Economic Foundations for Entertainment and Media

1. Economic Foundations for Entertainment and Media Production, Cost and Organization of Firms in E&M Industries

2. Technology and Production • Conventional aspects of cost and production for a commodity • Similarities to and differences from entertainment and experience goods

3. Classical microeconomics apply to the production of toasters and books Behind the price: How much does it cost to make a Cuisinart toaster? Costs of production • Variable vs. fixed costs • Marginal cost • Prices, costs and profits Brand: Cuisinart Price: About $80 1,200 pages. Retail: About $200 Marginal Cost? Fixed Cost? Total Cost?

4. Does it apply to Spotify?

5. Classical microeconomics apply to the market structure for toasters Brand: Cuisinart Price: About $80 Behind the market structure • Economies of scale – can small firms survive? Examples: Breweries, Car makers Counterexamples: Paper, Books, Toys, Small appliances In the middle: Movie studios • Economies of scope – is there a competitive advantage in producing more than one product? There are many brands Lots of competition Probably not unusually profitable

6. There are many movie studiosThis looks like a competitive market

7. Familiar Market Outcomes in Commodity Markets • Market power • Monopoly (Branding) • Market segmentation(Low and high end toasters) • Does the idea of “branding” extend to movie studies or TV networks? To the products they produce?

8. Producing Experiences • Most of the interesting differences are on the demand side. (We examined in Part 1.) • Features of Entertainment and Media Firms • Conventional economics explains much of production • There are a few special features of some E&M production

9. Producing Experiences Economic Foundations for Production • Production functions – the technology • Costs of production – an element of competition • Economies of scale and scope – produce market advantages • Technological change – markets evolve as technology changes (e.g., movie theaters)

10. Production Function Making movies has a well established production “technology.”

11. Spotify Production Function Output(s)? What does Spotify produce/sell Inputs? What resources do they use?

12. Characteristics of the Creative Industries • What do we mean by “the creative industries?” • Not synonymous with experience goods: E.g., amusement park vs. art • There are distinguishing features of creative industries • These features have implications for the organization of market activities: • Contracts among producers • Market organizations for distribution

13. Staging in Production • Creating experience goods • Music: Composition, Creation • Books: Authorship • Delivering experience goods • Pandora, Spotify, etc. • Prentice Hall Publisher, Amazon Distributor • Different production processes at work in different stages. • Contrast this to car manufacturers vs. dealerships

14. Creative Industries Some characteristics of production in creative industries that are unlike more conventional production • Producers’ emotional connection to the output – e.g., art, music, performances of many types … not toasters • Assembly of widely diverse skills for production - movies, sports • Durable products and durable rent streams. Contrast to one-off sale of the toaster.

15. Caves on Creative Industries Some characteristics of demand in creative industries that are unlike more conventional goods • Uncertainty of demand – difficult to resolve using market research • Differentiated products – different consumers have very different interests in the same product. • The role of time in consumption

16. Noteworthy Features of Production in Entertainment and Media • Multiple stages of production • Outputs are often downstream inputs: Think movies • Creation, Distribution, Exhibition • Creation stage is often very labor intensive • Little substitution between labor and capital • Less technologically oriented • Not always - animation is a major exception • Delivery (exhibition) may be very capital intensive • May allow substitution away from labor • Technological advance • Applications: Books, Movies, TV, Newspapers, Radio, Recorded Music, Live Performance (Theater, Concerts)

17. Production Processes Sometimes Allow Substitution Substitution of Factors • Live theater – the “cost disease” results from little opportunity to substitute capital for labor • The trend toward animated movies is an example of substituting capital for labor. The figure shows different combinations of capital and labor that can be used to produce 100,000 units. E.g., the USPS can use people or machines to sort 100,000 pounds of mail.

18. The cost disease. Now, after 500 performances, our producers have told us and our union that in order to cut costs they will chop our string section in half, releasing five musicians and “replacing” them with a synthesizer piped in from another room.

19. Production Functions • Output • Inputs – the factors of production • The “process” The amount producted, Q, depends on “inputs” or factors of production. Conventional inputs: Capital, labor, materials used in making movies Unconventional inputs: Music used in distribution and production in stores and offices.The crowd used to create big sporting events. Labor Capital Materials

20. Industrial Production Function

21. BB&B Production Function • Output: Distribution of things to consumers • Inputs: • Capital: Physical, Financial • Labor • Energy • Materials • Music • How do they use music? • Why do they use music? • How do they pay for it?

22. Live Performance Production is Unconventional • Production function – One “stage” • Simultaneous production and consumption • Feedback between consumers and producers • Concerts • Big Sports • eBay watchers

23. About Production Functions Factors and Factor Intensity • Higher education is very labor intensive, but less so over time. • Broadway (legitimate) theater – very labor labor intensive and there is almost no opportunity to substitute capital for labor • Creating Music – labor intensive, but some opportunities to substitute capital for labor. • Major League Baseball – only the game on the field is labor intensive. Most of the rest of the process is very capital intensive. • Casino – capital intensive. It takes relatively few people to keep a casino working, and fewer over time.

