Internet Exchanges for Used Books: An Empirical Analysis of Product Cannibalization and Welfare Impact

Internet Exchanges for Used Books: An Empirical Analysis of Product Cannibalization and Welfare Impact

InformationSystemsResearch Vol. 17, No. 1, March 2006, pp. 3–19 issn 1047-7047eissn 1526-55360617010003 informs® doi 10.1287/isre.1050.0072 © 2006 INFORMS Internet Exchanges for Used Books: An Empirical Analysis of Product Cannibalization and Welfare Impact Anindya Ghose Information Systems, Leonard Stern School of Business, New York University, KMC 8-94, 44 West 4th Street, New York, New York 10012, aghose@stern.nyu.edu Michael D. Smith, Rahul Telang H. John Heinz III School of Public Policy and Management, Carnegie Mellon University, 4800 Forbes Avenue, Hamburg Hall, Pittsburgh, Pennsylvania 15213 {mds@andrew.cmu.edu, rtelang@andrew.cmu.edu} Information systems and the Internet have facilitated the creation of used-product markets that feature a dramatically wider selection, lower search costs, and lower prices than their brick-and-mortar counterparts do.

The increased viability of these used-product markets has caused concern among content creators and distributors, notably the Association of American Publishers and Author’s Guild, who believe that used-product markets will significantly cannibalize new product sales.

This proposition, while theoretically possible, is based on speculation as opposed to empirical evidence. In this paper, we empirically analyze the degree to which used products cannibalize new-product sales for books—one of the most prominent used-product categories sold online. To do this, we use a unique data set collected from Amazon.com’s new and used book marketplaces to measure the degree to which used products cannibalize new-product sales. We then use these estimates to measure the resulting first-order changes in publisher welfare and consumer surplus.

Our analysis suggests that used books are poor substitutes for new books for most of Amazon’s customers.

The cross-price elasticity of new-book demand with respect to used-book prices is only 0.088. As a result, only 16% of used-book sales at Amazon cannibalize new-book purchases. The remaining 84% of used-book sales apparently would not have occurred at Amazon’s new-book prices. Further, our estimates suggest that this increase in book readership from Amazon’s used-book marketplace increases consumer surplus by approxi- mately $67.21 million annually. This increase in consumer surplus, together with an estimated $45.05 million loss in publisher welfare and a $65.76 million increase in Amazon’s profits, leads to an increase in total welfare to society of approximately $87.92 million annually from the introduction of used-book markets at Amazon.com.

Key words: publisher welfare; retailer welfare; consumer surplus; price competition; used-books sales; electronic markets History: Sanjeev Dewan, Senior Editor; Alok Gupta, Associate Editor. This paper was received on September 7, 2004, and was with the authors 31 4 months for 2 revisions. 1. Introduction as a leader in the bookselling industry, Amazon’s [used book] sales practices can have a significantly deleterious effect on new book sales. If your aggressive promotion of used book sales becomes popular among Amazon’s customers, this service will cut significantly into sales of new titles, directly harming authors and publishers.

—Author’s Guild and Association of American Pub- lishers, open letter to Jeff Bezos (CEO Amazon.com), dated April 9, 2002 We’ve found that our used books business does not take business away from the sale of new books. In fact, the opposite has happened. Offering customers a lower-priced option causes them to visit our site more frequently, which in turn leads to higher sales of new books while encouraging customers to try authors and genres they may not have otherwise tried. In addi- tion, when a customer sells used books, it gives them a budget to buy more new books.

—Jeff Bezos, open letter to Amazon.com’s used book- sellers, dated April 14, 2002 3

Ghose, Smith, and Telang: Internet Exchanges for Used Books 4 Information Systems Research 17(1), pp. 3–19, © 2006 INFORMS Globally networked information systems can reduce the search and transaction costs for buyers and sellers to locate and trade products (Bakos 1997), and can thereby facilitate the creation of technology- mediated electronic exchanges (Malone et al. 1987). These exchanges allow sellers to easily reach a world- wide market, and allow buyers to easily locate items that frequently would be unavailable in traditional physical stores.

Several papers in the literature have empirically analyzed the impact of lower search costs on retailer- level competition (e.g., Brynjolfsson and Smith 2000, Smith and Brynjolfsson 2001, Chevalier and Goolsbee 2003).

In this paper, we empirically analyze the impact of lower consumer search costs on product-level competition—specifically, competition between new and used books. The Internet facilitates the creation of side-by-side new- and used-product markets, allow- ing consumers shopping for new products to easily locate competing used-product offers. There is, of course, nothing new about the sale of used products. In the United States, the First Sale Doc- trine (17 U.S.C. §109) allows for the resale of copy- righted works such as books, and used bookstores are common in physical settings. Rather, electronic exchanges alter the scale, scope, and efficiency of what is possible with regard to the sale of used prod- ucts.

