Amazon’s Clever Price Discrimination Strategy

Amazon likes to discount books. Here are some examples, starting with Game Theory 101: The Complete Textbook:

We are only looking at the print prices in this blog post. Originally $13.99, Game Theory 101 is yours for only $11.75.

It’s a similar story for The Rationality of War:

Down from $10.54, you can buy The Rationality of War for $9.30.

And finally, here’s Game Theory 101: Bargaining:

Originally $11.09, Bargaining now sits just under $10.

I suspect the average consumer is pleased to see these discounts. For authors who publish through CreateSpace, however, these discounts are incredibly confusing. We can set the original price. No matter how much Amazon discounts it, they pay us a set amount of money per sale. As such, we also like Amazon’s discounts. In fact, the larger discount is, the happier we are.

The problem is, the discounts are inconsistent. When you initially publish a book, Amazon will always tag it with the list price. Then, after some time and without any warning, Amazon might reduce the price. Or they might not. I have discussed this problem with other authors, and there doesn’t seem to be any explanation for what’s going on.

That said, I now have a theory. Amazon has found a clever form of price discrimination.

What Is Price Discrimination?
The maximum price any of us is willing to pay for a good or service can vary heavily. A lot of Americans will pay $10 or more to see Fifty Shades of Grey. Meanwhile, others may only be willing to pay $1 to see such a movie. We call such a maximum price an individual’s reservation value.

As a business owner, your dream is to charge everyone their reservation value. For example, suppose Fifty Shades’ potential audience consists of two people, one who is willing to pay $10 to see the film and the other who is willing to pay $1. If you could somehow charge the $10 person $10 and the $1 person $1, you would make $11. This makes you the most amount of money possible.

Of course, movie theaters cannot easily distinguish between those high value and low value types. As such, like most businesses, they offer a single blanket price of $10. The $10 person sees the film but the $1 person does not.

Despite the difficulty in price discriminating, businesses try it to varying degrees of success. Student and senior citizen discounts are perfect examples. Both of these groups live off of fixed (and small) incomes. Consequently, as a whole, they are less willing to pay high prices for entertainment. Businesses like movie theaters therefore offer cheaper prices to these groups than to people who tend to have larger disposable incomes.

Airplane flight prices work in a similar way. Vacation travelers are unwilling to pay $1000 for a flight across the United States. In contrast, many business travelers who need to get to New York on short notice are willing. Airlines thus charge relatively cheap prices on flights booked well in advance and massively jack up the prices on the days before takeoff.

Don’t let these discounts fool you. Although they may make it seem like the businesses are acting generously, the discounts exist to maximize profits.

Price Discrimination on Amazon
Broadly, people who publish through CreateSpace fall into one of two categories: vanity authors and what I will call profit makers. Vanity authors write books without the intention to make money. They simply want to “publish” a book so they can say they have. These authors will sell tens of books to friends and family, but their work will never catch on with a larger audience. They give self-publishing a bad name.

Profit makers use CreateSpace because they do not want to hand over a large share of revenue to a traditional publishing house. Vanity is not a concern here. They invest time in writing books and publishing through CreateSpace because they know their works will make a substantial amount of money.

Unfortunately for Amazon, it is very difficult to differentiate between vanity authors and profit makers. Further, there are substantially more vanity authors than profit makers out there. As such, Amazon’s best guess for any new book coming from CreateSpace is that the work is from a vanity author.

This is where I think Amazon’s price discrimination comes into play. Amazon suspects that every new book is vanity. Sales of vanity books do not operate like a normal market. Vanity authors are selling virtually all of their books friends and family. These individuals are willing to spend more money on these books because they know the author. Their reservation price is consequently higher than your average individual. In many cases, it may be substantially higher—a poorly edited vanity book is essentially worthless to the average consumer, but friends and family might be willing to spend $10 or $20 on the book.

If you are Amazon, what incentive do you have to cut the price? Any discount you offer directly hurts your bottom line, and these vanity books are not responding to standard supply and demand factors. Consequently, you don’t have any incentive to discount. The vanity books will be sold to the friends and family and no one else. No discount maximizes your profit.

Of course, Amazon suffers when the book is from a profit maker, not a vanity author. These books respond to supply and demand, so cutting prices by 10% can actually cause more people to buy them. So Amazon might want to reduce the price in these circumstances.

Put yourself in Amazon’s shoes for a moment. You want to discriminate here to maximize your profit. But how?

From my personal experience and discussion with other authors, I think Amazon has figured out a way. They start by offering no discount, under the assumption that the book is from a vanity author. They then wait. And wait and wait and wait. Vanity books will see their sales fall off a cliff after a month or two. Profit making books will see continued sales over the long term. This differentiates the type of book. Amazon thus cuts the price of books that sell, knowing that doing so will lead to even more sales.

To be clear, this is speculation backed up with some non-random observations. Still, I think there is a good chance that price discrimination explains Amazon’s strategy. Although the discounts may seem to be applied randomly, I can’t imagine a company with $88 billion in revenue is doing this without purpose. Price discrimination explains it.