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The Government's Case Against Apple

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Whatever the outcome, the antitrust trial shows Amazon and Apple's very different paths to profits in modern publishing.

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The curtain has just gone up on the Justice Department's antitrust case against Apple (NASDAQ:AAPL), but whatever the verdict is, we've already gotten a whole graduate-level business course on the different paths to profit of Apple and its rival, Amazon (NASDAQ:AMZN), as demonstrated in the $40 billion-per-year book publishing business.

Here it is in a nutshell:

Amazon swoops into a market with surprisingly low prices on its Kindle hardware, and a bargain-bin $9.99 price on books. It does this even if it loses money, until its competitors fold and its suppliers scream for mercy but receive none. Amazon makes plenty of profit eventually, because of the awesome volume of its sales.

Apple creates premium products, and prices them at a premium. It also makes money on all of the entertainment media that the device is intended to play, and it routinely demands 30%. It makes plenty of profit, too, because 30% of all media sales adds up nicely over time.

How's that going for both companies? The latest figures on the market for e-readers, released in January, show that it works either way.

Amazon's Kindle, including its top-of-the-line Kindle Fire model, has a combined 75% of the e-reader market, while Apple's iPad holds a 34% share. Yet the Apple iPad still rules the category of tablet computers, the higher-priced and higher-powered devices that can handle multimedia as well as text. As of May, it has retained a 40% share against all Android (NASDAQ:GOOG) contenders, including the Kindle Fire at less than 4%.

The difference is that Amazon was willing to forego profit on content, and even on the hardware, at least until it gained a significant market share for a device that would continue to be a cash cow in the hands of consumers.

But Apple wants its 30% profit, guaranteed, from day one. To get the publishers to go along, it told them they could set their own prices, as long as Apple got its 30%. Crucially, Apple added a so-called "favored nation" clause that the publisher couldn't offer its e-books on a competitor's site for less than the Apple store price.

(Amazon, meanwhile, had negotiated prices with the publishers, reportedly paying the standard wholesale price when it had to, and even eating the loss when it couldn't. The publishers' primary concern was that they couldn't compete with themselves if the same book sells for $9.99 in e-book form and $28 in print.)

The Department of Justice argues that this alleged conspiracy by Apple and the publishers has cost consumers hundreds of millions of dollars.

Apple claims that the average e-book price has actually fallen since it opened its e-book store, from $7.97 to $7.34.

A spot check on Amazon shows that its e-book pricing now strays above and below the $9.99 special mark. Among current bestsellers, Dan Brown's Inferno is $12.99, but Stephen King's Joyland, published by a small house not named in the suit, is $9.56, and F. Scott Fitzgerald's classic novel The Great Gatsby is $4.99.

The Department of Justice is arguing that Apple was proposing "a dramatic business change," presumably from the new normal for the industry, as defined by Amazon. In openly discussing that change as a "common approach for all" of the publishers, the department argues, Apple served as the "ringmaster" of a price-fixing scheme.

Apple stands alone in this trial. The publishers named in the suit -- Hachette, News Corp.'s (NASDAQ:NWS) HarperCollins, MacMillan, Pearson's (LON:PSON) Penguin, and CBS Corporation's (NYSE:CBS) Simon & Schuster -- settled out of court.

Even the ghost of Apple founder Steve Jobs is on trial here. In an email to a publisher to be presented at the trial, Jobs suggests two price tiers of about $12.99 and $14.99 for the most popular new releases, and predicts that higher e-book prices would fail. Although the email is intended to bolster the government's antitrust case, Jobs actually seems to be suggesting that Apple's strong point is its ability to give publishers an alternative marketplace. That is, he asserts that if Amazon continued to dominate the business, it would soon force publishers to accept "70% of $9.99" as their wholesale price.

In its opening arguments on Monday, the Department of Justice alleged that the publishers used their plans with Apple to reopen negotiations with Amazon, threatening to withhold some of its bestsellers and new releases if it did not get a better price for them from Amazon. And, that "favored nation" clause virtually guaranteed that Amazon had to raise its prices on some books, or the publishers had to withhold them from Amazon.

That may be the most interesting part of this case. The "most favored nation" clause has become common throughout the entertainment industries. A ruling against Apple related to its use could "send a pretty strong message" about future pricing of online content, law professor Geoffrey Manne told Reuters.

The Department of Justice is not seeking monetary damages in the case, just a ruling that Apple can't do this kind of thing anymore. However, a victory for the government would leave Apple open to a related suit from a group of states, and more class action suits could follow.

Also see:

Samsung Aims to Cement Its Domination of the Mobile Market -- Here's How

The First Quarter Was Business as Usual for Cloud Companies -- and That's a Bad Thing

Why Microsoft Need Not Worry About Windows 8
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