Asymmetrical Information - Megan McArdle

10.30.12

No Matter What the Supreme Court Decides, Textbooks Will Continue to Be Expensive

In Kirtsaeng v John Wiley and Sons, the Supreme Court will decide whether to allow textbook importation from countries where they're cheaper. But don't get your hopes up; prices won't come down, no matter what they decide.

Textbook publishers charge rather breathtaking prices for their wares.  They have a captive market, after all--if you want to do well in a course, it's hard not to buy the textbook.  The people who choose the textbook rarely look at the price; indeed, I'm told that the textbook section of the catalogue often doesn't have prices.  And textbooks are fairly labor intensive to produce, so the cost basis is pretty high.  

But as in other industries where so much of the cost is in the upfront production, there's a strong impetus to use price discrimination: charge less in markets where people are price sensitive, more where money is no object.  The price sensitive consumers pay something quite close to the marginal cost of serving them, while the carriage trade pays most of the fixed cost for things like overhead and research.

With airlines, this strategy means that vacationers get cheap tickets, and business travelers pay most of the cost of operating the plane.  With textbooks and prescription drugs, it means that consumers in rich countries pay more (especially America), and students in poorer countries pay less.  

This tempts many consumers in the high-price markets to believe that they are being ripped off, and that they should be allowed to buy at the "real" price, which of course, they assume is the lower price.  But this is exactly wrong.   It is possible for a firm to make money with some of its customers paying less than the average cost (but more than the marginal cost of producing an additional unit).  It is not, however, possible for a firm to stay in business with all of its customers paying less than the average cost.  

But we want to believe that it is possible.  Indeed, no matter how often it is explained that we cannot all be the marginal cost consumer, someone will insist quite loudly that it is possible; that only greedy companies, incompetent bureaucrats, or bad laws stand between us and the joys of marginal cost pricing.  The delusion is so persistent that economists have a joke to summarize: "We're losing money on every unit--but we'll make it up in volume!"  

Why do I bring all this up, you may ask?  Well, because there's a case before the Supreme Court that raises all of these issues.  It seems that some bright person got the idea of importing textbooks to the US from countries where they are cheaper.  Under first sale doctrine--which says that anyone who buys a book has the right to resell it, or burn it, or do whatever they want with the physical book--this seems perfectly legal.  But it threatens to undermine the price discrimination regime which keeps textbooks expensive here and cheap abroad.  

Yay! say consumer advocates like PIRG.  Cheap textbooks for everyone! But as Gabriel Rossman points out, that's not how these markets actually work.  Ending price discrimination means low prices here; it means excessively high prices (and a lot of piracy) there.

Price discrimination is to charge at each buyer’s reservation price rather than just having a single price for all. This especially makes sense in an international context where incomes (and by extension, reservation prices) vary dramatically. Thai college students are much poorer than American college students. If Wiley sets a price of $150 for a textbook, no Thai students would buy it. Conversely, if they set a price of $30, they’re leaving money on the table in the United States. The solution is to charge $30 in Thailand and $150 in the United States.

Now let’s imagine a world in which first sale doctrine is applied in Kirtsaeng. You would very quickly see large scale reimportation of discount textbooks and this would take a huge bite out of the domestic edition textbook market. The publishers would thus be unable to practice regional price discrimination. Their response will inevitably be to converge all prices on the rich country price, or just stop offering editions in middle income and low income countries altogether.

Notwithstanding the hopes of PIRG to the contrary, if Kirtsaeng prevails students in rich countries will still be paying $150 for textbooks (at least once the inventory available for reimportation clears). As for students in middle income and low income countries, one of two things will happen. Either they will do without textbooks or they will rely on pirated editions. On the margins, US trade diplomacy may be able to suppress piracy but it is the overwhelmingly strong natural market response in the absence of price discrimination. Indeed this is already how the modal act of piracy works. Piracy is at fairly low levels in the United States itself and most other wealthy countries but is at very high levels in poorer countries. As a Social Science Research Council report on the issue noted, this is mostly because prices are very high relative to income. In theory the solution to this is price discrimination, but that has proven difficult in practice. We have regional encoding on DVDs in order to allow price discrimination but software like DeCSS means this hasn’t worked very well and most studios don’t even bother enabling the region encoding on Blu-Ray. Similarly, laws against reimportation are intended to make price discrimination in things like textbooks feasible but Kirtsaeng would change that. This will only exacerbate the tendency of IP industries to make the rich country price the world price and then make Quixotic efforts to suppress the inevitable piracy that follows.

We’re in a pick your poison situation here. Either we have a legally enforced price discrimination scheme (with all the damage this does to the already weakened first sale doctrine) or we accept massive piracy in low and middle income countries. I’m honestly not sure how I hope SCOTUS rules in Kirtsaeng, but I find it difficult to get enthusiastic about either outcome.  

If you're skeptical that this is true, consider an area where you're probably the beneficiary of price discrimination: business travel.  The first class and business passengers provide the bulk of the profit on airline tickets; they pay for the extra amenities, and the ability to make last-minute arrangements for short stays during the week.  Restricted economy travelers often generate very little revenue over and above the cost of transporting them--but since the seat is a wasting asset, you might as well sell it even if you'll only make a few bucks on it.

Let's say that businesses who travel a lot got a law passed to eliminate this sort of price discrimination, forcing airlines to set a single price for a given route, no matter what date or time the flight was.  Such a law might well pass, since people hate confusing airline prices.  

The result would not be that everyone got the tourist class price, however.  Imagine that you've got 10 business class passengers paying $100 apiece, and 100 tourist class passengers paying $5 apiece.  Assume that the marginal cost of taking on an extra business passenger is $2 and the marginal cost of a tourist passenger is $1.  Assume your fixed cost of getting the plane off the ground is $1300, so you've got a total cost of $1420 and revenue of $1500.  

Now say someone comes along and mandates that everyone has to be charged the same ticket price.  What happens?  Well, you charge all 110 passengers $13.50 and keep your margins about the same . . .

But wait!  The tourist class passengers are very price sensitive.  They're on average only willing to pay $5-$8 for a ticket.  When you raise the price to $13.50, half drop out.  Now you've got 60 passengers, which gives you revenue of $810.  But your cost has only dropped by $50.  Now you're losing a big hunk of money.  You'll have to raise prices.  $23 should cover it.  

Gee, $23 is more than 4 times what the tourists were paying.  They don't want to see Grandma that much.  Another half of the tourists drop out.  Now you've got 35 passengers.  But your costs have only dropped by $25. You'll need to raise prices again.  Maybe $40 would cover it?  

You can see where this is going; pretty soon almost all you have left is business passengers, paying what they were paying before.  In fact, depending on how many tourist class passengers drop out, the business class passengers might end up paying more.

someone has to pay for all those planes, and airline profit margins are far from reliably spectacular (which is why they keep ending up in bankruptcy). No, the tickets for your next vacation would probably cost three or four times as much.  Obviously, this is a made-up example, with numbers chosen more for ease of calculation than versimilitude--in the real world, most people would snap up a $38 plane ticket.  But empirical research bears this out; ending price discrimination doesn't necessarily mean consumers get a better deal.  It can easily mean they get a worse deal.  

But there's something deep within us that resists that insight.  We hate the feeling that someone else is paying less than us, even if it's not costing us anything. So while a decision for the textbook importer might not make consumers any better off in the pocket, it may make them feel better about the high prices they're paying.