Several large publishers hated Amazon’s pricing strategy, fearing that it would ultimately reduce the perceived value of their product. They thus pressured Amazon to accept an agency pricing model for e-books. Under this approach, the publishers would retain ownership of the e-books and, most importantly, would set their retail prices. Amazon would then be compensated as an agent for providing the opportunity for the publishers to sell at retail. Under this approach, Amazon would receive 30% of each sale, and publishers would receive 70%.

The strange thing about these negotiations is that their initial effect appears to be lower publisher profits. As I noted in my earlier post:

Under the original system, Amazon paid the publishers $13.00 for each e-book. Under the new system, publishers would receive 70% of the retail price of an e-book. To net $13.00 per book, the publishers would thus have to set a price of about $18.50 per e-book, well above the norm for electronic books. Indeed, so far above the norm that it generally doesn’t happen. … [In addition]  publishers will sell fewer e-books because of the increase in retail prices. Through keen negotiating, the publishers have thus forced Amazon to (a) pay them less per book and (b) sell fewer of their books. Not something you see everyday.

Publishers presumably believe that the longer-term benefits of this strategy will more than offset lost profits in the near-term. What they may not have counted on, however, is the attention they are now getting from state antitrust officials such as Connecticut Attorney General Richard Blumenthal. As reported by the Wall Street Journal this morning, Blumenthal worries that the agency pricing model (which is also used by Apple) is limiting competition and thus harming consumers. And the WSJ says he’s got some compelling evidence on his side:

The agency model has generally resulted in higher prices for e-books, with many new titles priced at $12.99 and $14.99. Further, because the publishers set their own prices, those prices are identical at all websites where the titles are sold. Although Amazon continues to sell many e-books at $9.99 or less, it has opposed the agency model because it argues that lower prices, as exemplified by its promotion of $9.99 best sellers, has been a key factor in the surging e-book market.

It’s also interesting to note that Random House decided to stick with the wholesale model, and many of its titles are priced at $9.99 at Amazon.

Of course, higher prices on select books are not enough to demonstrate an antitrust problem. Publishers will likely argue that there is nothing intrinsically anticompetitive about agency pricing, which is used in many other industries. Moreover, there is nothing to suggest that they are colluding on e-book pricing. Also, they may claim that their pricing strategy will allow more online retailers to enter the marketplace, thus providing more competition and more choice for consumers (albeit along non-price dimensions).

• I recently cheered the Obama administration’s success (so far) in fighting off excess spending on the F-22 fighter. However, business-as-usual is still the rule in Washington, as the Washington Post reports that the House will soon vote on a defense appropriations bill that is loaded with $6.9 billion in spending that President Obama and Defense Secretary Gates don’t want.

• On Tuesday, I discussed the difficult economics of mortgage modifications. This morning, the New York Times suggests another challenge: some servicers have a financial incentive to encourage delinquencies and defaults.

• I also welcomed the news that Yahoo and Microsoft had finally struck a deal to bring Bing to the Yahoo home page. It’s not surprising, however, that this deal among internet titans will attract close antitrust scrutiny, including from Congress and European regulators.

If the stock market is any guide, Microsoft is getting the better of the deal. As Techcrunch notes, Yahoo’s stock fell 12% on the day, lopping almost $3 billion off its market cap:

Microsoft , on the other hand, was up  about 1.4%  – boosting its market cap by about $3 billion.

The real question, of course, is how the deal will affect Google. GOOG was down about 0.8% (around $1 billion in market cap), a bit more than the decline in the Dow or the Nasdaq. That suggests that Google investors respect the MSFT-YHOO deal, but aren’t running scared just yet.

The logic of the deal seems impeccable. Yahoo is an also-ran in the search space, while Microsoft’s Bing is an exciting new entrant. Just how far Yahoo has trailed in search was driven home for me when I reviewed my posts about the search market (here is a list). Google gets the most attention in those posts, of course, but I also discussed competitors Bing, Wolfram Alpha, and Cuil. But it never occurred to me to mention Yahoo. That oversight is vindicated by today’s deal.

Personally, I am looking forward to having Bing on the Yahoo home page. I’ve spent far too much effort avoiding Yahoo’s search engine (e.g., by uninstalling the annoying Yahoo toolbar that various services foist on you when you get new software). Perhaps now I will have reason to let Yahoo take up a bit more valuable screen space.

Disclosure: I don’t own stock in any of these companies.

Early on, the article notes some ironies of the current situation:

More than 15 years ago, federal regulators began making Microsoft the symbol of anticompetitive behavior in the tech industry. Now, a newly activist DOJ may try to do the same thing to Google.

It is an ironic position for the search giant to find itself in. [CEO Eric] Schmidt not only campaigned enthusiastically for the very Obama administration that appointed [DOJ antitrust chief Christine] Varney, but also was one of the most devoted opponents of Microsoft in the mid-’90s, eagerly helping the government build its case against the software firm.