Thus, while brick-and-mortar bookstores have high search costs, limited inventory capacity, lim- ited geographical coverage, and relatively high prices, IT-enabled markets for used books offer low search costs, nearly unlimited (virtual) inventory capacity, global coverage, and—through competition among sellers—relatively low prices. These market charac- teristics are clearly attractive for consumers. Internet sales of used books made up an estimated 67% of all used-book sales in 2004 (Wyatt 2005). This repre- sents the highest Internet penetration for any physical product category that we are aware of, and compares to a penetration of only 12.7% for Internet sales of new books.

These changes in used-book sales have also raised concerns among publishers and authors. Groups such as the Author’s Guild and the Association of American Publishers reason that because authors and publishers are only paid for the initial sale of a prod- uct, the lower search costs, increased selection, and lower prices of online used-book markets will canni- balize new-book sales and cut significantly into both publisher revenues and author royalty payments. However, to date, the publishing industry has been unable to precisely measure the degree to which used books cannibalize new-book sales because key sales data have been unobservable in online mar- kets.

For example, Tedeschi (2004) quotes Paul Aiken, the Executive Director of the Author’s Guild, as say- ing “[t]here has always been used-book sales, but it’s always been a background noise sort of thing. Now it’s right there next to the new book on Amazon  We think it’s not good for the industry and it has an effect, but we can’t measure it” (emphasis ours). Like- wise, Kelly Gallagher, chairperson of the Book Indus- try Study Group’s Research Committee, observes “everybody has anecdotal evidence to show used books’ cannibalization of new books, but we don’t have any accurate numbers” (emphasis ours, Publishing Trends 2004).

Therefore, the motivation of this study is to provide direct empirical estimates of the degree to which used books cannibalize new-book sales, and analysis of the resulting impact on publisher welfare, consumer sur- plus, and social welfare. Our paper contributes to the literature in that, while a variety of analytic mod- els have analyzed competition to new-product sales from used-product markets, ours is the only paper we are aware of to empirically analyze the elasticity of new-product demand with respect to used-product prices, and the resulting changes in new and used- product sales and overall surplus.

This analysis also contributes to the literature by providing publishers and industry analysts with a methodology to conduct similar analyses based on data that can be readily col- lected from Internet markets, which as noted above is a capability publishers and content creators have been lacking.

We use Amazon.com’s used-book market as our setting to answer this question because it is one of the most prominent used- and new-book market- places online (Brynjolfsson et al. 2003, Brynjolfsson and Smith 2000), and it lists new and used products side by side on product pages. This creates a setting where cannibalization is most likely to occur as new- book purchasers can easily become aware of compet- ing used-product offers. We use this market to collect

Ghose, Smith, and Telang: Internet Exchanges for Used Books Information Systems Research 17(1), pp.

3–19, © 2006 INFORMS 5 a unique data set from Amazon.com’s new and used marketplaces documenting prices and quantities sold for new and used books. Our data cover two samples: one collected from September 2002 to March 2003, and one collected from April to July 2004. Together these samples include 41,994 observations for 393 individ- ual book titles. Our data suggest that used books are not a strong substitute for new books for most of Amazon’s customers. The cross-price elasticity of demand for new books with respect to used-book prices is only 0.088. As a result, only 16% of used-book sales at Amazon cannibalize new-book purchases.

The remaining 84% of used-book sales apparently would not have occurred at Amazon’s new-book prices. This increased access to low-priced (used) book titles increases consumer surplus by $67.21 million annually. While much of the discussion of the value of the Internet to consumers has revolved around lower prices, consumers’ benefit from access to used-book markets is nearly as large as consumers’ benefit from access to lower prices on new books (Brynjolfsson et al. 2003).1 With respect to retailer losses, our results show that without raising prices, book publishers lose approxi- mately $45.05 million annually in gross profit from the presence of Amazon’s used-book markets.

This rep- resents approximately 0.3% of total publisher gross profits in 2003.2 It is also important to note that this figure does not take into account any secondary rev- enue that might accrue to authors from increased readership. Moreover, this number does not take into account the possibility that publishers could raise their prices on new books as a result of consumer resale opportunities in the used marketplace (Ghose et al. 2005).

We also note that the overall impact of used-book markets on social welfare is overwhelmingly posi- tive. The consumer surplus gains and producer sur- plus losses, together with an estimated $65.76 million 1 Brynjolfsson et al. (2003) find that the consumer surplus gain from access to low new-book prices on the Internet (versus brick- and-mortar stores) is between $100.5 million and $103.3 million annually. 2 The Book Industry Study Group (2004) places publisher revenue at $26.0 billion dollars and Brynjolfsson et al. (2003) place publisher gross margins at 60%.

increase in Amazon.com’s gross profit from the used- book exchanges, suggest a net welfare gain to society of approximately $87.92 million from these used-book exchanges.

