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Are prices higher under an agency model than a wholesale pricing model?

by Joshua Gans

31st March 2012

This is the question floating around with regard to the DOJ’s investigation into eBook pricing. Given the discussion I figured that I would just write down a simple model to explore the issue. This model is based on Gans (2012).

Suppose that the (inverse) demand for an eBook is given by P = a - Q where P is the price consumers pay for an eBook and Q is the quantity they purchase. eBooks are assumed to cost nothing to distribute to consumers who have devices. Gans (2012) explores the consumer’s choice to purchase a device as well but this will not be considered here.

MODEL 1: Wholesale Pricing

Suppose that a book publisher charges a price of p to a retailer. Then, based on this, the retailer sets a price to consumers of P and earns (P - p)(a - P).

In this case, the retailer’s optimal price is:

P* = (a + p)/2

Given this, the publisher’s demand is Q = a - P* or Q = (a-p)/2. The publisher chooses p to maximize its profits of pQ which results in a price of p* = a/2. This implies that the final equilibrium price under the wholesale pricing model is:

MODEL 2: Agency

P* = 3a/4

Under an agency model, the publisher sets P directly while the retailer receives a share, s, of revenues generated. The publisher, thus, chooses P to maximize its profits of (1-s)PQ. This generates an optimal price of:

Conclusion

P* = a/2

Regardless of s, the price under the agency model is lower than the price under a wholesale pricing model. The reason is that the agency model avoids double marginalization. The comment here does not reflect other effects arising from ‘most favored customer’ clauses that can apply in both wholesale pricing and agency models and are discussed further in Gans (2012).

References

Gans, Joshua S. (2012), “Mobile Application Pricing,” Information Economics and Policy,