companes enjoy greater economes of scale and advantages n bddng for authors and new manuscrpts. Retalers are small book stores, bg bookstores (such as Barnes & Noble) and onlne retalers (such as Amazon.com). In the 1970s, bg bookstores provded systematc book dscounts that reduced the number of small bookstores. Bg bookstores forced the remanng small stores to mprove ther servce or to specalze n nche subjects. Begnnng n the 1990s, bg and small bookstores competed wth onlne retalers for market share. The bggest onlne book retaler s Amazon.com, currently provdng consumers wth about 17 mllon dfferent versons of books 3. The advent of computers and Internet profoundly changed the ndustry, affectng the wrters, the publshng houses, the retalers and the readers. For authors, the ICT weakens the tradtonal role of publshng houses. Tradtonally authors reled on publshng houses to publsh ther books. Wth new technology, authors can publsh ther books n dgtal forms through companes lke Smashwords 4, and receve sgnfcantly hgher royaltes than tradtonal publshng houses. In Mexco, Tortllera Edtoral 5 acts lke a cooperatve for authors, wth database, software and web ste that allow members to prnt and sell ther books (UNCTAD, 2008). For publshng houses, the dgtal revoluton lowered prntng costs, mproved nformaton flow, and decreased the number of unsold books. The old prntng process used photolthography and ncurred large fxed costs assocated wth each prnt run, thus makng t uneconomcal to publsh short press runs. As a result, publshers prnted large runs and smply destroyed unsold books (Flemng, 1999). The computerzaton of prntng lowered the fxed costs, and made short press runs more effcent, thus reducng the number of unsold books and encouragng publshers to prnt more books n short edtons. The advent of dgtal books pushed these trends even further. For retalers, the mplementaton of computer checkout systems and sophstcated enterprse software permtted real-tme nformaton on the quantty of the books sold, geographcal dstrbuton and even background nformaton on customers. Onlne retalers provde 2 accessed on February 11, We searched for the number of new prnt books on January 10, 2010 at Amazon.com. It provded 17,768,539 results. 4 At accessed n September 15, At accessed n September 15,

7 customers wth recommendaton lsts, book revews and mages of book pages. Customers can easly fnd the books they want and gan nformaton about other books they mght lke. Actually, new technology dramatcally changed the retal ndustry before dgtal books came along. For example, a major onlne retaler, Amazon.com, was founded n 1995 (Amazon.com Annual Report, 1997) Data and Summary Statstcs: In ths secton we explan the detals of prce and sales data of New York Tmes bestsellers. Our basc data are the August 2009 Amazon.com prces and sales rank for 981 bestsellers. The specfc ttles nclude all that appeared on the best-seller lsts from June 01, 2008 to Aug 16, The Tmes publshes the lsts weekly, and each lst contans 15 to 35 books. A book can stay n a lst for several weeks. For example, Outlers by Malcolm Gladwell was on the lst for 37 weeks. We consder only the bestseller lsts of paperback nonfcton, paperback advce, trade fcton paperback, paperback books and mass market paperback. We focus on paperback bestsellers, because, as explaned n the next secton, our analyss compares paperback books wth dgtal books. Data nclude the number of pages of a paperback, Amazon sales rank, author, publsher, the lst prce of the paperback, the Amazon sellng prce of the paperback, the sellng prce of a Kndle book, and the sellng prce on Amazon.com of a used book. Lst prce s the prce prnted on the books, set by publshers. The lst prce of a paperback averages $11.59 wth a mnmum of $4.99 and a maxmum of $30.00 (Table 1). The Amazon retal prce of a paperback book averages $9.54 wth a mnmum of $4.86 and a maxmum of $ The prce of a Kndle book averages $7.87 wth a mnmum of $2.87 and a maxmum of $9.99. Retal prce s on average 82% of lst prce, Kndle prce s on average 68% of lst prce, and used prce s on average 22% of lst prce. In our sample, books average 398 pages. The shortest book has 96 pages, and the longest book has 1104 pages. Some publshers have more bestsellers than others n our sample, wth a range of 1 to 34 bestsellers. Averagng the sales rank of each author s books n our sample, we fnd that 26% of authors rank n the top 10,000. We defne those authors as famous authors for the purpose of regresson analyss Methodology: We do not consder dgtal books as new goods, but rather a new way to convey the same content. Our method s dfferent from those used by Gentzkow (2007) and Goolsbee and Pentrn (2004) n related studes. Gentzkow (2007) uses a consumer survey on Washngton Post and Washngton Tmes, treats an onlne newspaper as a dfferent good from a prnt newspaper, and estmates that onlne newspapers crowded out prnt newspapers and ncreased consumer surplus. Goolsbee and Pentrn (2004) use a consumer survey on televson choces, and treat cable TV as a dfferent good from drect broadcast satelltes (DBS). They 6 Avalable at ( 7

