Why Do Authors Get Paid Royalties?

Why do authors get paid royalties on their books rather than a lump sum payment? The immediate answer that springs to mind for most people is that it is a risk-sharing agreement. Neither the author nor the publisher know how well the book will sell. Profit-sharing allows them to share in both the risk and the benefits.

While this seems plausible, careful thought seems to rule out this explanation. Publishers tend to diversify. They publish a lot of books. The risk that one book is not a success is not going to make or break the publisher. On the other hand, the author is not diversified. The author might prefer to get a lump sum payment and put all of the risk on the publisher. Since the publisher is diversified, they might be willing to do this. Furthermore, some authors actually do get a lump sum payment in the form of an advance. Why do some authors get treated differently?

Yoram Barzel argues that the problem has to do with measurement.

When two people make an exchange, they are trading one thing for another. Suppose that the consumer is buying an orange. Are all oranges created equal? No. Some oranges are sweeter than others. Some are juicier than others. The consumer would like to make sure that he or she is getting an orange with desirable characteristics. To assess whether the orange has desirable characteristics requires inspection, which is costly.

This problem has actually been emphasized quite a bit in the monetary literature, but gets less attention elsewhere. Consider a world of commodity money. If someone is trading goods for gold, the price of the goods will be quoted in terms of gold. The person receiving the gold will want to make sure that they are receiving the amount of gold that was agreed upon. This requires inspecting the weight and fineness of the gold. No one wants fool’s gold or some similar problem. This sort of measurement and inspection is costly. If it is sufficiently costly or the gains from trade are otherwise sufficiently small, these costs might preclude what would otherwise be mutually beneficial trade from taking place.

One solution to this is for someone to start minting gold coins that are stamped with the value. This shifts the burden of inspection from the seller in my example to a third-party that specializes in inspecting gold. This specialist can then mint gold coins that are stamped with a stipulated value. By establishing a brand name, people will trust that what is stamped on the coin reflects the true value and people will happily trade the coins.

While this has been emphasized in the monetary literature, the same is true on the other side of the market with the goods being traded. In fact, Armen Alchian argued that this problem is evident for many goods and that these measurement issues might help to explain what type of good might emerge as commodity money in the first place.

What this framing reveals is that many goods are bundles of characteristics. The quality of the good depends on these characteristics. One orange might have more juice or more flavor (or both) than some other orange. Even two cars that are the same make and model are different. This could be due to human error when building the car, a faulty fuel pump, or some other such problem.

When there are characteristics of the good that differ, this encourages inspection and measurement. Who ultimately does the measuring and inspecting, the buyer or the seller, will tend to be determined by who can do so at the least cost. The observation that some produce is sold pre-packaged while other produce is selected by the customer reflects this point.

The car example points to something else that follows from measurement costs and inspection: store return policies and warranties. Sometimes the quality of the good is hard to detect when it is produced. Nonetheless, the quality reveals itself through the use by the consumer. In this case, store return policies and warranties make sense. The consumer is allowed to use the product. If the product is found to be defective in some way, the product can be returned or brought somewhere that it can be repaired.

At this point you might be wondering what any of this has to do with authors and their royalties. The answer is that the quality of a book is difficult to determine. The publisher might think the book is great, but that does not always mean that the potential customers will agree. The quality of the book will be reflected in the magnitude of the demand for that book, but the demand for a particular book is difficult to determine ahead of time. It is not always clear what is going to be a successful book.

If publishers who are interested in the book were going to pay a lump sum, they would need to get an idea about the likely success of the book. This would require costly market research. After the research, the publishers would bid on the book by offering lump sum payments to the author. The author would choose a publisher. Those publishers who lost the bidding process still paid the cost of trying to measure the market. In addition, the winning bidder might still get their estimate wrong. If the mistake was to over-estimate the demand, they will have overpaid the author. Finally, the cost of estimating the magnitude of demand is somewhat wasteful. Just like a faulty fuel pump will be revealed through use of the car, the true demand for the book will be realized once it is published.

If the true demand for the book will be realized over time, then a sharing contract makes sense. As demand is revealed through sales of the book, both the author and the publisher share in the rewards.

But if this is true, how can we explain why some authors do get a lump sum payment from publishers in the form of an advance?

Note that the explanation for a sharing contract relies on the idea that there is a significant information problem. A corollary of this argument is that when the information costs about the level of demand are low, one should expect greater use of lump sum payments to authors. This is precisely what is observed. Popular, established authors are much more likely to get an advance than a brand new author.