A few weeks ago, I described some of the arguments that Google might use to defend itself. The Wired article elaborates on one of these: it’s fine for a company to be a monopoly if, as John Houseman used to say, they earn it. It then points to the other issues that may raise concerns:

In and of itself, Google’s size is not a legal problem. Varney herself has pointed out that, while Google may enjoy a monopoly in the search-ad business, the company acquired it legally by building better search products that competitors were simply unable to match. Lawyers and economists say that things get complicated, though, when Google moves beyond search and into Web services like online spreadsheets and video sites. Because its search and advertising algorithms are secret, there is no way for competitors or partners to know whether Google tweaks results to direct traffic to its own properties over theirs. Enter a street address into Google’s search engine, for instance, and Google Maps tops the results. Type “Britney Spears” and Google News comes up before People magazine or TMZ.com. … If Google is using its search position to promote its other businesses, that could leave it open to charges of illegal bundling and leveraging–the same changes that Microsoft faced for packaging its browser onto the Windows desktop.

The article does have one major lapse, offering up one of the dumber antitrust arguments:

Google can use the surplus cash from its search business to subsidize the development of new, free products and services. That’s a frightening prospect for would-be competitors without such a robust revenue stream–potentially scary enough to discourage them from entering the market. The possible result: less innovation overall.

By that logic, Google could only avoid antitrust scrutiny by either (a) not making profits or (b) not innovating. That’s absurd.

As someone who has given brief thought to competing with Google, I can tell you that the company is daunting. But not because it’s so profitable (otherwise Apple, George Soros, and Alex Rodriguez would be just as concerning). No, the reasons Google frightens competitors are its servers, software, know-how, user base, brand, etc. Any rational person would think twice before trying to compete with a company that’s become a verb.

• Paul Kedrosky says that the U.S. Venture Capital industry needs to shrink – by 50%.  [my latest post on this]

• SubsidyScope presents some cool visualizations of the TARP money and other bailouts. (ht: Marcus Peacock in the comments) [latest post]

• Barrons analyzes the Citigroup arbitrage.  (ht: Jonathan Feldman in the comments) [latest post]

• The New York Times traces the roots of the exploding budget deficit.  [latest post]

• The Deal Professor examines how Treasury negotiates the TARP warrant repurchases. (ht: AF) [latest post]

• The Washington Post describes the key roll that the Congressional Budget Office — and, in particular, Doug Elmendorf, its director — will play in this summer’s health policy debate. [latest post]

• The Wall Street Journal discusses the antitrust scrutiny that Google is receiving. [latest post]

How will Google try to defend itself?

As Horwitz reports, Google will undoubtedly employ two classic defenses:

Defense 1.  Being a monopolist isn’t illegal.  If firms achieve market dominance through “superior skill, foresight, and industry” (as Justice Learned Hand put it decades ago), that’s fine under our system.  We want to reward firms that gain market share by being innovative and delivering value to customers.

To overcome that argument, antitrust authorities (or private plaintiffs) will need to identify some specific actions that Google has taken to “restrain trade”, gaining market share by interfering with competition, rather than by demonstrating superior skill etc.

Google will then reply with:

Defense 2.  Furthermore, we aren’t a monopolist.  To identify a monopolist, you first have to identify a market.  That sounds simple, but it actually inspires lots of debate in antitrust cases (and, in the process, enriches a certain cadre of economists who specialize in such issues). As Horwitz notes, commentators usually characterize Google as enjoying 70% or more of the revenue in the search advertising business, which certainly sounds like a big share. But Google thinks that market definition is too narrow.  If you look at all advertising, for example, Google’s share is microscopic, less then 3%.  Thus, Google will argue, it isn’t even a monopolist.  (The truth is somewhere in the middle. Banner ads certainly compete with search ads, and thus may fall in the same market. But billboards?)

What happens if those two arguments aren’t sufficient to deflect further antitrust scrutiny? Well, Google has at least one more arrow in its quiver — an arrow that got stronger with this week’s launch of Bing, the new search engine from Microsoft:

Defense 3. Our business constantly faces new competition.  Even if we are a monopolist right now (which we’re not), there’s no guarantee that will last.  This argument emphasizes the dynamic nature of competition.  If new firms can enter the market — and, in fact, are entering the market — then any monopoly power may be transient.  Faced with new competitors, leading firms must continue to innovate if they want to stay at the top of the market.  In short, pressure from new competitors may prevent a dominant firm from exploiting any temporary market power.

The lawyers at Google probably welcomed Bing’s arrival, because it makes this line of argument much more plausible.  Other new competitors — anyone remember Cuil?  – haven’t posed much of a threat to Google, but Bing may be different.  So may Wolfram Alpha, which provides a really different approach to search.

If antitrust scrutiny heats up, you should expect to hear Google extolling the virtues of both those competitors.