Ignorance and Competition in the Book Market


I’ve been having a long Twitter discussion with Will Wilkinson about the economics of the book industry. Will wanted to know how authors could make money without “digital rights management” technology, and I replied by saying that writing a book has always been less about making money than it is about promoting the book’s author, and I suggested that the activity is going to become a lot less lucrative in the future.

To think clearly about the future of the book industry, it’s essential to understand its present. In particular, to make an educated guess about what the price of a book will be in the future, we need to understand why books cost what they cost today. I think there are two key insights that largely explain the structure of the book market. First, publishers are really bad at predicting whether any given book will be a success. And second, there is an almost unlimited supply of aspiring authors, some non-trivial fraction of whom would, if given the opportunity, produce a best-selling book. Call these the ignorance and competition assumptions, respectively.

Now, today’s book prices have two distinct and puzzling characteristics. First, book prices don’t vary much and don’t seem to be correlated with popularity or quality. Most categories of hardcover books cost around $25.00. Publishers do not seem to charge extra for books by famous people. They don’t jack up the price if a book is well-reviewed, or offer discounts they’re panned in the New York Review of Books. As Paul Graham has observed, publishers seem to price their books in rough proportion to the cost of the raw materials: longer books are somewhat more expensive, but what’s actually printed on the page has relatively little effect on a book’s price.

This can be explained by ignorance (on the part of customers) and competition (among publishers). A customer generally don’t get to read a book before you buy it, and other indicators of quality, such as reviews, are only weakly correlated with a given customer’s enjoyment of a book. Moreover, there are lots and lots of books to choose from. These factors, together, make the book-buying public strongly price-sensitive. A publisher selling a $40 book in a market where the norm was $25 would lose a lot of customers. Because book-buying is always a hit-or-miss affair, few would want that specific book enough to pay an extra $15 for it, while most would have plenty of other books of similar perceived quality and dramatically lower price.

The second puzzling characteristic is that books are dramatically more expensive than their cost of raw materials. Printing and distributing a book costs around $5. This means that every book sold for $25 represents a huge profit to be divided among the bookseller, publisher, and author. This too is explained by ignorance, this time on the part of publishers. The print process is characterized by high fixed costs and economies of scale. This means you have to sell several thousand copies of a book to recoup the costs of printing it. Most books do not hit this target and so lose their publishers money. Hence, when you buy a book for $25, you’re not only covering the $5 it cost to print and distribute that book, but you’re also helping to defray the costs of several other books that wound up in the remainder bin.

With this background, it should be easy to see how authors’ compensation is determined. To simplify the math a bit, let’s assume there are only two outcomes for a book: hit or not-hit. Then the value of a manuscript is the profit from a hit, times the probability of a hit, minus the losses from a non-hit times the probability of a non-hit. Our ignorance assumption means that the probability of a hit is low, which means that the expected value of printing a book—and hence the value of a manuscript from a first time author—is very low. And this is what we see in the marketplace. When a publisher takes a chance on a non-famous, first-time author, the advance tends to be relatively small.

Things look different for repeat authors because the ignorance assumption doesn’t apply with the same force. Stephen King and J.K. Rowling have demonstrated that they can write books that appeal to large audiences. And this means that not only is the payoff for a hit higher, but the probability of a hit is much higher as well. And this puts them in an extremely strong bargaining position with publishers and allows them to become very wealthy. Hence, we see a highly skewed distribution of earnings, with a tiny minority of authors getting multiple hits and making millions of dollars, while a huge number of authors write only one or two books, get paid very little for it, and fade back into obscurity.

Now imagine a world with omniscient publishers. Every publisher can now predict exactly how many books any given author will sell. This will have two effects. First, obviously, publishers will no longer print money-losing books. Only those books that can recoup their costs will be printed. And second, given my competition assumption, many more best-selling authors will be discovered. Both of these developments will push prices downward. The ability to avoid wasting money on duds means that publishers have a lot of room to cut prices. And publishers’ ability to find new bestselling authors greatly increases the number of bestselling books that can be printed. A world of omniscient publishers would be a world of commodity publishing: publishers would get much smaller margins and bestselling authors would get much smaller advances.

So let’s return to our own, non-omniscient world. We might say that what makes a best-selling author valuable isn’t just his writing talent—an author was probably just as talented before he was discovered as after—but in the knowledge that the author is, in fact, capable of producing best-selling books. And producing this knowledge is (or at was until recently) really expensive—to find one John Grisham, you had to publish a bunch of books by unknowns and see which ones sell. This means that the people who have convinced a publisher to bear the costs of “discovering” them have what amounts to a uniquely valuable credential. They can extract significant rents because even though there are likely plenty of others who could produce novels of similar quality, it’s too expensive to figure out who they are.

