Megan McArdle is Most Likely Wrong About the Coming Destruction of Hollywood

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Megan McArdle

Megan McArdle

Will cord-cutters destroy the feature film production business?  This is one of the several forecasts made by Megan McArdle in her April 17 Washington Post columnShe has two main points.  First, if you are not paying for cable or dish TV, you are not paying enough to support video productions in the quantity and quality you have come to expect.  Second, people like bundling.  Let me deal with those two points in order before I do a little economics.  I’ll wrap up by discussing technological change and the ways it might offset some of Megan’s more dire predictions.

Before I dig into the details, I need to make one central point.  Megan conflated “bundling” with what economists call “pure bundling.”  Under pure bundling buyers are offered a binary choice: buy the bundle or buy nothing.  (Yes, it’s possible to offer more than one bundle.)  In making this assumption, she overlooked the possibility of mixed bundling in which buyers can either buy a bundle or they can buy individual products.  Bundle pricing becomes quite important, as you can imagine.  I’ll discuss how mixed bundling works later in this article.

Cord-Cutters Will Destroy Hollywood

Are those of us who have cut the cord really not paying enough for content to support the Hollywood behemoth?  Well, that’s not exactly what she says.  Instead she points out that Netflix subscribers paying $8 per month won’t support blockbusters like Avatar Clearly that monthly subscription rate won’t support a movie that expensive – unless, of course, the number  of Netflix subscribers exceeds one billion or so.  But she has assumed the cost structure of the industry will be the same in the future as it is today.  There are good reasons to suspect costs will actually fall.

The Long and Short of It

Megan’s basic economic argument is that if everyone cut the cord there would not be enough revenue to support the current model of film production.  But that ignores the adjustment to long-run equilibrium.  As the profitability of making movies fell, firms would leave the industry, reducing supply.  That would drive up the price of films. If Amazon and Netflix really wanted to maintain quantity and quality, they already have a solution to that: rent individual movies for, say, $10 each.  Alternatively, if Netflix is firmly wedded to its single price strategy, they could offer a second tier with premium movies.  One common outcome in models of markets like this is fewer firms but more output per firm.  Whether the total number of movies would increase, stay the same, or decrease is an open question.

But as long as prices are free to adjust the market will not collapse.

Bundling

Megan’s second point is that people like bundling.  There are many examples of bundling.  Because I’m a techno-geek I use the Microsoft Office example.  You can buy, for example, Microsoft Word 2016 for $129.99. (Microsoft does not make it easy to find this page.  Click here to find it.)

Word standalone

Or you can do what I do: subscribe to Office 365 for $100 per year.  That gives my family access to as many as five copies of Office, regardless of platform.  In our home office that’s two Macs, one Windows machine, two iPads and one installed in the vmWare Fusion Windows virtual machine on my Mac.  If you haven’t used Excel on an iPad you’re in for a treat (although a fair amount of functionality is gone).

Microsoft Office Bundles

Microsoft Office Bundles (click for larger image)

Pure Bundling

But what Megan misses is the possibilities of mixed bundling.  Which is what Microsoft does, albeit at a much less intensive rate than they used to.  Mixed bundling means offering buyers both individual products and various bundles.  Mixed bundling is usually at least as profitable as  pure bundling or pure separate sales strategies.  The exact result depends on the extent of negative correlations between willingnesses-to-pay of the various buyer groups. (The following example is based on Robert Pindyck and Daniel Rubinfeld, Microeconomics (9e, 2018). Pearson Education, Inc. pp. 412-418.)

A common example is a movie distributor (Ace Films) that has two films to place: Gone With the Wind (GOTW) and Getting Gertie’s Garter (GGG).  There are two theaters, the Apollo and the Broadway.  Apollo is willing to pay $12,000 and $4,000 respectively for each film. Broadway is willing to pay $10,000 and $3,000.

Before getting into the details, there’s one important point. Ace can get away with this because the company has market power.  It is the sole licensed distributor for these two films.  In fact, with respect to these movies, Ace has a localized monopoly.

