A few weeks back, I read Ken Auletta’s New Yorker article on the release of the iPad.  The piece focuses on the future of publishing, ebook pricing and sales; the impression it leaves is one of confusion.  Publishers demand higher prices, consumers expect lower prices, and big distributors, like Amazon and Apple, have their own motives for trying to please both parties without alienating either.  For the time being, there seems to be little agreement about just how much ebooks should cost.

Auletta’s article was clear about one thing though: in the long run, ebook prices must fall.  He closes by quoting “a skeptical literary agent” who says, “You can try to put on wings and defy gravity, but eventually you will be pulled down.”  In other words, eventually, consumer expectations will win.  If buyers think ebooks should be cheap, then they better be cheap or no one buys.

But how cheap?  With no printing or shipping, the cost of making and selling one more ebook is practically nonexistent.  This is the biggest advantage of digital publishing, and maybe also the biggest obstacle to fair ebook pricing.  If one more ebook costs publishers nothing, how much should they charge for it?  They have to charge more than nothing, but how much more?  How low can prices go to meet consumer expectations and still benefit publishers?

Fair warning to the faint of heart: this is about to get intensely nerdy.  It’s about to get economic.

First my qualifications as an economist: I took a couple of economics courses in college, I regularly read the Economist, and I’ve enjoyed books like Freakenomics and The Armchair Economist.  I also make a lot of assumptions.  With that in mind, I’d like to offer an amateur attempt at modeling price for a product that incurs no marginal costs, and I’d like to invite criticism from any of you masochists who read past the jump.

Theoretically, a firm will maximize profits by producing to the point where the marginal cost of one more unit is equal to the marginal revenue generated by that unit.  If we assume MC = 0, then a firm will maximize its profits where MR = 0.  Beyond this point, it could sell more copies, but only at lower prices and a net loss to total revenue.

Given a normal, linear, downward-sloping demand curve, MR will always have the same y-intercept as the demand curve and double the slope (in absolute value, since both will have a negative slope).  So MR will cross the quantity axis, meaning zero out, at a point exactly half way between the origin and the demand curve.

What does this mean for ebook pricing?  As my microeconomics professor taught his classes to say, it depends on the elasticities.  Elasticity describes the responsiveness of one variable to change in another.  It’s reflected in the slope of the demand curve.  A steep slope means demand is inelastic, and a unit change in price corresponds to a proportionally smaller change in the quantity demanded.  A shallower slope means demand is elastic, and a unit change in price will cause a proportionally higher change in the quantity demanded.

Bored yet?  The painful part is almost over.

Here’s why that matters: if demand for ebooks is inelastic, then MR = 0 at a point closer to the origin, corresponding with higher prices and lower quantities on the demand curve; publishers will maximize profits by selling fewer ebooks at higher prices.  If, on the other hand, demand for ebooks is elastic, then MR = 0 at a point farther from the origin, corresponding with lower prices and higher quantities on the demand curve; publishers will maximize profits by selling more ebooks at lower prices.

This is all fairly dense, it rests on a lot of assumptions, and in order for this analysis to be any help in setting a specific price point publishers would need to know a lot of things that they probably can’t know.  So what good is it?  Here, I believe the theory accurately describes the situation publishers currently face.  Should they continue jockeying to charge higher prices for their products, or should they seek opportunities to charge less and sell more?

Everything I know about ebooks suggests that demand for them is essentially elastic.  There are a lot of substitutes available, other titles we might buy, paper books, or other things we might choose to do with our leisure time besides read.  This is the last assumption I’m going to make here, and if it’s correct, then not only should ebook prices be falling, but publishers should be falling all over themselves to push new, creative (and cheap) marketing strategies to increase demand for ebooks so they can sell more and more of them at lower prices.  Everyone will be better off.

That being said, ebook prices will necessarily be sticky for a while.  Publishers need time to reduce their fixed costs, and since most books sold are still paper bound, publishers still have real marginal costs.  But publishers have to move.  They should be racing each other to lower prices by promoting and packaging ebooks more intelligently.  To borrow a phrase from Richard Feynman, there’s plenty of room at the bottom.  If the publishers don’t get there first, there are armies of startups and upstarts, people for whom books are a passion first and a business second, and many of them are better positioned to take advantage of new media and digital distribution.