8 estmate that the competton of DBS aganst cable TV decreased cable prces and ncreased the qualty of cable servce. They also estmate DBS provded ts buyers a consumer surplus of $2.5 bllon per year, and ncreased the welfare of cable subscrbers by $3 bllon per year. We use a dfferent method from them mostly because we have dfferent data. Gentzkow (2007) and Goolsbee and Pentrn (2004) have a survey of each consumer s choce but have no data on quantty demanded at dfferent prce levels. Thus they cannot estmate the effect of prce on demand but they can estmate the substtuton effect of dfferent goods. In contrast, we have no data on each consumer s choce, but we do have data on quantty demanded at dfferent levels of prce. So we can estmate the effect of prce on demand, but not the substtuton between the old goods and the new goods. We assume that dgtal books perfectly substtute for paperback books. That assumpton s conservatve, and wll most lkely under-estmate the degree to whch dgtal books ncrease consumer and producer surplus, because dgtal books wll lkely ncrease the demand for hardback books. Dgtal books create new sales of prnt books by ncreasng the vsblty of the prnt versons. Hlton and Wley (2010) use BookScan sales data of 41 books, and fnd that after the publshers release free dgtal versons, the sales of the prnt versons ncrease n the short term. Moreover, lower prces or ncreased qualty of ereaders may ncrease demand for books. We compare dgtal books wth paperback books rather than hardcover books. Publshers release hardcover books at a hgher prce and earler than paperback books to dscrmnate n favor of consumers who prefer good qualty and tmely access to new books (Clerdes, 2002). Dgtal books cannot help publshers dscrmnate n favor of those consumers, so we assume that consumers of dgtal books are the same group as the consumers of paperback books. We use the data on paperback books to estmate the relatonshp between cost reducton and prce reducton and between prce reducton and sales expanson. Unfortunately Amazon does not release sales nformaton for Kndle dgtal books, the predomnant type of dgtal book. The book market s a market of olgopolsts, as s descrbed n Secton 2.1. Famous wrters, large publshers and large retalers all have some power to nfluence costs and/or prce. Famous wrters can negotate wth publshers for favorable royalty rates, large publshers can negotate wth retalers for a hgh wholesale prce, and large retalers can set retal prces across many dfferent books. Snce our analyss does not mpose the assumpton of a compettve market, prce does not equal margnal cost n equlbrum, and the zero varable cost of dgtal books does not translate nto an equlbrum prce close to zero. 3. Benchmark Estmaton of Consumer and Producer Surplus: Consumer surplus s the dfference between prce and wllngness to pay. Producer surplus s the dfference between prce and costs. We do not estmate total consumer or producer surplus. Instead we estmate by the amount by whch dgtal books wll change surplus. We 8

9 assume that the value of convenence s equal to the cost of the dgtal reader, so the dfference between the dgtal and paperback prces measures how much the new technology benefts consumers. In ths secton we provde a hypothetcal estmate of a long-run equlbrum n whch dgtal books replace all paperback books. It measures the sze of the pe that wll be dvded by authors, publshers, retalers and consumers. Ths long-run estmate s based on the relatonshp we observe between costs and prces and between prces and sales of paperback books n the last week of August 2009; we assume that these relatonshps reman constant. We treat dgtal books n the same way as any new technology that lowers the producton costs of paperback books. Snce dgtal books lower producton costs, prce drops and sales ncrease. Consumer surplus ncreases because prce drops and sales ncrease. Smlarly, producer surplus ncreases because costs drop and sales ncrease. To estmate the ncrease n consumer and producer surplus, we need exstng sales, change n costs, change n prce and change n quantty. We estmate change n prce usng a cross-secton regresson of prce agan costs, and we estmate change n sales usng a regresson of the number of books sold aganst prce Prce Reducton Due to Dgtal Books: Prces fall because dgtal books reduce producton costs (Fgures 2a and 2b), and part of the cost reducton passes through to prce reducton, dependng on the slopes of the demand curve and the margnal revenue curve (Bulow and Pflederer, 1983). Measurng costs drectly s usually dffcult, so researchers nstead use proxes of costs. For example, Gron and Swenson (2000) proxy the costs of automobles wth US local wages, foregn local wages, and the shares of local and foregn nputs. We estmate the share of cost reducton that wll pass through to prce reducton by lookng at the supply sde (authors, publshers and retalers) as a whole, and model the relatonshp between costs and retal prces. The costs nclude those related to authors (royaltes), those related to publshers (edtng, prntng, bndng, marketng, managng and other costs) and those related to retalers (shppng, storng and other costs). Followng Gron and Swenson (2000), we assume a log lnear relatonshp between prce and costs. prce s the Amazon retal prce of a paperback book. The key coeffcent s b, the share of cost reducton that wll pass through to prce reducton. Ths equaton mples that f costs ncrease by 1%, prce wll ncrease by b%. (1) ln( prce ) a bln( cost ) u Although we lack data on cost, we do have data on lst prces. We can derve an equaton that can be estmated wth avalable data by assumng that (1) varaton n cost across ttles leads to 9

