Internet Exchanges for used books: An empirical analysis of product cannibalization and welfare impact.
In this blog post I will provide a summary and discussion of the article Internet Exchanges for used books: An empirical analysis of product cannibalization and welfare impact, written by A. Ghose, M.D. Smith and R. Telang. This article was published in Information systems research in march 2006 and can be accessed for free. The URL to the article can be found in the reference list.
The market for used books is nothing new. Even before the rise of the internet people have been buying, selling and sharing used books. Since the inception of the online market platform amazon.com this process has become much easier. In contrast to a brick-and-mortar bookseller, Amazon is not limited by geographical location or shelf space, and can sell for a lower price.
Groups like Association for American publishers believe that used-book sales through Amazon will cannibalize new book sales and even “threaten the future of authorship.” (Russo, 2014). Ghose, Smith and Lang put it to themselves to quantify and publish the effect of used book sales though amazon on the welfare for all stakeholders, and it is these findings we will analyse.
Let us start with the theoretical analysis.
The authors identify two ways the market for used books has an effect on the market for new books. These effects are dubbed the price effect and the substitution effect. The price effect works as follows: when there is a market for used goods, such as books, a consumer will be willing to pay more for the product because he can sell it later on the used-goods market. A consumer that values a book at $25 will be willing to pay a maximum of $40 when he knows that he can sell this book on the secondary market for 15. This mark-up, which is equal to the second-hand price is a direct welfare gain to the original seller.
The second-hand market also creates a substitution effect: For many consumers, new and used products are substitutes. Some people who would otherwise have bought a new product will instead buy a used version. This is the cannibalization the authors guild is afraid of.
The welfare gain or loss to the publisher is therefore the net effect of the price effect minus the substitution effect. A positive number means welfare gain, while a negative number means welfare loss.
The empirical evidence seems to indicate that the substitution effect outweighs the price effect. The authors’ results show that publishers lose about $45 million, or 0,03% in gross profit per year from amazons used book market. Consumer surplus is estimated to be around $67 million annually, and Amazon’s increase in gross profit from used books amounts to about $88 million annually. The net effect on welfare is therefore positive, with consumers of books and amazon’s shareholders being the clear winners from this development, and traditional book publishers losing out.
According to the researchers’ data, only 16% of used book sales through amazon cannibalize new book sales, while 84% of used books would not be sold without amazon. This 84% helps explain the net welfare gain. Amazon sells these books above cost, therefore creating producer surplus. Consumers value the books above their sales price, which is where the consumer surplus comes from.
What about the authors? Are they helped or hindered by the rise of amazon?
The researchers did not investigate the effect amazon has on the authors themselves, which could be an interesting topic for further research.
One effect on author welfare that must be considered is what is known as the “Long tail effect.”
Because physical stores have limited shelf space, they generally only sell items that are popular. This is great for authors of popular fiction, but that means there is less space in the store for niche books. This is unfortunate for the authors of these books, but do the customers ever care? According to the Long tail theory, the answer is yes. The theory of the long tail effect postulates that the demand for goods that are not sold in physical stores might as big as, or bigger than, demand for goods that are. Because amazon.com and similar online platforms are not limited by shelf space of physical location, they are better equipped to fill this demand. This is great news for authors and consumers of niche books, and an additional source of welfare gain.
Source: Brynjolfsson, Yu and Smith (2006)
There is also an additional threat to the welfare of authors that was not mentioned in the articles: the rise of e-books. Traditionally, the net profits of a book were split evenly between publisher and author. For e-books , the author receives a much smaller share of net profits. The division of profits differs from publisher to publisher however, and this topic is still hotly debated between authors, publishers and amazon. Only time will tell how the market for e-books will develop.
Since the inception of amazon.com the market of used books has grown to a size never seen before. While it is natural for publishers to worry that this will cannibalize new book sales, this fear is largely unfounded. New and used books are imperfect substitutes at best, and many book sales would not have occurred without amazon. Because the platform is less limited by physical constraints, amazon can serve niche markets in a way physical stores cannot, thereby increasing welfare for consumers and writers of niche books.
Will e-books help or harm authors? How will the market for books, new and used, develop from here? Can traditional booksellers capitalize on the digital revolution? I’m interested to read your thoughts and ideas in the comments.
Ghose, A., Smith M.D. and Telang, R. (2006), Internet Exchanges for Used Books: An Empirical Analysis of Product Cannibalization and Welfare Impact, Information Systems Research Vol. 17, No. 1, March 2006, pp. 3–19
Brynjolfsson, E., Yu, H. and Smith M.D. (2006), From Niches to Riches: Anatomy of the long tail. Sloan Management Review, 2006, Vol. 47, No. 4, pp. 67-71.
The Authors Guild (2014), Letter from Richard Russo on the Amazon-Hachette Dispute