The remainder of this paper proceeds as follows. In §2, we discuss the literature relevant to our present work. In §3, we develop an analytic model of used-product markets to highlight the importance of empirical measurements in determining the degree to which used products cannibalize new-product sales. In §4, we compare the characteristics of the brick-and- mortar used-book market to the Internet used-book market to show that the Internet may have a signifi- cant effect on used-book sales. We describe our data in §5 and present our empirical model and results in §6. We discuss the implications of our results in §7.

2. Literature Our research is related to different streams of extant work. The first stream of relevant literature relates to implications of concurrent availability of new and used goods. The difficulty of maintaining monopoly power on durable goods is due in part to the prob- lem of time inconsistency first pointed out by Coase (1972). Coase conjectured that if a firm were to exploit its residual demand in future periods, then rational consumers would anticipate this behavior and price would rapidly fall to the competitive level. The inter- relationship between the markets for new and used goods was pointed out by Benjamin and Kormendi (1974) and Liebowitz (1982).

They argued that a monopolist can maintain market power by restrict- ing the used market. Using the textbook market as an example, Miller (1974) suggests that the opening of secondary markets will force publishers to increase new-good prices to extract the maximum possible profit from the onetime sale of a new good. Further research in this area has shown that a monopolist can avoid the commitment problem by leasing as opposed to selling (Bulow 1982), and that depreciation reduces the monopolist’s incentive to cut price (Bond and Samuelson 1984). The main argument of these papers is that secondhand markets need not hurt the man- ufacturer because manufacturers will anticipate the resale value of their product and will increase the price of the new good accordingly.

Ghose, Smith, and Telang: Internet Exchanges for Used Books 6 Information Systems Research 17(1), pp. 3–19, © 2006 INFORMS A more recent stream of the literature uses analytic models to show that secondary markets also create a substitution effect because new goods face com- petition from used goods (Anderson and Ginsburgh 1994, Hendel and Lizzeri 1999). When considering the impact of used-good markets in competitive new- good markets, upstream suppliers such as book pub- lishers can benefit from secondary markets under some conditions, as shown by Ghose et al. (2005). Recent empirical work in the context of used goods has used aggregate data to show that text- book sell-through—new sales as a proportion of total sales—declines radically from 90% in the first year of a textbook’s publication to 45% in the second year and 10% in the third year (Greco 2005, pp.

185–186; Greco et al. 2005). A more recent study also uses text- book data to show that students are forward looking when making their purchases—and that their value of a textbook declines when the release of a new edition will foreclose on the resale market for a new textbook purchase (Chevalier and Goolsbee 2005). A third stream of literature relevant to our study is research developing techniques to estimate welfare effects from the introduction of new goods. Classic economic theory shows that if the price of an existing good changes from p0 to p1, the resulting change in welfare is given by how much the consumer would pay, or would need to be paid, to be just as well off after the price change as they were before the price change.

This measure corresponds to Hicks’ (1942) compensating variation measure. To measure the wel- fare change from the introduction of a new good, Hausman (1997a) modifies Hick’s measure by using the product’s “virtual price”—the price that would set demand to zero—as p0 and the introductory price as p1. This technique has been applied to measure welfare gains for new goods ranging from Honeynut Cheerios (Hausman 1997b) to increased product vari- ety on the Internet (Brynjolfsson et al. 2003). Related techniques have also been used to analyze the welfare impact from online auction sites (Bapna et al.

2005). Finally, our research draws on the literature relat- ing to competition on the Internet (e.g., Brynjolfsson and Smith 2000, Clay et al. 2001, Baye et al. 2004), and specifically the direct measurement of consumer price sensitivity. Papers in this literature have shown that BarnesandNoble.com seems to face much stronger competition from Amazon.com than Amazon does from Barnes & Noble (Chevalier and Goolsbee 2003). Various papers in this literature have also analyzed the own-price elasticity for offers listed at shopbots, finding elasticity measures ranging from −6 to −10 for shopbots listing books (Brynjolfsson et al.

2004) and PDAs (Baye et al. 2004) sold by differentiated sellers to −50 for a shopbot listing computer mother- boards and memory modules sold by undifferentiated sellers. Elasticity measures at Internet shopbots are relevant for our study because the display of informa- tion at these services is comparable to the information display in Amazon’s used-book marketplace. 3. Theoretic Analysis In this section, we develop a model to analyze the impact of secondary markets on welfare to publish- ers, retailers, and consumers. Our model spans two periods and consists of a single publisher, S selling a new good through a retailer at a wholesale price of w, to a unit mass of consumers.

