Economic surplus

Economic surplus

Digital strategies and competition laws – lessons for Australia from Apple and Amazon

eBooks raise competition issues. wikimedia

The interaction of competition policy and the digital economy is complex. The digital economy may not fit easily with current rules.

For example, business contracts may restrict the way that one of the parties to the contract can interact with other ‘third party’ businesses. If these other businesses are competitors or ‘rivals’ then the contracts may raise antitrust concerns. And these contracts have been causing major issues for on-line businesses like Apple and Amazon.

The problems relate to ‘most favoured customer’ or ‘most favoured nation’ (MFN) supply contracts. Under an MFN contract, the buyer must always receive the ‘cheapest price’ from the supplier. If the supplier offers a lower price to a different buyer then the seller must also offer that lower price to the existing buyer who has the MFN contract.

Sounds reasonable. After all, why should I pay more than you charge someone else?

But the problem arises when the buyers are not ‘end users’ but are competitors in a downstream market.

In this situation, an MFN contract can limit competition and raise final prices. A business cannot create a competitive advantage by negotiating a lower supply price, because any successful negotiations will simply lead to the same lower supply price being passed on to their competitors. And suppliers will be reluctant to offer a special deal, say to a new entrant, if they are required to pass on this same deal to all their other customers.

The anti-competitive potential of MFN contracts is well known. But they have recently raised antitrust concerns through a new guise – most favoured platform arrangements.

A ‘most favoured platform’ contract requires that a supplier who offers a product on one internet platform, such as Apple’s iBook store, cannot offer that product at a lower price on a competing platform, such as Amazon’s Kindle.

The US Courts recently determined that Apple used such a contract as part of a conspiracy to raise eBook prices.

The MFN clause changed the way that the emerging market for eBooks operated. It effectively stopped Amazon from discounting by changing the way publishers could supply books to Amazon. The Court concluded that it “eliminated any risk that Apple would ever have to compete on price when selling e-books”. It led to an immediate ‘spike’ in eBook prices (see p.95 of the Court opinion).

However, the Apple case is unusual. The MFN applied to end user prices, not wholesale prices. Apple has organised iBooks like its Apps market, where Apple is an agent who supplies a platform and takes a commission. The publishers set the retail price for eBooks.

In contrast, Amazon was using a standard wholesale model. It paid a wholesale price for eBooks then resold them at a retail price set by Amazon. This meant that Amazon could discount its eBooks, setting a retail price below the wholesale price and encouraging customers to buy the Kindle.

Amazon’s strategy is pretty standard for platforms. But the Apple MFN contracts killed this discounting because, as the Court noted, it forced publishers to “adopt the agency model across the board”.

This means that the anticompetitive effect was not just in the price of eBooks, but also in the ‘device’ market. Apple’s iPad, which was new at the time, is a lot more than an eBook reader. By effectively preventing the discounting of eBooks, Apple could limit competition against the iPad from dedicated eBook readers like the Kindle.

The case was also unusual because publishers were in favour of the MFN contracts even though it meant a drop in eBook revenues. Publishers had to pay a fixed commission on each book rather than set a high wholesale price then benefit from high sales due to Amazon’s discounting.

Of course, publishers were protecting their ‘physical book’ market. eBooks represent a challenge to publishers. In particular, as eBooks become more popular it is not clear why existing publishers are needed. Authors could deal directly with platform suppliers like Amazon and Apple. So publishers were following a standard ‘Canute’ strategy and trying to slow the eBook tide.

In the digital world, the Apple eBooks conduct is far from unique. For example, Amazon has recently been investigated by the UK Office of Fair Trading (OFT) because of a ‘most favoured platform’ clause in its contracts with sellers.

As the Guardian notes, “The clause meant that a trader could not sell a product, including the delivery charge, for a lower price on its own website or another site such as eBay or play.com”.

As a result of the investigation, Amazon agreed to drop the clause from its EU agreements.

The problem for policy makers is that the internet not only creates new business models, it creates new competition concerns. It is far from clear that Australia’s competition laws are ready for these challenges.

For example, section 98(2) of Australia’s Competition and Consumer Act explicitly allows a wholesale business to withhold supply if a retailer has been selling ‘below cost’. But what are the implications of this exemption in a platform market where it is both common and profit maximizing for a retailer to sell one product at a loss in order to either promote sales of a complementary product (like the Kindle) or encourage key players (like advertisers) to participate in the market?

We are likely to have a review of Australia’s competition laws and policies in the near future. Such a review must consider the digital economy as well as the traditional economy. The interaction between competition laws and the way the emerging digital economy evolves is a key issue for Australia’s competition agenda.