Ace could rent the two films separately.  In that case, revenue would be maximized by charging the lowest willingness to pay for each film: $10,000 for GOTW and $3,000 for GGG.  Both theaters will rent both films and Ace’s total revenue will be $26,000 (= $10,000 x 2 + $3,000 x 2).  Let’s see what happens when we try offering a bundle.

Apollo is willing to pay $16,000 for both films ($12,000 + $3,000)Broadway is willing to pay $13,000.  Instead of offering to rent the films separately the distributor can make a take-it-or-leave-it proposal: rent both films for $1\3,000 or you get neither.  Both theaters accept the bundle offer and Ace’s total revenue is $26,000.  This is the same result as separate pricing.  In which case there’s no point to bundling. 

Pure bundling two customers

Pure bundling two customers

The problem is the structure of the pricing.  Apollo is willing to pay absolutely more for each film.  But the real problem is that their willingnesses to pay both change in the same direction.  Each is willing to pay more for GOTWT than GGG. One principle of bundling is that profits will only increase when some customers have willingnesses to pay that change in opposite directions. Let’s see what happens when we add two more potential customers.

Let’s see how that works. Suppose the willingnesses to pay of Broadway is reversed.  Broadway is willing to pay $10,000 for GGG and $3,000 for GOTW.  Economists call this negatively correlated willingness to pay.  Unless there are at least two groups of buyers with this negative correlation, bundling cannot increase revenue.  And, sure enough, that works.  Pure separate pricing would generate $22,000 in profit while bundling produces $26,000.. 

Bundling WTP reversed 2 customers

Bundling WTP reversed 2 customers

Selling the movies separately, the profit-maximizing prices are $12,000 for GOTW and $10,000 for GGG.  Total profit is $22,000.  But if the bundle is priced at $13,000, both theaters will buy that for profit is $26,000.  In this case even pure bundling increases profit.

Mixed Bundling

Mixed bundling means offering the products separately and offering one or more bundles.  Microsoft does that with its Office suite (although it’s difficult to imagine anyone paying $120 for a copy of Word.) There are two situations in which mixed bundling may become an optimal strategy. The first condition is positive marginal cost.  Second, mixed bundling may become attractive if the willingnesses to pay are not perfectly negatively correlated.  A good example is a restaurant that offers both a prix fixe and á la carte menu selection.  The former is a bundle and the latter is separate sales.

The easiest way to illustrate mixed bundling is by adding two more theaters (Cosmopolitan and Delta) to the market.  Their willingnesses to pay are

Pure bundling 4 customers

Pure bundling 4 customers

This will get messy, so I’ll just deal with two cases.  First, for pure bundling there are four possible bunndle prices (the total willingness to pay of each of the four customers).  The outcomes are

Pure bundling revenue 4 customers

`Pure bundling revenue 4 customers

At a price of $10,000 all four customers buy the bundle. Total profit will be $40,000.  At $12,000 three customers will buy.  You get the idea.

Developing a mixed bundling pricing strategy can be challenging. While there are some tools available, a good deal of trial and error is involved.  Here are three possible mixed bundling strategies.

Mixed bundling 4 customers

Mixed bundling 4 customers

Pw is the price of GOTW, Pg is the price of GGG, and Pb is the bundle price. For example, in the first column, the $12,000 bundle price is greater than Delta’s willingness to pay.  But the $6,000 cost of GGG is consistent with their willingness to pay.  The other three will buy the bundle.  Total profits will be 3 x $12,000 + 1 x $6,000 = $42,000.  Note that profits are now $2,000 higher than the best pure bundling outcome.  Both of the other cases are worse than pure bundling.

I have to add that these are three examples.  The best solution may not be one of them.  If anyone finds a better solution, please let me know.

One gotcha to watch out for is the possibility of buyers “growing their own” bundle by purchasing the products at the separate prices.  Make sure that your calculations take that into account.

