June 29, 2022
A non-economist friend of mine innocently asks why some authors receive advance payments and others do not. Little did he know that economics offers an answer!
Just a few weeks ago, I pondered why exchanges take so many disparate forms. In fact, even narrowing that question quite a bit—why don’t all contracts with a particular type of producer (authors) look the same?—reveals interesting variation.
Yoram Barzel to the rescue in his classic 1982 paper.
For context:
“The royalty contract between author and publisher stipulates that the author will receive a given share of the revenue from the sale of the book. Since the success of the book and the total revenue its sale will generate are not known when the contract is drawn, the author's income is uncertain. Had authors been paid a lump sum, their entire risk would have been shifted to publishers. Publishers are often diversified to start with, and thus paying a lump sum would increase the riskiness of their operations only moderately. The desire to reduce risk, then, would have generated the outright purchase of rights to books rather than the common royalty contract.
What else, then, could explain the sharing arrangement? In the royalty contract the share, or share structure, is set in advance, but the absolute amounts the two parties will receive are contingent on consumers' actual demand subsequent to publication. Because of the difficulty in predicting the ultimate success of the venture, the determination of the appropriate lump sum is expensive to reach. If publishers make competitive lump-sum bids, each of them will require some market research. Even the successful bidder's effort is excessive, since subsequently the information will emerge anyhow. Had publishers attempted to lower the cost by spending only a small amount on research, their bids would be subject to large errors, and the winning bidder might turn out to be a big loser. By sharing, the need for market research is reduced and the error is largely limited to the sharing percentage, making the expected value of the royalty contract larger than the lump sum would have been.”
Now for his answer:
“Share contracts are subject to incentive problems absent from lump sum contracts and in this regard are more costly. For instance, the publisher will tend to advertise less than when he does not share added revenues with the author. The lesser the information problem, the more attractive the lump-sum arrangement; thus share contracts are expected to be more common with new authors than with established ones, with the first editions than with subsequent ones, and with novels than with "how-to" manuals.
The sharing arrangement, then, makes some search less profitable. Market forces dissuade publishers and authors from acquiring prior information on the value of the traded property. But because such acquisition would have been wasteful, the sharing arrangement is a more
efficient solution.”