Creative Destruction and the Ebooks Market

In 1982, Clint Eastwood appeared before a congressional committee to testify about the dangers of VCRs. He testified alongside Jack Valenti, then president of the Motion Picture Association of America.

Fearing that the VCR would destroy the film industry, Mr. Valenti argued, “the VCR is to the American film producer and the American public as the Boston Strangler is to the woman home alone.”

Frankly, I think the line would have sounded better coming from Dirty Harry.

Americans bought the VCR despite the film industry’s objections and by innovating and providing high-quality recordings, the film industry benefited from the invention. It also encouraged innovation at theatres, which, having lost some of their power over moviegoers had to find new ways to attract customers.

In 1942, author Joseph Schumpeter coined the term “creative destruction” to explain how new technologies can supplant old ones and radically change an industry. When this happens, established players, usually relying on an older business model, do everything in their power stop innovation and preserve the status quo.

Nothing has caused more creative destruction in recent years than the internet. To name one example, the film industry now fears Netflix at least as much as it ever feared the VCR. So it is hardly surprising that in response to Netflix’ success, the industry is refusing to grant immediate access to new releases, fearing the availability of titles on Netflix will cannibalize rental and DVD sales.

The internet also threatened to change a much older industry; the book publishing business. Advances in display technology have enabled a new wave of devices that allow an entire library of ebooks to be stored in the palm of your hands.

To be fair, this isn’t the first time the book business has undergone such a change. Following the invention of the printing press in the 15th century, a monk and scholar named Johannes Trithemius wrote an essay entitled “In Praise of Scribes.” Trithemius worried that the printing press would not only put scribes out of work, but also make monks lazy. After all, copying the Bible by hand built character.

It should come as no surprise then, that the age-old giants of the book publishing business have concerns over the inevitable transition to ebooks.

In fact, we recently filed a fascinating lawsuit alleging that five of the largest publishers, with a helping hand from Apple, cooked up an illegal agreement to slow down and control the growth of ebooks by fixing prices.

Ebooks have certainly increased in popularity over the last few years, especially since Amazon’s release of the Kindle in 2007. There had been ebooks before then, of course, but the Kindle’s paper-like screen and realistic looking text made it the first device that was truly accessible to mainstream consumers. Reading on the Kindle is as easy as reading a real book.

Following the release of the Kindle, Amazon began offering large discounts on ebooks in order to encourage the adoption of the device. Amazon set a price of $9.99 for all new releases, even if that meant it had to sell some ebooks for a small loss.

This is in line with how books have been sold in the past, under what is called the wholesaler model. Under this model, publishers sell books to retailers like Barnes and Noble or Amazon who then can set a price for the book and resell it to consumers.

The wholesaler model encouraged retailers to compete on price, allowing consumers to bargain-shop for discounted books. While consumers celebrated $9.99 new releases, the publishers worried. If people became used to paying $9.99 for a fiction or non-fiction new release, they might demand low prices in the future.

Worse still, if Amazon became the dominant retailer in the ebook market, they too might pressure the publishers to lower their prices.

At the height of publishers’ anxiety over Amazon’s low prices, Apple was looking to get into the ebook market. With its iPad consumers who already used the iTunes store for music, movies and other media would be able to purchase and read ebooks.

We believe that Apple feared Amazon’s low prices, and worked with the publishers to cook up a plan that would not only force Amazon to raise its prices, but also help publishers to regain some of the power they had lost since the advent of electronic publishing.

Nearly simultaneously last year, five of the largest ebook publishers announced that they had reached a deal with Apple to publish ebooks for the iPad. This deal had two major components. First, it guaranteed that no ebook could be sold for a lower price than on Apple’s iBookstore.

Second, the deal restructured the age-old “wholesaler” model for selling books and instituted a new “agency” model. Under the model, retailers would no longer be able to discount books. Instead, the publishers would set the prices for ebooks, and retailers would be entitled to a pre-determined markup, in this case 30 percent, on each book sold.

Following signing of agreements with Apple, the five publishers approached Amazon and informed the retailer that due to both of these clauses in their contracts with Apple, Amazon would also have to switch to an agency model.

Amazon, faced with losing access to books from five of the six largest publishers, capitulated and agreed to the change.

The new system was clearly not helpful to consumers, as it meant that they could no longer shop for a bargain amongst retailers. Instead, prices at each retailer would be identical. Alongside the elimination of competition between retailers over price, the agency model allowed, we believe, a 30 to 50 percent increase in the price of the ebooks.

Each publisher’s decision to sign an agreement with Apple was not illegal by itself. What would be illegal, however, would be the coordination of five of the largest publishers joining forces to thwart price competition. Given the nearly simultaneous timing of the actions of these five publishers, and the fact that their actions coincided with the launch of the iPad, we believe there was coordination.

Apple’s part in this is troubling as well. The company played a large part in the transformation of our daily lives over the last several decades. If our suspicions are proven true, then it acted to prevent innovation in order to increase its profits.

We have filed suit against Apple and the publishers for violations of the federal antitrust laws. These laws protect consumers from artificially high prices caused by anticompetitive activity. More importantly, though, these laws encourage innovation in the marketplace by preventing competitors from joining forces to slow down market-driven changes.

In addition to our work to preserve innovation by litigating antitrust cases, we recently opened a new intellectual property practice. Our IP practice seeks to protect the rights of inventors, who often face infringement from large corporations with legions of defense attorneys.

Those inventors rely on patents, which provide an incentive for them to innovate, and to continue transforming our world for the better. Their rights as inventors must be respected.

Innovation is the lifeblood of our economy. Whether it is threatened by a large company determined to infringe on an inventor’s patent or by collusion and anticompetitive behavior by a group of companies, we will work tirelessly to preserve it.

I think that even Dirty Harry would agree with that.