Economic Foundations for Entertainment, Media, and Technology

1. Economic Foundations for Entertainment, Media, and Technology Production and Cost in E&M Industries Spring 2001 (4) Professor W. Greene

2. Production and Cost • Production Functions • Costs of Production • Economies of Scale and Scope • Technological Change • Integration: Horizontal and Vertical • Economic Profits

3. The Production Function • Output • Inputs – The factors of production • The “process” Labor Capital Materials ?

4. About Production Functions • Factors and Factor Intensity • Higher education • Broadway Theater – Labor intensive • Major League Baseball - ??? • Casino – Capital intensive • Multiple stages of production Outputs as downstream inputs

5. Multiple Stages in Production The TV broadcast Capital Equipment Labor The game The viewer Players Capital Equipment TV Sports F(x) F(x) What’s better for this process, one firm or two?

6. Production Functions • Managing a multiplex • Casino • Making movies (indies vs. studios) • Professional sports • Delivery of professional sports • Music • Publishing

7. The Costs of Production • Fixed cost: Not a function of output. Capital • Sunk cost: One time, nonrecoverable costs (very significant in the movie business) • Variable cost: Variable with respect to output • Labor • Materials • Marginal cost: Avoidable cost of one more (less) unit

8. Economies of Scale • Working definition: Declining average cost • Market based definition: Competitive advantage of large size • Sources • Supply based: Technical, • Demand based: Networks • Indivisibilities: Lumpiness

9. Economies of Scale in EMT • Cablevision • Professional sports • Publishing/Movies – Backlists of titles • Casinos • Movies • Television • Telecommunications • Web based businesses

10. Economies of Scope • Cost effect C(Q1,Q2) < C(Q1,0) + C(0,Q2) • Not the effect behind vertical integration • Applications? • Cable TV, Internet (convergence?) • Basketball, Hockey

11. Technical Advance Average total cost Cost Reduction Digital setup in newspapers Product innovation: Adult orthodontics Rapid, disruptive product innovation Seagate disk drives Satellite delivery of electronic content (Cablevision?) t1 t2 t3 Output

12. Digitizing Entertainment – Technical Advance in Delivery of Existing Forms • Music • MP3 - affects distribution, not creation • Pop music without musicians. (Britney Spears) • Literature: • E-books?? (Maybe not yet) • E-zines (Slate.com) • Web based news services (NYTimes.com) • Movies: • Creation – digital equipment • Distribution – transmission without film • Exhibition – digital projection (expensive)

13. Multistage Production Financial Services Professional Sports Publishing Back office Team sports Author Large scale Advertising and Publisher content assembly Retail banking Broadcast to homes Retail distribution

14. New Football LeagueNFL XFL Labor Pool Labor Pool Other inputs NFL Draft WWF/NBC NY LA CLE CHI Homes ABC NBC CBS FOX Is it vertical integration? Is it a cartel in the labor market? Why are salaries so low compared to NFL? What does WWF bring to the party? Homes

15. Integration of Firms Markets Financial Services Professional Sports Traditional Publishing Final Consumers

16. Theoretical Departure Pointon Firm Integration • Perfectly Competitive Markets • All firms atomistic price takers • All firms fully informed and efficient • Reasons for firm integration: None • Reasons against integration: None • Reasons we observe integration: • Reaction to market failure of some sort • Creation of a market failure

17. Conglomerate Mergers Markets Financial Services Professional Sports Traditional Publishing Why do this? Why do we observe this?

18. Economies of Scope? Markets Financial Services Professional Sports Traditional Publishing Sports broadcasting and newspaper

19. “Synergistic” Mergers • Firms in related industries • Not a conglomerate merger • Exploitation of commonalities • Are there economies of scope? • Applications? • Hockey and basketball? • Newspapers and book publishing? • Others?

20. Horizontal Integration Markets Financial Services Professional Sports Traditional Publishing What objective?

21. Horizontal Mergers • Increases market share • Extends market power forward • Monopolization • Hirfindahl index =firms(market shares) (S1+S2) = S1 + S2 + 2 S1 S2 • May extend market power backward • What justifies horizontal integration? • Economies of scale • “Synergies?” (What is this?) • Capture market power • Application: The media mogul 2 2 2 2

22. Vertical Integration Markets Financial Services Professional Sports Traditional Publishing Final Consumers

23. Benefits of Vertical Integration All arise from some market failure • Lower transaction costs: Firm organizational limitations • Transactions involving information • Avoidance of government restrictions, taxes, or regulations. • Extension of market power (forward or backward) • Avoidance of upstream market power • Assurance of steady or reliable input supply • Murdoch’s (alleged) attempt to influence staffing decision of a baseball field manager before a broadcast • Internalization of market failures • Franchising reduces problems of free riding

24. Costs of Vertical Integration • Private costs • Loss of economies of scale • Organizational complexity • Assumption of risk • Social costs • Creation or extension of market power • Possible cartelization

25. Vertical Integration in EMT • Analysis • Where is it observed? • What are the benefits / motivation? • What are the costs? • Applications • Seagram and Vivendi • Cablevision and home delivery of cable generally • End to end production • Internet service providers and cable operators • The movie business (at several stages)

26. AOL Time Warner • AOL Internet service provider Instant messaging • Time Warner Time Warner Cable Time Inc. (Magazines) HBO Turner Broadcasting The WB Network New Line Cinema Warner Music Time Warner Publishing Warner Brothers Studio • Horizontal vs. vertical integration • What kind of merger is this?

27. Cablevision CSC Holdings and Optimum TV: The cable system Optimum Online Knicks Rangers Liberty Homes Radio City Enter. Lightpath Rainbow Media Businesses The Wiz Madison Square Garden Clearview Cinemas

28. Rupert Murdoch Markets Financial Services Professional Sports Traditional Publishing Mogul take all?

29. Profits and Losses Simple Cases: Electronic Commerce Average Total Cost Amazon Average Variable Cost EToys Average Fixed Cost Amazon: P > AVC, P < ATC EToys: P < AVC (RIP, April 6, 2001)

30. Profits in Multistage and Multiple Output Processes • Allocation of revenues to activities • Multiple revenue sources (outputs) • Allocation of costs to activities • Fixed costs in multiple output firms • Net vs. gross in Hollywood A Miami Fish Story

31. Economic Profits and Losses • Opportunity cost of capital • Valuing an investment? t=years • Economic value of a business • How to do this? (Offer the business for sale.) • When is a business “losing money?” Profits in year t (1 + r) t