E-books, Collusion, and Antitrust Policy: Protecting a Dominant Firm at the Cost of Innovation

• Publication year: 2014

SEATTLE UNIVERSITY LAW REVIEW Volume 38, No. 1, FALL 2014

E-books, Collusion, and Antitrust Policy: Protecting a Dominant Firm at the Cost of Innovation

Nicholas Timchalk(fn*)

I. INTRODUCTION

Technological progress will inevitably drive the law toward a path of modernization. Specifically, antitrust law must remain aware of the ever-changing economic environment driven by innovation.(fn1) Amazon led the charge with one such innovation by transforming the reading experi-ence into the modern digital age with the e-book. Amazon catalyzed the inception of the e-book market by introducing the Kindle to gain wide-spread commercial acceptance in 2007.(fn2) Amazon became the dominant firm in the sale of e-books and e-book readers by controlling about 90% of the market.(fn3) As an innovator, Amazon had the luxury of determining the retail price for its books as well as the supply arrangement with its publishers. Thus, its market positioning as a large online discount retailer influenced its decision to use a wholesale model(fn4) and use a discount pric-ing strategy by charging $9.99 for certain new release and bestselling e-books.(fn5) With a digital book discount, Amazon's $9.99 price point rough-ly matched the wholesale price of many of its e-books.(fn6)

Rival firms quickly positioned themselves to enter and compete in the e-book market after witnessing Amazon's substantial success and the changing consumer preferences towards the digital consumption of me-dia.(fn7) Indeed, Apple's iPad and Barnes & Noble's Nook were the two potential competitors in the beginning and are still currently Amazon's main competitors.(fn8)

United States v. Apple Inc. arose from the aftermath of firms at-tempting to pressure Amazon's initial dominance in the e-book market.(fn9) In short, book publishers were unhappy with Amazon pricing their new releases and bestsellers below the wholesale price Amazon paid.(fn10) Apple-preparing to launch its iBookstore in conjunction with its iPad- recognized the publishers' discontent with Amazon's prices and offered the publishers a different supply arrangement. (fn11) This arrangement (known as an agency arrangement) allowed the publishers to set the retail prices and allowed Apple to receive a commission on the books it sold.(fn12) For this plan to work, each publisher had to commit to the new arrangement to pressure Amazon to abandon its discount pricing strategy.(fn13) In the end, Apple launched the iBookstore with the publishers under an agency arrangement.(fn14) The publishers attempted to compel Amazon to switch to similar agency agreements in order to have more control over the retail price for their books.(fn15) Consequently, Amazon complained to the Federal Trade Commission about the publishers' simultaneous de-mands for it to switch to an agency contract.(fn16) The Department of Justice filed a suit against Apple and the publishers for violating Section 1 of the Sherman Act, alleging a price-fixing conspiracy between all the defend-ants.(fn17) After a bench trial in the Southern District of New York, Judge Cote found Apple liable for a price-fixing conspiracy with the publisher defendants in restraint of trade.(fn18)

Although the e-book market has leveled out to a competitive mar-ketplace with diverse participants due to the increase of market entry,(fn19) a period of time existed during the market's inception when the innova-tor's-Amazon's-market share was highly suggestive of monopoly power.(fn20) Antitrust enforcement can better spot red flags and use greater discretion if they properly consider the market conditions created by the innovator and the resulting market structure post enforcement. This is important because now that e-reader prices have generally dropped due to market saturation, Amazon will likely not need to go back to the deep e-book discounts to promote the Kindle.(fn21) In essence, even after the enforcement of Section 1 of the Sherman Act against Apple, e-book prices rose, which may or may not have harmed consumers(fn22) when compared to the alternative of the status quo before the publishers and Apple collud-ed. Hence, an understanding of the unique market conditions prior to the illegal conduct can help antitrust law adapt to future cases by understand-ing the incentives and market forces that influenced the publisher de-fendants' collusion and Apple's risky agency agreement switch.