10 an equal percentage varaton n lst prce and (2) lst prces are a functon of publsher volume and author sales: (2) ln( lst _ prce ) c ln( cost ) d rank _ publsher e fame _ author cost s the total costs of a book, lst _ prce s the lst prce of a book, rank _ publsher s the number of books that a publsher publshes n our sample, and fame _ author equals 1 f the author s famous and equals 0 otherwse. The assumpton that lst prce s proportonal to costs and unaffected by quantty sold of ndvdual ttles s reasonable, because publshers set lst prce n advance of publcaton. In contrast to lst prce, retal prce vares sgnfcantly as a share of lst prces because retal prce reflects demand condtons. In our sample of 981 book ttles, retal prce ranges from 55% to 100% of lst prce. Lst prce s also a functon of the barganng power of publshers and authors. Large publshers may be able to set a hgher lst prce (and thus wholesale prce) than others. Famous authors may be able to command hgher royaltes than other authors. We average the sales rank of an author s books n our sample. A small sales rank means the book s popular. If the average rank s less than 10,000, we defne the author as a famous author. We do not consder retalers costs n our model, because Amazon s the only retaler n our sample, and we assume that all books sold by Amazon have smlar retaler costs proportonal to ther lst prces; those costs become part of the constant term of the model. Solvng (1) and (2) to elmnate cost, we derve: (3) ln( prce ) a b bc e bln( lst _ prce ) fame_ author b b d u rank _ publsher Table 2 presents an ordnary least squares (OLS) estmate of equaton (3), where prce s the Amazon retal prce. We estmate that f cost decrease by 1%, prce wll decrease by 0.57%, and that nfluental publshers usually ask for a lower lst prce, and that books of famous authors wll have a slghtly lower lst prce than books of other authors. Snce dgtal books wll lower producton costs on average by 27.3% of exstng producton costs 7, we multply 27.3% by 0.57, and thus estmate that paperback prces would drop by 15.7% n our hypothetcal long-run equlbrum. The error terms could be correlated wth costs, and t s ambguous whether we would overestmate or under-estmate the rato of pass-through. Our estmated rato seems reasonable 7 Total costs of paperback books are 47.7% of lst prces. Dgtal books lower costs by 13% of lst prces, the amount of prntng, bndng and other drect costs (Table 3). 13%/47.7%=27.3%. Dgtal books may also lower the shppng and storage costs, but we have no data on those costs and choose to gnore them. So our estmaton of cost reducton s conservatve. 10

11 though. Our estmated rato s 0.57, close to the pass-through rato of 0.47 of US automobles (Gron and Swenson, 2000) Sales Increase Due to Prce Reducton. The second source of surplus s ncreased sales. We estmate the prce elastcty of demand usng the followng equaton. (4) ln Q ln( prce ) ln(# pages ) fame _ author rank _ publsher where Q s the quantty sold of a book ttle and # pages s ts number of pages. Amazon does not provde quanttes sold of ndvdual ttles, but does provde sales rank. We formulate the relatonshp between Amazon sales rank and weekly sales as Quantty Rank. Brynjolfsson, Smth and Hu (2003) use a sample of 321 books, and estmate that Quantty e Rank. Chevaler and Goolsbee (2003) estmate that the elastcty of quantty to sales rank s Wengarten (2001) and Poynter (2000) respectvely estmate that the elastcty s and We use the estmaton of Brynjolfsson, Smth and Hu (2003) because they have a large sample of books. We do not mpose the value of, because t reflects the expanson and contracton of the book market. We nsert Quantty Rank nto equaton (4) and obtan: (5) ln Rank ln ln fame_ author prce ln(# rank _ publher pages ) OLS estmaton s a standard approach n the lterature of Internet book demand (Ghose, Smth and Telang, 2006, and Chevaler and Goolsbee, 2003). The problem that the market smultaneously determnes prce and quantty s less severe for books than for other goods, because Amazon sets book prces at a standard level, so that sales of a partcular book does not seem to affect ts prce. Table 4 shows that f prce ncreases, quantty decreases. At the same prce, a book of more pages sells better than a book of fewer pages. Good sales of a partcular ttle are assocated 11