Hollywood’s Pricing Is Not Rational

With cable TV today you are offered pure bundles.  But marginal cost is positiveAnd, there are almost certainly groups of customers with negatively correlated willingnesses to pay.  In my household I would pay relatively more for sports channels than, say, a channel devoted to women’s shoes.  My lovely wife’s preferences would probably run in the opposite direction.  Is it possible that cable companies are leaving money on the table?

I can say for sure that there is at least one household that might be willing to pay for a few channels separately but will not buy the bundle.  That’s our household.  We cut the cord decades ago and will never, ever pay for cable or dish TV.  We have Netflix and Amazon Prime streaming and we can easily rent streaming movies through iTunes or Amazon. And we are still willing to see movies we really think we’ll like in an actual theater.  While I firmly believe we are unique, I don’t think it’s our attitude toward cable TV that makes us that way.

Here’s what I want.  I’d like to be able to buy sports channels and maybe a few movie channels.  Don’t shove the USA and Home Shopping networks down my throat.  I would pay a fair amount for that.  And I have decades of economic research pointing to mixed bundling as the profit-maximizing solution.  Sadly, Hollywood is run by people who would not recognize marginal cost if it bit them on the ass.

Technological Change

Steven Soderbergh won an Oscar for best director in 2000 for “Traffic.”  If you’ve seen the movie you know the importance of camera work.  More recently, under the nom de plume Peter Andrews, he was the cinematographer for Unsane (2018).  He shot the entire movie on an iPhone.

It happens that my lovely wife has become fairly proficient at iPhone video, especially recording multiple audio tracks while shooting.  She can do things that would have required a full-blown video camera just a few years ago.  And, as a bonus, there are apps that let you edit video on the iPhone.

I personally have gotten pretty good at video and audio work, largely using Adobe Audition and Premiere Pro.  Like any good geek, I also use Photoshop, Illustrator, and Acrobat.  I can do things on my Macbook that would have been very difficult, if not impossible, five years ago.  For example, suppose you have a video track that includes audio, but the audio is not very good.  But being the good creative director you are, you recorded a separate audio track using a good microphone.  Premiere Pro and Final Cut Pro will automatically sync your separate audio with the audio from the camera.  And, yes, I’ve used this featue.  It works.

Today the standard movie crew is huge.  Consider the 2018 release “Traffik.”  I count 96 crew members.  Eight were involved with camera work.  As far as I can tell there were three cameras involved.

Imagine a future in which those eight people were replaced by a single individual and four drones.  Both drone and camera technology are improving so fast that this barely even qualifies as a forecast.

Then there is augmented reality.  I first heard about this in a talk about ten years ago.  Augmented reality overlays the camera with a scene. In 2017 New York digital agency Firstborn released Gruesome Gotham.  Wander the streets of Manhattan.  When you happen upon the site of a previous (gruesome, of course) murder, point your smartphone at the location.  You can then see all the gory details superimposed over the location.  And, of course, you can walk around, looking at the scene from different angles.  Here’s how Firstborn describes it:

Manhattan’s bloody history lurks around every corner, and this Halloween we brought the city’s horror stories to life with a location-based AR App. Gruesome Gotham features six chilling murders from 19th Century New York and lets users experience the deadly deeds in the exact locations where they occurred.

When users reach a murder on the map, they can load the scene in AR and explore every angle of the moment it happened.

Ominous narration accompanies each haunting scene to further immerse users in the experience. No matter where they are, users can access a newspaper feature to get all the gory details.

Today, most video productions need extensive post-processing to add special effects.  AR gives the possibility of shooting some scenes with the effect already in place.  Oops!  There go a few post-production editors.

Finally, the cost of computing power continues to decline.  I can edit video on my iPhone.  More computing power means faster rendering of CGI and other special effects.  More efficient production translates into lower costs.

Conclusion

Megan worries too much.

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About Tony Lima

Retired after teaching economics at California State Univ., East Bay (Hayward, CA). Ph.D., economics, Stanford. Also taught MBA finance at the California University of Management and Technology. Occasionally take on a consulting project if it's interesting. Other interests include wine and technology.