This Note argues that the combination of Amazon's 90% market share, network externalities, and an innovative technology market creates an environment that highly incentivizes a dominant firm to exclude potential rivals for as long as possible. Accordingly, when cases like United States v. Apple Inc. arise, there must be serious concern for not only price increases for consumers, but also diminished innovation in the market, which further harms consumers. I attempt to show that the market struc-ture for e-books failed in some respects, which created an incentive for Apple-being a sophisticated and very large firm-to take highly risky steps to enter the e-book market. While Apple's decision to coordinate with the publishers could have been out of greed, the market might have also failed by allowing substantial barriers to entry(fn23) created by Amazon's pricing strategy. Although antitrust law attempts to keep firms from harming consumers with entry barriers for rivals, substantial barri- ers for Apple to enter the e-book market would necessarily be substantial for smaller potential e-book retailers as well. Thereby, Amazon's dominant position in the market could still harm consumers. While the district court found that the higher prices resulting from Apple and the publish-ers' agreements harmed consumers, the de facto protection of Amazon's dominant position could also harm consumers through reduced innovation in the marketplace. Accordingly, when the government challenges practices in markets with a dominant buyer in the future, it should give extra care to ensure that the dominant firm is not de facto protected in a way that harms innovation in the marketplace. United States v. Apple Inc. exemplifies a modern trend of enforcement agencies pursuing claims based on collusive conduct as opposed to unilateral exclusionary con-duct, which might not give sufficient weight to innovation concerns.

To be clear, I am not arguing against the district court's ruling that Apple violated Section 1 of the Sherman Act when it coordinated a switch from wholesale to agency contracts with publishers. My primary inquiry is into the potential effects on innovation when enforcement oc-curs against rivals of a dominant firm in an innovative technology market. Amazon's main rival, Apple, went to great lengths and took major risks to enter the e-book market. Why did Apple simply choose not to compete on the merits of its product and brand equity (the iPad and iBookstore) as it does with its other products? Why did Apple decide not to continue to rely on its earlier success of situating its products differ-ently in the market than other electronics and working hard to be differ-ent and cutting-edge with its e-book delivery?(fn24) I argue that the market failed in some respects. I explore the theory that entry could not occur without an increase in price and, further, without entry, harm to innovation would result over time.(fn25)

This Note is structured as follows: Part II discusses antitrust policy and innovation as a metric for consumer welfare. Part III discusses the facts of the Apple price-fixing case with a particular focus on the market conditions during the window where Amazon possessed 90% of the ebook market. Part IV considers whether the market needed new entry. In other words, whether Amazon's buyer power or the market structure gave rise to potential consumer harm. Market entry would thus be desir-able to promote competition and innovation. This includes an analysis of Amazon's pricing strategy before Apple entered the market and whether anticompetitive effects were present. Finally, Part V suggests that innovation concerns in the e-books case were left on the backburner, and proposes how antitrust enforcement should keep innovation concerns as a primary goal to best fulfill the goals of protecting consumer welfare. Part VI concludes.

II. BACKGROUND on ANTITRUST LAW AND BUY-SIDE POWER

Antitrust law attempts to solve an incentive problem of the free market. Economic analysis provides insight into how firms will act in the free market and, at the same time, reveals the potential harm that can re-sult to the economy and consumers if marketplace regulation did not ex-ist. In 1890, Congress passed the Sherman Antitrust Act to advance con-sumer welfare by outlawing business arrangements that harm consum-ers.(fn26) Section 2 of the Sherman Act reads: "Every person who shall mo-nopolize, or attempt to monopolize, or combine or conspire with any other person or persons, to monopolize any part of the trade or commerce among the several States . . . shall be deemed guilty of a felony."(fn27) To understand how Section 2 attempts to create the right incentives for a healthy economy and protection for consumers, I will briefly discuss the economic theory behind the Sherman Act.

At the core of economics is the assumption that firms are profit maximizing.(fn28) This assumption is the foundational incentive that drives firm behavior; hence, different market conditions will dictate different...