12 wth famous authors, but not wth successful publshers. Snce , the prce elastcty of sales to prce ( ) s , mplyng f prce drops by 1%, quantty wll ncrease by 0.761%. Snce n the hypothetcal long-run equlbrum dgtal books are estmated to drop prce by 15.7%, quantty sold s estmated to ncrease by 11.9% Increased Consumer and Producer Surplus: In a hypothetcal long-run equlbrum n whch dgtal books replace paperback books, consumer surplus ncreases because prce drops for exstng quantty sold and because sales ncrease. For exstng consumers (the effect of prce reducton), book prces drop by 15.7%, ncreasng total consumer surplus by 15.7% of exstng revenues. Addtonal books sold generate a surplus rangng from 0% to 15.7% of book prce for each book. Some of these addtonal books yeld a surplus of 15.7% of book prces for each book; the purchasers are ndfferent between buyng and not buyng a book at the old hgher prce. For some of the other addtonal books, the surplus s 0% of prce; these purchasers are ndfferent between buyng and not buyng a book at the new low prce. All other addtonal sales generate a consumer surplus between 0% and 15.7% of prces. Averagng ther consumer surplus, we estmate that new books sold on average have a surplus of about 7.9% of book prces. We multply 7.9% by 11.9%, and estmate that sales expanson creates a consumer surplus of 0.9% of exstng revenues. (See Table 5 for summary of calculatons.) Addng up the effect of prce reducton and sales expanson, dgtal books wll ncrease consumer surplus by 16.6% (15.7%+0.9%) of exstng revenues. The exstng revenues of the paperback trade and mass market books are $9.16 bllon n 2008 (Assocaton of Amercan Publshers, 2009), so dgtal books ncrease consumer surplus by $1.52 bllon n the hypothetcal long-run equlbrum. Producer surplus ncreases because costs drop for exstng quantty sold, and because sales ncrease. For dgtal books, producers margnal costs are a constant and equal to royaltes, so we estmate producer surplus usng new sales and the dfference between reducton n margnal costs and reducton n prce. Total sales now equal 111.9% (100%+11.9%) of exstng sales. Costs drop by 27.3%, and prces drop by 15.7%, so the dfference between reducton n margnal costs and reducton n prce s 11.6% of exstng prce. We multply 11.6% by 111.9%, and estmate that dgtal books ncrease producer surplus by 13.4% of exstng revenues or $1.19 bllon n the hypothetcal long-run equlbrum. It should be noted that a porton of the new sales estmated above may result from addtonal ttles beng produced rather than an ncrease n average sales per ttle. Dgtal technology lowers the cost of producng each ttle, and lower storage cost allows ttles to be made avalable for a longer perod of tme. Increased producers surplus, because of an expandng market and retaned monopoly over ndvdual ttles, wll contnue to provde ncentves to produce new content. 12

