Farhad Manjoo had a provocative piece at Slate, predicting that Amazon will soon start giving away Kindle readers. Fellow pricing geek, Rags Srinivasan and I got into a Twitter discussion, with Rags claiming that Manjoo was way off base. Rags wrote a thoughtful response, backed up by numbers.

While I have no idea if Manjoo is correct in predicting behavior from Amazon (which they have denied), I think it’s possible.

To quote from Rags:

Cost? $1.58B for 20 million units. Just to stay where there are with current gross margin, they have to gain gross margin(not sales) of $1.58B from content and merchandise sales.  To put that in perspective, Amazon’s 2011 gross margin is $10.8B from sales of $48B. At its 22.4% gross margin, this $1.58B means $7B in sales.

This assumes a cost of $79. Next year, the cost will be lower, and the year after that, lower still. In theory, the Kindle could cost Amazon $1. Would the math work then? What about at $20? $50?

And this $7B  sales will all have to be incremental new sales, sales that are made possible only because of the free Kindles. Sales that would have any way happened, because customers do shop even without free Kindle, cannot be counted towards these numbers.

Absolutely. This is an important point that a lot of marketing promotions seem to forget. You need net sales.

On a per Kindle basis that means every free Kindle user must spend additional $350, above and beyond what they are already spending with Amazon. How likely is that scenario? Say amazon now has 100 million shoppers, its current revenue of $47B means, each shopper spends an average of $470 per year. Can a free kindle somehow add $175 per year (assuming device lifetime of 2 years) to this $470?

There’s an important variable left out of this equation. What percentage of Kindle owners are also Amazon Prime members? If all Kindle owners are also Prime members, the idea of giving them free Kindles doesn’t help much. But if 50% or 80% of the people who are eligible for the free Kindle, which requires a $79 per year Prime membership in Manjoo’s prediction, would not have otherwise bought the membership, Amazon has suddenly covered the cost of the Kindle immediately. If the members stays for 2 years or 5 years, Amazon gets more money in $79 chunks. (In some ways, Amazon might even make more money in the short term if this person only buys Kindle ebooks, and forgoes other purchases that might cost Amazon money in free shipping.)

Now this is just the simplest of the math. You can see how unfavorable it gets when you add in lost profit from those who buy other Kindle models and Kindle Fire switching to free version.

Note that none of the Kindle devices is designed to make money. Amazon is pursuing the opposite strategy from Apple. Amazon could also offer a credit on other Kindle models if someone wanted to upgrade from the basic device.

Amazon does not want to cede control of digital content to Apple. They are fighting back in music, but it may be too late. Putting more Kindles into the hands of more Amazon Prime members makes a lot of sense. Scaling Amazon’s traditional warehouse business has similar economics to scaling other big retailers. But digital product economics scale much better. Whether Amazon actually launches a “free Kindle* (*with Amazon Prime membership) promotion or not, I expect them to push hard on digital content and Prime memberships.

(Add to the discussion on Hacker News.)

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