In Defense of Apple

Now Apple has become the bull’s eye of antitrust enforcers, with their formal complaint filed in early April 2012.2 Apple’s violation, according to Justice Department lawyers? Seeking to make inroads into the Amazon-dominated e-book market by “conspiring” with major publishers to devise an innovative pricing strategy—the so-called “agency model”—under which the publishers agreed to a set of selling prices for their e-books sold on Apple’s iBook portal and to give Apple a percentage of the take. The selling prices would also be applied to all other e-book download sites, including Amazon’s. The net effect has been that e-book buyers now have an additional outlet, Apple, for e-books to read on their wildly popular iPads, at higher e-book prices, of course. Indeed, being able to muscle its way into the e-reader market was no doubt a strong motivation for Apple to develop the iPad (and iPhone) in the first place.

The current antitrust attack on Apple and its presumed co-conspirators confirms the validity of Judge Robert Bork’s decades-old assessment of antitrust law and enforcement: “[M]odern antitrust has so decayed that the policy is no longer intellectually respectable. Some of it is not respectable as law; more of it is not respectable as economics; … a great deal of antitrust is not even respectable as politics.” 3 Given the hordes of publishers and the growing ease of entry these days, it is truly ludicrous that antitrust enforcers can think that a cartel of only five, albeit major, U.S. publishers can long achieve the anticompetitive effects that the Justice Department imagines. It is equally ludicrous for the Justice Department to declare that within the U.S. borders, there is “no substitute” for e-books, a conclusion the Department can draw only by narrowly defining the relevant market as encompassing only e-books (and ruling out print books and a range of domestic and foreign information sources). 4

Antitrust enforcers have long misunderstood monopoly theory or misapplied the theory at the behest, and to the benefit, of the competitors of the targeted “monopolist.” But even conventional monopoly theory, narrowly understood, is fundamentally flawed, as Dwight Lee and I have argued in detail elsewhere.5 It misleads antitrust enforcers to file anticompetitive complaints against firms like Apple, whose actions are profoundly pro-competitive; this explains why the targeted firms’ competitors so often support the Justice Department’s antitrust actions.

It is true that in its complaint, the Justice Department appears to have nailed Apple and the publishers for meeting and exchanging emails with the intent of raising e-book prices (although two publishers continue to vigorously contest the complaint6). The issue is whether their agreement should be seen as a conspiracy to extract monopoly profits from e-book readers or as a form of collaboration that has ultimately enhanced not only the bottom lines of Apple and the publishers, but also the welfare of e-book readers.

The Justice Department lawyers see the publishers’ e-book pricing as an anticompetitive conspiracy because they dutifully studied in law school some version of conventional monopoly theory in economics. Under their textbook theory of monopoly, the good produced by the monopolist already exists by assumption. That is, the monopolized good (and the market for it) does not have to be developed, and no one needs an incentive to create anything.

Under this model, any restriction on production, arising from the market dominance of a single firm or from collusion of multiple firms, leads to an above-competitive price. Such an elevated price must be “bad” because it creates a presumed “inefficiency” and converts consumer value into monopoly profits.

Conventional monopoly is fundamentally flawed for several reasons.

First, the model views monopoly profits as “unearned rents” because they serve no useful purpose. What useful purpose could be served? How about the creation of the good in response to the prospect of monopoly profits? But the model has already assumed the good into existence, which is hardly the way real-world goods emerge.

Second, in assessing the efficiency consequences of monopoly, conventional analysis assumes a market standard of competitiveness—perfect competition (under which market entry is free and costless)—that is unrealistic and unachievable. Such a market structure would also be undesirable if there is an upfront cost of developing new goods and markets for them. And development costs are almost always present. What firm would ever incur development costs when facing the threat of a multitude of copycat firms instantaneously swooping into the market and pushing the price down close to the marginal cost of production, eliminating any chance that the good’s creator would recover its development costs, much less make an economic profit? Ironically, zero entry costs and perfect fluidity of resources, which conventional microeconomic theory holds up as the foundation for perfect economic efficiency, are the ultimate barriers to entry when goods must be imagined, developed, and produced at real costs.

Third, the issue of creative product development is especially problematic in the case of e-goods, including e-books. They are made of 1s and 0s, which means they have a marginal production cost of practically zero. With no market power, the price would go to zero. With the prospect of a zero price for their items, producers would never, or rarely, produce such goods.