13 These estmates are based on a number of assumptons, and may turn out to be conservatve. For example, a major dfference between prnt books and dgtal books s that dgtal books requre a computer or a dgtal reader such as Kndle. However, for those that purchase a dgtal reader, the value of convenence and lower prces exceeds the cost of the readers. As the prces of ereaders contnue to declne, we suspect the value of convenence (whch we have not separately measured) wll greatly exceed the cost of readers. Several other factors may affect the sze of the pe. If dgtal readers drve up the demand of dgtal books, that wll ncrease the sze of the pe. If one publsher or retaler domnates the market of dgtal books, that monopolst may control prce and shrnk the sze of the pe. If dgtal books replace only a fracton of paperbacks, the sze of the pe shrnks accordngly. Case study: Text books. Dgtal books have many advantages over prnt books (Wkpeda, 2009). For example, consumers have mmedate access to over 2 mllon free books to download n August 2009; chldren s books have moton capablty; senor readers can enlarge the font for easy readng; readers can search for text. Here we focus on estmatng the dollar value of one beneft, cheaper textbooks for students. A typcal undergraduate spends $4488 on textbooks n a four-year publc school (College Board, 2009). After dgtal books replace prnt textbooks, a student s estmated to pay 15.7% less for textbooks. If students value convenence at least as much as the prce of Kndle dgtal reader, each student saves $704.6 durng the fouryear college experence. 4. Current Dvson of Benefts: The long-run hypothetcal equlbrum n the prevous secton wll exst, f at all, many years n the future. Ths secton provdes a snapshot of what the market s at the moment, and gves nsghts nto the ssues that wll affect how t may develop as dgtal books contnue to be more and more wdespread. As books become dgtal, prnters and wholesalers lose some busness. As to the wnners and losers among publshers, retalers and consumers, we analyze the current market followng a smlar structure as Dedrck, Kraemer and Lnden (2010). They study how dfferent players on the supply sde dvde the profts from the Pod and notebook PCs, and explan why Apple successfully captured the proft from Pod whle HP faled to capture most of the proft from a new model of a notebook PC. We examne how much consumers, publshers and retalers beneft from dgtal books n the current market. The prevous secton does not consder changes n the dstrbuton of market power. But as Teece (1986) shows, market power s a key determnant of whether an nnovator wll beneft 13

14 from ts nnovatons, so t s mportant to examne how dgtal books may have changed at least temporarly the market power of publshers, retalers and consumers. Snce we are at the begnnng of a new trend we need to understand the dynamcs of market power n order to examne the general condton of the book ndustry Current developments n the use of dgtal technology n the book ndustry are at an early stage. Generally, technologcal evoluton starts wth the ntroducton of the new product. Then the evoluton enters the early stages when frms compete on many dfferent desgns of the new product (Abernathy and Utterback, 1978 and Dos, 1982). As competton goes on, one desgn or one type of desgn emerges as the standard desgn that meet a complete set of users needs. After the domnant desgn emerges, frms stop competng on desgn and start competng on prce. If a frm controls the domnant desgn, the frm can capture a large market share of the new product. The dgtal book market s followng ths pattern. In 2003, a European company, Cytale, ntroduced the frst ebook reader and faled. There are now more than 40 dfferent desgns of ebook readers avalable, most of whch were ntroduced after 2008 (Wkpeda, 2010). Amazon s Kndle captured 60% of the market share of dgtal readers n the US n 2009, and an even greater share of dgtal book sales (Forrester, 2009). It appears that Amazon s Kndle strategy s smlar to the strategy Apple used wth Pod to establsh ts product as the domnant desgn (Dedrck, Kraemer and Lnden, 2010). Frst, both Apple and Amazon carred out a marketng campagn. Apple spent $200 mllon on advertsng n the frst four years after Pod was ntroduced, far more than rvals. Amazon lsts Kndle on the front page of ts US webste, usng homepage traffc to advertse Kndle. The marketng campagn expands the customer base of Kndle. However, the platform battle may be more complex for dgtal books than for musc. The Kndle reader s essentally dedcated to ebook readng, wth lmted addtonal uses. In January 2010, Apple announced the ntroducton of the Pad, a tablet computer whch has many of the functons of a laptop computer n addton to servng as an ebook reader. Wth Apple s strong reputaton among consumers and the establshment of the Books dgtal book store, the Pad quckly became a strong compettor to Amazon n the markets for dgtal readers and books. Second, both Apple and Amazon use the sale of devces to bolster ther sales of content and lnk the two types of transactons through closed platforms usng dgtal rghts management. For dgtal musc, Apple controls Tunes software and the Tunes store, whle, for dgtal books, Amazon controls the formattng and retalng of Kndle books. The Pod most convenently plays musc that Pod owners buy from the Tunes store. Smlarly, Kndle reader owners have to buy ther ebooks from Amazon. On the other hand, other ebook readng devces (ncludng the Pad and other dedcated ebook readers) accommodate more open formats 14

