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In a recent post, the Nudge blog linked to a piece pointing out how Amazon’s pricing strategy for e-books is causing a headache for Apple. Of relevance to this example is a 1986 paper by Richard Thaler, Daniel Kahneman, and Jack Knetsch, “Fairness as a Constraint on Profit Seeking: Entitlements in the Market,” (gated copy here). In it, the authors develop the concept of a reference transaction in notions of fairness. A reference transaction is “a relevant precedent that is characterized by a reference price or wage, and by a positive reference profit to the firm.” Amazon’s $9.99 price for best-seller e-books was a money loser for the company, but that doesn’t mean its customers know that. After all, what does it cost to electronically publish a book? Blogs are free! As the authors point out, “The reference transaction provides a basis for fairness judgments because it is normal, not because it is just.” The $9.99 price has been around as long as the Kindle, which is long enough to be normal.

Reference transactions can change, and they will in the e-book world. Until then, since consumers are used to the current $9.99 price, the standard rules of prospect theory will apply. That means price increases are likely to lead to dissatisfaction, particularly since its not clear that the costs of electronic book publishing are any different now than they were three years ago. Why? Because of how Amazon marketed the first e-books.

Amazon can’t go back and re-run history, but it can learn for the future. When selling a new, or little used, product, it’s better to offer two prices. The first price is the price you’d charge for the product if it were popular and profitable. For Amazon in 2007, this might mean the price it would like to charge consumers in a 2010 world where e-books are no longer so strange. The second price is the discount price. This strategy is similar to the kinds of introductory trial prices that cable companies offer, although without the explicit time frame to start and end them. When the company decides it can no longer keep subsidizing the product, it ends the discount. Plain and simple.

This isn’t what Amazon did, though. $9.99 wasn’t a special discount price. Amazon didn’t make a big deal that the standard retail e-book best-seller price was $16.99, and that it was offering a 40 percent discount. $9.99 was just…the retail price. Raising prices usually irks consumers. But as any good student of prospect theory knows, taking away discounts is much easier for consumers to swallow than raising prices — even though it’s effectively the same thing — because of loss aversion and some consumers’ understanding of the retail price as the reference price. This logic even applies for hot products. The original retail price acts as the reference point against which consumers judge the price increase. Since they already thought they were gaining something with the discounted price, it hurts a bit less when it’s taken away, compared with simply jacking up the discount price when it’s not framed as a discount.

It turns out that Amazon’s actions aren’t just affecting Amazon at the moment. They are a costly externality for Apple as it tries to figure out a pricing strategy for books on the iPad. Unlike Amazon, Apple is starting fresh, which means it can adopt the two price strategy on iBooks. It hasn’t so far, but there’s still time.

Addendum: Amazon did advertise its Kindle book prices relative to the hardcover list price. But that wasn’t a useful reference point since customers did not see the two products as identical.

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Determining a “fair” price is a subjective endeavor. William Poundstone points out that for now, Apple has decided that the fair price for an e-book is what Amazon is charging (which, incidentally may or may not be what the “market” price for an e-book would be).

Apple’s new iPad Bookstore allows publishers to set prices. Contrary to early speculation, Apple is selling many bestsellers for the “Amazon” price of $9.99. Otherwise $12.99 is a common price point at the iPad Bookstore. Meanwhile, Amazon has quietly raised prices for many eBooks — often inscrutably — as a result of new agreements with publishers…The net effect of the iPad so far: There’s a wider range of eBook prices and less price difference between Apple and Amazon than the pundits predicted.

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