How traditional publisher ebook pricing works
The discussion started with complaints about traditional publishers setting the price of their ebooks too high, usually roughly equal to the hardcover price upon release.
Let's begin with a dialog:
Me: Who sets the price that a book sells for?And in every other case, because that's how the market works... it's just the aggregate decisions of lots of buyers and lots of sellers and lots of products rather than one buyer, one seller, and one product.
Friend: the publishing company sets a base price, the one on the book jacket, and the stores mark it down if it doesn't sell at that price.
Me: OK, I have a book I want to sell you. Just the one copy, wrote it myself. I'll sell it to you for $100. Will you buy it?
Friend: Probably not. It would depend on how big it is, and whether it's on a subject I can't get anywhere else, I guess.
Me: How about $99?
Friend: still depends. This is the supply and demand part, right?
Me: Look, I really don't have any use for this book. I wrote it, so I've already read it, I don't need to keep it. It's just sitting in my closet. How low do I have a price it before you buy it?
Me: Sold. So who sets the price?
Friend: I did, in this case.
The seller can ask for a price but he can't make people pay it. What he tries to do is set his asking price and level of production (number of products he makes) to be the "profit maximizing" price, ie, the price at which he will make the most money. That's not always the price that sells the most units... if he can sell 5 units for $50 or 10 units for $1, he should choose to sell 5 units.
Now, the way publishing works, there is another important dimension: time. For traditional publishing, the publisher uses time to create a tiered pricing model. $25 for a hardcover on first release, $10 for a paperback in a year. In both cases the price is set by what the buyers are willing to pay; by staggering the time of the releases, the publisher makes $25 from everyone willing to pay that price and then also makes an additional $10 from everyone willing to pay $10 but not $25. The big difference in price between paperbacks and hardcovers is not printing and distribution, it's time -- and time is being used as a proxy for demand. High demand people buy the hardcover. Low-demand people buy the paperback.
It may help to think of this like a calculus problem. If you graph the price a buyer is willing to pay and number of buyers at that price, you get a curve. The area underneath that curve is your gross revenue. If you set a constant price, it's like drawing a straight horizontal line across the graph -- you get a sale for every point under the original curve that is also below the straight line of your price point. You can get more of the possible revenue by drawing rectangles rather than straight lines -- that is, by selling to people willing to pay $30 at that price (a tall, rectangle), then to people willing to pay $20 (shorter, wider rectangle), then to people willing to pay $5 (very short, very wide rectangle), and so on.
Since publishers can't know what each buyer is willing to pay, and given a choice everyone would pay the lowest price, they have to find some way to discriminate between buyers. They do that with time, and with book formats. The result is that they capture more area of the area under the curve -- more revenue.
So where does the ebook fit in? Well, you don't want to lose your profit margin on the hardcover, so you price your ebook roughly the same as your hardcover when it first comes out. People don't buy it (because it's obviously not a good deal, as you noted), so you drop the price bit by bit until you find the right price to sell ebooks and preserve your profit margin. (Currently, that's about $16 for a new ebook release also new in hardcover). Maybe you don't sell as many hardcovers, but your profit margin on the ebooks that replaced the hardcover sales is the same, so you don't care. (Well, not much; you make a note to print fewer hardcovers next time).
There's another catch here; ebooks don't count in sales figures for the NYT bestseller lists. The Wheel of Time books aren't sold in ebook format until months after the hardcover sales for precisely this reason. And of course you printed lots of hardcovers that you need to sell, you don't want the ebook cannibalizing your hardcover sales.
Then you wait a year for the hardcover demand to run out. When you think the time is right and everyone willing to buy a hardcover has, you release the paperback for $10. People stop buying your hardcovers (hopefully you've run out by then anyway) and start buying the paperback.
How do you price the ebook now? Well, people have a cheaper option available in the paperback. Unless they have some reason to prefer the ebook, they'll buy the paperback for $10 rather than the ebook for $16, and you've already printed a gazillion paperbacks that you need to sell. You want people buying the cheaper paperback since they are already in your warehouse.
Also, you know that your ebook readers constitute a market segment of their own -- they have self-identified as people willing to drop a few hundred bucks on an electronic device to read books. You can charge them a higher price for the product (a book) in their desired format (an ebook) because you are catering to their specific tastes and you know they have a higher demand for books than the rest of the market. They have reasons to prefer the ebook format (with me, it was bookshelf space) and may well be willing to pay a premium for the desired format.
Eventually, of course, you start to run out of paperbacks, and you figure you've satisfied all the demand you can for $10 paperback books. How many people would buy the book for $5? Is it enough to do another print run? Probably not judging by book pricing these days, the difference between a $5 book and a $10 book isn't enough to justify printing more to satisfy the remaining demand.
You could re-price your ebook to cover the gap, but if people are still occasionally buying your ebook for $16, there's still demand for that price and no reason to lower it if people will pay it. Maybe you drop your ebook price gradually towards your paperback price as your supply of paperbacks dwindles, but there's no reason to go below your paperback price while you still have paperbacks to sell. You want people to buy the physical book since it's already printed and taking up warehouse space.
Once you think you've sold everything you can, there's no reason to lower the price of the ebook -- you're not going to pick up enough new customers to care. At that point in the sales cycle, you're selling a trickle of books, mostly to people who already know the book and have some reason to look for it specifically... and by doing so, they identify themselves as having higher demand than the average person for that book, so they'll pay whatever reasonable price you set for the ebook version. The number of people who would buy a $5 ebook but not a $10 paperback is tiny, and there are still people willing to buy the $10 ebook, just not many of them. Why not charge them $10 if they'll pay it?
The answer, of course, is that you don't keep charging $10 if the readers won't buy your ebooks at $10, which they will keep doing so long as all the ebooks are priced around that point. But if they have a choice between a traditional publisher's ebook at $10 and a independent author's ebook at $1, that's a whole different story.