15 Thrd, both Apple and Amazon nternally provde a large range of the assets complementary to the products. As Dedrck, Kraemer and Lnden (2010) show, dependng on the negotaton power of the lead frm (nnovator) and ts supplers and dstrbutors, supplers and dstrbutors could capture more proft than the lead frm. To mnmze the proft captured by other frms along the supply chan, Apple nternally developed the Pod and Tunes clent software, lcensed (or patented) the dock connector nterface of Pod, and used Apple Stores to market Pod. Smlarly, Amazon controls the format of Kndle books, uses the Amazon webpage to market Kndle, and uses the Amazon webpage to sell Kndle books. It leverages ts long lst of dgtal ttles by also makng them avalable to owners of other devces (ncludng the Pad) Retalers: For the paperback books n our sample, we estmate that Amazon makes a proft equal to 18% of lst prces from both Kndle books and prnt books. Our sample shows that the paperback prce s 82% of lst prces, and Amazon s gross margn s 22% (Wngfeld, 2003), so proft s 18% of lst prces (multplyng 22% by 82%). Amazon s gross margn on Kndle dgtal books s also 18% of lst prce. The wholesale prce of Kndle books s 50% of paperback lst prces, and retal prces are 68% of lst prces on average (Table 1). On the other hand, Amazon appears to have been ncurrng a loss on the dgtal edtons of new hardcover bestsellers. Snce, untl 2010, ts top prce for a dgtal book was $9.99, the wholesale prce of a dgtal book was the same as for a prnt book, and the wholesale prce of a prnt book s about 50 percent of ts lst prce, Amazon was losng money on the ebook edton of any prnt book wth a lst prce exceedng approxmately $20. Presumably, t was ncurrng ths loss to boost profts from sales of ts Kndle reader and to mantan ts domnant poston n the ebook marketplace. Amazon made between $73 and $213 from each Kndle reader sold. Amazon ncurred a cost of $186 to make a Kndle dgtal reader (Suppl.com, 2009), and charged $399 for a reader n 2008, and $259 n 2009 (Amazon.com). Thus, Amazon made $73 from each reader t sold for $259 and $213 for a reader sold for $399. Snce there are over 3 mllon Kndles n use (Auletta 2010), the sale of Kndle readers appears to have been a sgnfcant source of proft. In the long run, f Amazon were to establsh Kndle as the major dgtal book reader as the Pod became for musc, Amazon may capture surplus from publshers and consumers n several ways. For example, Amazon could negotate wth publshers to reduce the wholesale prces of dgtal books and rase the prces of Kndle books to capture some of the consumer surplus book by book. However, the dgtzaton of books presents establshed book retalers wth sgnfcant new competton from other companes that have staked out a poston n less specalzed aspects of the dgtal world but are new entrants to book retalng. Apple s Pad and Books store, a prme example of ths phenomenon, represents sgnfcant competton to Amazon. Ths competton 15

16 has recently led to large cuts n the prces of the Kndle and other ereaders, undercuttng Amazon s effort to use low ebook prces to generate sales for ts devces. Apple has agreed wth major publshers on a prcng model that appears to nvolve hgher ebook prces for best sellers than Amazon has been chargng. As of ths wrtng, Amazon appears to be adoptng ths prcng model, whch may lead to somewhat less growth n sales and an eroson of ts market share. Further, Google has announced the launch of ts own dgtal bookstore Google Edtons that may present addtonal sgnfcant competton. In addton, other consumer electroncs manufacturers (such as Sony) and dgtal retalers (such as telecom operators n many countres) are vyng for a pece of the overall revenue that consumers spend on publshed book content and delvery Publshers: A publsher s a monopolst for each book t publshes; ths gves publshers the ablty to protect ther proft margns to some extent. Untl the change n the prcng model assocated wth the Pad ntroducton, publshers retaned the beneft of cost reducton they charge Amazon the same prce for dgtal books as prnt books, 50% of the lst prce of paperbacks (Publshers Weekly, 2009). Thus, for each dgtal book, publshers ncreased ther proft by at least the saved drect costs, 13% of lst prce. However, publshers became concerned that the low prce at whch Amazon was sellng dgtal books would lead to reductons n the retal prce of prnt books, thus threatenng the vablty of ther other retal dstrbuton channels, especally brckand-mortar bookstores. As a result, n order to acheve the hgher retal prces resultng from the new prcng model negotated wth Apple, publshers apparently agreed to lower the wholesale prce of dgtal books, allowng retalers to capture a greater share of dgtal book revenue. 8 Publshers, however, wll contnue to face pressure from the unbundlng n the steps of the meda value chan that are descrbed at the begnnng of ths paper. Authors ablty to connect drectly wth readers through a multplcty of sales channels may tend to lmt publshers roles Consumers: The drect mpact of the ebook phenomenon on consumers s to lower the prce of publshed book content. A consumer swtchng from a prnt book to a Kndle book pad 40.5% of lst prce less for Kndle books than for paperback books. For Kndle books, consumers pay 68% of lst prce, and for prnt books, consumers pay 108.5% of lst prce (pay 82% of lst prce for the book and 34% of lst prce for shppng, and on average receves 7.5% of lst prce because they can 8 See Auletta (2010) for a descrpton of the relatve postons of ebook publshers and retalers as of the sprng of