In my next post, I’ll explore how these considerations shake out in the age of the Kindle.

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9 Responses to Ignorance and Competition in the Book Market

  1. Rhayader says:

    This is an entertaining analysis, I’m looking forward to the next post. And also hoping Wilkinson joins the discussion in a non-Twitter form.

  2. Aaron Massey says:

    Great post. I agree with most of what you’ve written here, but one thing stuck out to me as inaccurate:

    “…an author was probably just as talented before he was discovered as after…”

    Writing talent isn’t an innate thing determined when you’re born; it’s a skill that people develop over time. This leads to two cases, which I suspect will be important parts of your analysis in your second post. Some authors have horrible first books and end up producing something much better later in their career. There are also numerous authors who have a great first book and then never live up to the standard they’ve set for themselves.

    In the omniscient world you describe, talent variability is irrelevant since publishers simply know which books will be hits and which ones won’t. In the real world, this becomes rather important to publishers because both situations are effectively a loss. In the first, the publishers are missing out on hits because they “know” the author’s not that talented based on their previous book. In the second case, the publishers are signing up for a non-hit based on the author’s previous hit. As the cost of publishing goes to zero, I suspect that these situations would move from losses to gains.

  3. Sean Gerrish says:

    You familiar with Hal Varian? He’s Google’s chief economist (on sabbatical from Berkeley) who’s somewhat familiar with the economics of the book market (along with just about every other market) and co-wrote the book Information Rules, about information goods. I seem to remember him talking about Amazon’s book market at some point in the past, and he’s very friendly. He might be worth contacting for another data point on information monopolies in the book market for the next stages of the analysis..

  4. Aaron: right, that was an overstatement. I guess think there’s a certain amount of raw talent you develop when you’re young, that you either have or don’t have, and that primarily determines whether you’re able to produce best-selling books over time. But you’re obviously right that authors also mature over the course of their career. Regardless, I think it’s the case that an author’s past book sales are the best predictor of future book sales, even if the correlation is rather weak.

    Sean: I’m familiar with Varian. Not sure I want to spend a ton of time on this since I’ve got CS research to be doing, but I’ll add that to my reading list. Thanks!

  5. Akusu says:

    Personally I find one of the problems with books right now is that I feel like I’m late to the game.

    Stephen King was started being published at the very least when I was a young child. One of the authors I want to read all of, Micheal Slade, is the same.

    I can’t go out and acquire all of those books now, without a considerable amount of effort. And a large amount of fail.

    I’ve found that in the age where things are so easy to rip off, if I’m actually loyal to something, I’m willing to buy the entire set(let alone the one that hooked me) so I have a physical copy. If not… well, I don’t really care.

    Point being that sales of current books also sell past books…. but only if they’re still available. That’s just not always possible with physical books, but relatively easy to accomplish in electronic formats.

    So personally I’m looking forward to books in electronic, universal formats, and I currently already enjoy my PDF archived textbooks.

  6. mealworm says:

    I think your competition analysis is just wrong, for two reasons. One, it ignores the extent to which publishers themselves improve the quality of books their authors write, through editing, typesetting, art etc. (even marketing if we’re being market purists). Second, on the macro side the demand for books is a lot more inelastic than you think, a situation far different from movies or music. That is, while any given book which costs more than the average book will not be bought (micro price elasticity), reducing the average price of books will not much increase the total number of books sold (macro price elasticity). So although there are plenty of books out there that, if published, would sell as well as or better than those that are published, it doesn’t follow that more books could be sold than are, in fact, sold. The massive numbers of unbought, extremely low-priced books at any used bookstore should convince one of that. The vast majority of books can’t even be given away at zero cost.

  7. mealworm says:

    I meant “competition assumption” rather than “competition analysis” in the previous comment.

  8. Tim Lee says:

    mealworm: I agree with your macro-vs-micro distinction, but I think it’s clear that micro-elasticity is what matters for the behavior of any given player in the e-book market. That is, if other publishers are selling their books for $10, and I offer my book for $9, I’m going to get a lot more sales. It might be true that if everyone else cuts their price to $9 our combined sales won’t have changed very much. But price-fixing agreements tend to be fragile–not to mention illegal–so I don’t think publishers will manage to hold prices above the equilibrium level, even though it might be in their collective interest to do so.

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