Fourth, seen from the perspective of a world in which goods and their markets are not given, but must be created, firms need solid incentives to develop them, which means they also need market pricing power. The resulting “monopoly profits” can be welfare-enhancing. Even collusion (or collaboration) on price among competitors or among suppliers and resellers (e-book publishers and Apple, for example) can also be welfare-enhancing because the collaboration can expand the array and quantity of the goods sold. Monopoly pricing power and the resulting monopoly profits can cause producers to bring more goods than otherwise into existence. Seen from this perspective, consumers don’t lose the inefficiency, or “Harberger,” triangle7 from underproduction (which, in conventional monopoly graphics is the area bounded by the marginal cost curve and the demand curve to the right of the monopoly price); they gain as consumer surplus the rarely mentioned “Dupuit” triangle (which is the area above the monopoly price and bounded by the demand curve and the vertical axis).8 In short, you can’t consume what doesn’t exist. The prospect of temporary monopoly profits is what entices producers to develop new products. Consumers might not get the “statically optimal” amount of the good (which, again, is grossly unrealistic and unachievable), but at least they get the good.

Interestingly, since 2010, when Apple and the publishers were supposedly conspiring against consumers, e-book sales have escalated by several hundred percent and as a percentage of all book sales, perhaps, in part, because of the so-called “anticompetitive conspiracy.” That fact is prima facie evidence that the “conspiracy” is pro-competitive.

In the case of e-books, market collaboration, which leads to higher prices, can be doubly beneficial. E-book buyers can buy their books on an alternative platform, the iPad, with greatly enhanced features that the dominant platform, Amazon’s Kindle, couldn’t come close to matching in 2010. It’s no wonder that Amazon has responded to Apple’s entrance into the e-book reader market by bringing out the Kindle Fire and that most (not all) new e-readers on the market since 2010 have tried to emulate the iPad, not the Kindle.

The Justice Department acknowledges that in 2009 Amazon was a dominant e-book retailer (accounting for over 90 percent of all e-book sales). Surely Amazon had at least the potential for monopsony pricing—that is, monopoly on the buyer’s side. If so, then Amazon’s $9.99 price could have been below the competitive price and had several effects: suppressing publishers’ conversion of their print books to e-books; suppressing publishers’ formatting of their e-books to fit the limited functionality of the first Amazon’s Kindle; and undercutting, to some extent, authors’ incentive to write books and have them converted to e-book formats. Interestingly, in its complaint, the Justice Department stipulated that Amazon intentionally did “lower substantially” its e-book price to stimulate sales of the Kindle and effectively told publishers to take its dictated price or leave it. 9

Hence, while the prices the defendants were able to set through collusion were higher than they could have charged absent their combination, the price they set need not have been a monopoly price or even above the “competitive price” and, indeed, could still have been below the competitive price. And there is one good reason to suspect that the publishers’ set prices did not match with the profit-maximizing monopoly price: Apple and the publishers still had to operate within a highly contestable market, as evidenced by the fact that the five publishers accounted for only half of Amazon’s domestic e-book revenues, as the Justice Department acknowledged. 10 The conspiring publishers had to assume that higher e-book prices would give many other publishers an enhanced incentive to convert more of their print books to e-books.

Granted, my comments on Amazon’s monopsony pricing power are somewhat speculative. However, they are grounded in the Justice Department’s assumed tie between market dominance and pricing power (with antitrust law applying to both monopoly and monopsony market power, as recognized by the courts11). Other than the fact that the cartel’s agreed-to prices were higher than Amazon’s price, the Justice Department offers no evidence that the prices developed by the “combination” were, indeed, monopoly prices (or even above the competitive price. As noted, Amazon’s price could have been a welfare-destroying monopsony price.12 (And even if the Apple/publisher combination amassed market pricing power, economic theory recognizes that when a monopoly faces a monopsony—or a situation called “bilateral monopoly”—the price is, at best, indeterminate, subject to the relative negotiating skills of the two parties.13).

What is truly amazing is that Apple is revered for its creative product designs, and yet the Justice Department cannot see how Apple’s innovative pricing strategy has benefited hordes of e-book readers. If in doubt, drop by an Apple store and ask the throngs of customers milling about if they feel oppressed by Apple. (Apple stores have become the new “anchor stores” in malls, displacing the relative importance of the much larger “big box” stores such as Macy’s in terms of total sales, as well as sales per square foot.14)

Perhaps, seen from my revised perspective on monopoly theory, an independent prosecutor should be appointed to investigate how the Justice Department has conspired with Amazon to maintain, and possibly extend, Amazon’s e-book dominance, as well as to suppress the development of the e-book market.