17 sell the used book) 9. (For each new prnt book, the consumer pays $3.99 for shppng -- 34% of the average lst prce n our sample). Prce senstve markets wth techno-savvy readers such as textbooks may be especally senstve to ths change. Beyond prce reducton, however, ICT has changed the consumer experence of buyng and readng books. In effect, ebooks have become a new product n many respects, makng conservatve the prevous secton s analyss of the market expanson that dgtzaton wll generate; that analyss reflected only the mpact of cost reducton. Dgtal readers can allow the convenent vewng of vdeo clps placed n chldren s books or other nteractve content and of related nformaton anywhere on the nternet. Senor readers can enlarge the font for easy readng. Readers can search for specfc text. Books of short stores can be unbundled and sold separately. Dgtal books can be easly bundled for sale wth related dgtal content and be the focal pont for socal networkng actvtes; both of these may create unque marketng advantages n some stuatons. Dgtal books are convenent. Some consumers value the convenence of ereaders more than others. Some consumers have bought Kndle readers at a prce of $259 or hgher. They amount to less than 10% of Amercan readers. About 90% of Amercan readers value the convenence at less than $250 for the useful lfe of a Kndle reader. About 60% of Amercan readers value the convenence at less than $98, and they wll not buy Kndle readers or Kndle books unless Amazon lowers the prce of Kndle readers to $98 (Forrester Research, 2009). 5. Concluson: Both consumers and producers beneft from dgtal books. The cost reducton due to ICT wll sgnfcantly expand the market. In a long-run equlbrum f dgtal books replace paperback books, dgtal books would ncrease consumer surplus by $1.52 bllon or 16.6% of exstng sales, and producer surplus by $1.19 bllon or 13.0% of exstng sales, of paperback trade and mass market books, f dgtal books do not change the market power of the supply sde of the market (authors, publshers, and retalers as a group). Certanly, as wth other nnovatons, the relatve postons of these tradtonal players n the market wll be substantally dsrupted. Several other factors may affect the sze of the pe. If the convenence, tes to socal networkng, and/or multmeda features of dgtal books drve up ther demand, that wll ncrease the sze of the pe. If one publsher or retaler establshes a platform that domnates the market of dgtal books, that monopolst may control prce and shrnk the sze of the pe. If dgtal books replace only a fracton of paperbacks, the sze of the pe shrnks accordngly. 9 Used books make up 23% of total new and used book sales at Amazon.com (Ghose et al., 2006). We roughly estmate that 30% of new book buyers sell ther books later (23%/(100%-23%)=30%). The prce of a used book s about 50% of new book, and Amazon takes away half of that revenue as commsson. So used books brng buyers of new books a revenue equal to (30%*25%) =7.5% of lst prce. 17

18 Competton s not over costs. Rather competton s over desgn, marketng and the control of content. Snce dgtal books are n the early stage of technologcal evoluton, Kndle s competng wth other ebook readers to become the domnant desgn paradgm. Smlar to Apple s marketng strategy wth Pod, Amazon s tryng to establsh Kndle as the domnant desgn paradgm of ebook readers. Moreover, Amazon controls most of the supply chan of Kndle books to capture a large share of value of the new product. Amazon controls the format of Kndle books, and markets Kndle on ts own webste. The case of dgtal books reflects a general trend n the knowledge economy. ICT decreases varable costs to almost zero n many ndustres. In order to capture proft, companes nvest heavly n upfront fxed costs such as R&D, desgn and brand equty to buld up market power. If Amazon were as successful wth Kndle as Apple s wth Pod, Amazon most lkely could earn large profts n the future. Apple ntroduced Pad n Aprl 2010, competng wth Amazon s Kndle. Followng the ntroducton of Pad, bg publshers sparred wth Amazon over the prcng of dgtal books on Amazon.com. In June 2010 Barnes & Noble dropped the prce of ts dgtal reader, Nook, to $199, and Amazon dropped the prce of Kndle to $189. The fght s affected by many factors, such as dgtal rghts management and the nterchangeablty of formats. We are stll at the openng of the contest and we dare not predct f Amazon wll be the wnner. Because of dstnctve characterstcs of the book publshng ndustry, the dgtal revoluton may not affect other meda ndustres n the same way. Moreover, we analyze dgtal books under the US regulatory framework; ncreased surplus may be even larger n other countres that have more regulatons governng retal competton. 18

