Economic surplus

Economic surplus

Lessons from the Apple e-book case

The Court of Appeals in the US has ratified Apple’s guilt in the e-book case. It was a two-to-one decision by the three judges on the Court. And it provides two lessons for Australia.

First, when industries are being disrupted, incumbents may collude with entrants to prevent competition.

Second, those who are calling for changes to our competition laws need to read the dissenting judgement. It shows how easy it is to confuse protecting competition and protecting competitors.

The background

Before 2010, Amazon dominated e-books. It set the price at US$9.99 per book, which was less than the wholesale price that Amazon paid to the publishers. The reason was simple. Amazon was loss leading on the e-books in order to encourage consumers to purchase its Kindle reader.

Amazon had achieved a significant market share, selling around 90% of all e-books in the US. But the publishers hated the Amazon model. Cheap e-books meant that the publishers sold fewer (highly profitable) hard and soft backs. The publishers also feared that Amazon could evolve as a peer-to-peer platform that would “allow authors to publish directly with Amazon, cutting out the publishers entirely” (Court of Appeal at 14).

When Apple entered, it offered a different business model. The publishers controlled the retail price of each e-book on the ibookstore, with Apple taking a 30% cut. This is not unusual. Apple uses a similar model for Apps. And by itself, Apple’s agency model was not illegal.

However Apple and the publishers also agreed to a ‘most favoured customer’ clause. Under this clause, the publishers had to ensure that the price they set on the ibookstore was no more than the price for the same e-book on any other site – such as Amazon. Effectively this meant the publishers had to go to Amazon and require that Amazon raise its prices. And the data shows that prices went up.

The agreement between Apple and the publishers breached the anti-collusion laws in Section 1 of the US Sherman Antitrust Act.

The incumbents fight back

When industries are disrupted, whether by Amazon, Uber or Airbnb, the incumbents will fight back.

In the case of Uber, this has been through existing taxi laws, labour laws and government assistance.

In June 2015 the California Labor Commission ruled that an Uber driver should be treated as an employee. Uber is appealing. But fear of both labour and taxation laws have led a number of peer-to-peer providers, such as Shyp (a packing and shipping service) and Instacart (a grocery delivery company) to shift informal contract workers to full time employees.

On May 1, 2015, the Uber offices in Guangzhou, China, were raided and closed down. The municipal government then announced plans to launch its own online taxi App which would cover incumbent taxi services.

For Airbnb, the incumbents have fought back through zoning laws and takeovers. Hyatt hotels revealed in May 2015 that it is investing in Onefinestay, a competitor to Airbnb. Similarly, Wyndham hotels has invested in Love Home Swap, a UK home swapping site.

The Apple case illustrates how incumbents can fight back by using dirty competitive tactics. Fortunately, in the Apple case, the competition regulators were ready to act. But we can expect incumbents in other sectors to similarly push the legal boundaries to protect their profits.

Protecting competitors or protecting competition?

The Apple case also highlights the problem of leaving the interpretation of abuse of market power laws to the Courts.

The US Sherman Act provides little guidance to the Courts. However, the US has a long history of sorting out ‘good’ behaviour from ‘bad’ behaviour. The ‘rule of reason’ approach adopted by the US Courts is similar to the approach under Australia’s current abuse of market power laws. In Australia, a firm with market power only breaks the law if it ‘takes advantage’ of that power. The US Courts similarly ask whether or not the impugned conduct is really pro-competitive, not anti-competitive, behaviour. Both approaches try and ensure the law fosters competition rather than protecting individual, potentially inefficient, competitors.

Unfortunately, the recent Competition Policy Review recommended changing our laws. The new laws will take out the ‘take advantage’ test and leave it to the Courts to sort out the behaviour. But even in the US, with more than 100 years of legal cases, the Courts can get this wrong.

The dissenting judgement in the Apple decision illustrates the confusion. The dissenting judge concluded that Apple’s behaviour, that raised prices for e-books, was unambiguously and overwhelmingly pro-competitive. By raising prices, the cartel made it easier for new businesses to enter the market!

On this basis, all cartels would be good. If you raise prices and profits then the businesses benefit. This encourages new entry, but harms consumers. It is the classic confusion between competition (which benefits consumers) and collusion (which benefits businesses but hurts consumers).

Fortunately, two judges in the Apple case avoided this confusion. But protecting competitors can be tempting for a court – particularly when the industry is rapidly changing through innovation and disruption. In the Apple case it was tempting enough to have one judge dissent. And in Australia, we risk throwing the courts in at the deep end, if the legal changes recommended by the Competition Policy Review go ahead.