The book is new when it is marketed in Period 1 and can be sold as used in Period 2 when it undergoes some degrada- tion in quality. The retailer opens a secondary (used book) market where consumers can buy and sell used goods. Whenever a consumer sells the used book, the retailer gets a commission k per used good sold, while the rest 1−k is the gain to the consumer. For exam- ple, Amazon charges a 15% commission (as a fraction of the used-book sale price) to each used book seller, while the remaining 85% of the used-book sale price goes to the consumer.

Further, let  be a consumer’s valuation for a good, where 

∼ U 0 1 . The type parameter  indicates a consumer’s marginal valuation for quality. For any given quality, a consumer with a higher  is willing to pay more for the product than one with a lower . Without loss of generality, let 1 denote the quality of the new good and q denote the quality of the used good, where 0 < q < 1; thus, q can be interpreted as the degree of quality degradation of new book. If a consumer purchases a book of quality q at price p, her utility is U  q − p.

The game is modeled as a multistage game.

First the retailer chooses an optimal new good price given the per-unit wholesale price w set by the supplier. Then market forces determine the optimal price of

Ghose, Smith, and Telang: Internet Exchanges for Used Books Information Systems Research 17(1), pp. 3–19, © 2006 INFORMS 7 used goods from clearance conditions. Finally, con- sumers demand is realized. We consider a subgame perfect equilibrium of this game using backward induction. 3.1. No Secondary Electronic Market We begin by modeling the case where only new goods are sold in the marketplace. We denote the price of the new good in the absence of a used-good market as PN . Thus, consumers buy a new book as long as they get positive surplus; i.e., as long as 

−PN > 0. Hence, the demand for a new book is DN PN  = 1 = 1 − PN .

Under these conditions the profit of the publisher is, S = DN ∗ w = 1 − PN w (1) and profit to the retailer is R = DN ∗ PN − w = 1 − PN PN − w (2) In equilibrium, the retailer maximizes this profit by setting P∗ N = 1 + w/2. At this price, the publisher makes a profit of S = w1 − w/2, while the total profit of the retailer is R =DN ∗PN −w=1−PN PN −w= 1−w2 4  (3) Note from (1) that in equilibrium the publisher will set w∗ = 1/2.

3.2. Retailer Establishes a Secondary Electronic Market The presence of a secondary market allows new-book buyers to sell them later. Rational consumers take this into account in their utility function in the buying process. As a result, the retailer (and/or publisher) should be able to sell the new book at a higher price. This is the price-increase effect, as outlined in the prior literature (e.g., Miller 1974, Swan 1980). However, Waldman (1997) and Hendel and Lizzeri (1999) argue that the used-book market also cre- ates a substitution effect. The substitution effect arises from the fact that new books face competition from used books.

Accordingly, some consumers who pre- viously would have bought a new book will shift to the used-book market, cannibalizing new-book sales. The price-increase effect will increase publisher wel- fare, while the cannibalization effect will decrease Figure 1 Market Segmentation in the Presence of a Secondary Electronic Market 1 θ1 θ2 Buy new and sell Buy used Buy nothing publisher welfare. The actual impact of used-book markets on publisher welfare depends on the actual elasticity and propensity to resell books observed in the market.

Figure 1 describes the segmentation of the market based on consumer types. Let PU N and PU denote the new and used-book prices, respectively, in the pres- ence of used-book markets. An artifact of secondary markets is that not all consumers resell their used books. There could be multiple reasons for some con- sumers to hold on to their used book. For example, not all consumers may be aware of the existence of the used-book market, or the transactions and search costs faced by some consumers could be sufficiently large that they do not have an incentive to partici- pate in the used-book markets.

In short, the net util- ity to some consumers from keeping the book might exceed that from selling it. To account for this fact, we assume that only a proportion  of new-good buyers eventually sell their used goods.3 Hence, the expected revenue from a used-book sale (which is equivalent to 1 − kPU ) realized by consumers is 1 − kPU , where  ∈ 0 1 and the commission charged by retailers for selling used books is k. Hence, the corresponding expected utilities derived from various strategies are as follows: (i) Buy new good and sell it − PU N + 1 − kPU .

(ii) Buy used good: q − PU . (iii) Buy nothing: 0. Thus, higher-valuation consumers buy new goods and lower-valuation consumers wait and buy used goods later. It is important to recognize that, in our model, the number of consumers in these groups emerges endogenously. This ensures that clearance conditions will equalize demand and supply of used goods at all times. The new profit of the publisher is given by U S = DU N wU = 1 − 1wU (4) 3 We do not model flows within the used-book markets, i.e., used- book consumers who resell their used books.

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