19 Fgure 1: Sales of Dgtal Books n the US $mllon Source: Assocaton of Amercan Publshers

20 Table 1. Summary Statstcs Varable Mean Std. Dev. Mn Max Mean prce as % of lst prce lst prce n.a. new paperback prce % Kndle book prce % number of pages n.a. sales rank n.a. author s avg. sales rank< n.a. (yes, 1, no, 0) #books a publsher has n our n.a. sample Source: Our data are the prces, the number of pages, sales rank, author and publsher of 981 New York Tmes paperback bestsellers sold n Amazon.com. These data are not tme seres; they are the values durng the last week of August 2009, when we accessed and parsed Amazon webpage. Mean prces are calculated as a percentage of lst prces, usng lst prces as the weght. 20

21 Fgure 2a: Dgtal Books Changed the Value Chan of the Book Industry the Old Value Chan author & publsher publsher author & publsher publsher Preparng for a master copy Prntng, bndng and other drect costs Sellng& marketng Return of unsold books Other SG&A; pub s proft 14% 13% 23% wholesaler retaler consumer Shppng & storage Other costs Shppng & storage Rent of the stores Other costs Dscount 50% Source: 2005 Annual report of HM Publshng Corporaton. 21

22 Fgure 2b: Dgtal Books Changed the Value Chan of the Book Industry the New Value Chan author & publsher publsher author & publsher publsher Preparng for a master copy Prntng, bndng and other drect costs Sellng& marketng Return of unsold books Other SG&A; pub s proft 14% 13% 23% wholesaler retaler consumer Shppng & storage Other costs Shppng & storage Rent of the stores Other costs Dscount 50% New Costs publsher & retaler Neglgble storage and delvery costs consumer Dgtal reader Source: 2005 Annual report of HM Publshng Corporaton for the old value chan. 22

23 Table 2. The Effect of Costs Reducton on Prce Reducton Log paperback prce Ln lst prce 0.54 (51.19)*** Rank of publsher (1-34) (#books by a publsher n our sample) Fame of author =1 f the average sales rank of books by that author s <10000, and =0, otherwse Constant 0.94 (39.31)*** Log paperback prce 0.55 (50.46)*** (2.32)** 0.92 (36.32)*** Log paperback prce 0.57 (49.73)*** (1.83)* (-7.67)*** 0.89 (34.36)*** R-squared obs Source: Sources: Our data are the prces, the number of pages, sales rank, author and publsher of 981 New York Tmes paperback bestsellers sold n Amazon.com. Our data are not tme seres. They are the values durng the last week of August 2009, when we accessed and parsed Amazon webpage. Note: OLS regressons and robust standard errors. *, ** and *** respectvely denote sgnfcance at 90%, 95% and 99% confdence level. Table 3. Breakdown of the Prce of Prnted Books Components % of lst prce Royaltes 7 Other costs to produce a master copy of books 7 Prntng, bndng, and other drect costs 13 General sellng and admnstratve costs 20 Total costs 47.7 Publsher s proft 2.3 Dfference between wholesale prce and lst prce 50 Total 100 Source: 2005 Annual report of HM Publshng Corporaton. Note: The operaton of HM Publshng Corporaton ncludes K-12 publshng, college publshng, trade and reference publshng and other publshng. We estmate a prce breakdown from the costs breakdown n 2005 fnancal statements. Our prce breakdown s close to that of trade books n the UK provded by the Booksellers Assocaton (1998). For more nformaton, please see the text. 23

24 24

25 Table 4. The Determnants of Sales Rank Log sales rank of a paperback book Log prce (3.17)*** Log number of pages 0.07 (0.42) Fame of author =1 f the average sales rank of books by that author s <10000, and (-24.76)*** =0, otherwse Rank of publsher (#books by a publsher n our sample) (0.63) Constant 8.31*** (7.09) #obs 981 R-squared 0.44 Source: Our data are the prces, the number of pages, sales rank, author and publsher of 981 New York Tmes paperback bestsellers sold n Amazon.com. Note: OLS regressons and robust standard errors. *** denotes sgnfcance at 99% confdence level. Our data are not tme seres. They are the values durng the last week of August 2009, when we accessed and parsed Amazon webpage. 25