24. Multiple Output Processes • Managing a multiplex – Two outputs from one production facility • Concessions (the primary source of profits) • Movies (the secondary profit center) • Casino – • Gambling • Food and entertainment • One capital intensive output, one labor intensive

25. Multiple Output Processes • Professional sports performance • The sport: Outcome on the field and the signal for broadcasting • Concessions including food and merchandise • Sky boxes in stadiums • Music Distribution: Many products – many distribution channels • Performances (public) that also distribute recorded versions plus t shirts and souvenirs • Music videos • Music for private consumption • Music input to other entertainment • Music blended into advertisements

26. Marberger, D., “Optimal Pricing for Performance Goods,” Managerial and Decision Economics, 1997, 18, 5, 375-381. A Mathematical Model for a Movie Theater (1) Movie theaters sell two products: Tickets, T = the number of movie goers who come to the theater Food (concessions), F = amount of food sold that night (2) Mathematical statements for the two products Tickets= Demand for movie tix: T(Pt,W). Marginal cost = Ct Depends on factors like weather (W), the movie, and ticket price, Pt Food = Demand for food: F(Pf,T,O). Marginal cost = Cf Depends on the price of food, Pf, the number of movie goers, T, and other things (O) including the movie. (3) Central (and intuitively reasonable) result dF/dT > 0 More movie goers buy more food. Selling more tickets will result in selling more food.

27. Mathematical Model for a Movie Theater • The manager must decide on the ticket price • (1) Ignore the relationship between tickets sold and food sold or • (2) Figure out both tickets and food at the same time. • Ignoring the connection to food The theater owner acts like a ticket monopolist: Profit = T*Pt - T*Ct - fixed costs • Maximize by equating marginal revenue to marginal cost: Pt + T*(dPt/dT) = Ct The resulting price is a monopoly outcome. Pt = Ct (marginal cost) plus a monopoly effect

28. Mathematical Model for a Movie Theater • Considering the connection of movie tickets and food • The theater owner tries to maximize profits from tickets and foodat the same time. Recognizes the ticket price will affect the amount of food they sell. Total Profit = Tickets profit + food profit = (T*Pt - T*Ct ) + (F*Pf – F*Cf) They must equate MR to MC in both parts. For the tickets part, now Pt + T*(dPt/dT) + Pf*(dF/dT) = Ct The ticket price is lower than if the food is ignored Pt = Ct - T*(dPt/dT) - Pf*(dF/dT) [the second minus part is positive.]

29. Movies and Food Ticket Price Pt is the monopoly price if the owner ignores the effect of tickets on sales of food. Pt|f is the ticket price if the owner also considers the effect of tickets sold on sales of food. Pt Pt|f Marginal Cost Food Effect Marginal Cost minus food effect Demand Tickets Conclusion: To account for the effect of ticket prices on the demand for the main profit center (food), the theater owner drives down the ticket price. Marginal Revenue

30. Two Product Monopolist

31. Multistage Production Is Common This is not the same as joint production of more than one product. Early stages are inputs to later ones.

32. Multiple Stages in Production  The TV broadcastNetwork The game on the field Team  The viewerCable Operator Capital Equipment Labor Players Capital Equipment F(x) F(x) TV Sports What’s better for this process, one firm or two? Disney  Pixar, or Disney/Pixar?

33. The Costs of Production • Fixed cost: Not a function of output. Capital • Sunk cost: One time, nonrecoverable costs (Often very significant in the movie business) • Variable cost: Variable with respect to output • Labor • Materials • Marginal cost: Avoidable cost of one more (less) unit • Operating Profit = Gross Revenue - Costs $Multimillion model of Titanic

34. Box Office Revenue 1997-2013

35. Production Costs

36. 2003 (2003) Marketing Costs: $ 85M U.S. Box Office: $ 150M World incl. US: $ 417M (#113 all time – on a list that does not correct for inflation, currency, or anything else.) Rights: WB 50M Sony 75M http://www.slideshare.net/MissConnell/film-distribution-costs http://www.edwardjayepstein.com/x-rar1.htm

38. Changing Economics for Stars • Before 2010: $10M, $15M, $20M, … • Trend since about 2010: • Small or no up front • Except for Angelina Jolie – first choice for Gravity but could not agree on a deal. Sandra Bullock got $20M for signing. Unusual now. • CB 0 contract (Cash-Break zero – percentage after break even) • Far smaller total compensation for start • Why? • Economics of film making • Falling demand for star power in movies

39. Production cost $100M Exhibitors At least $300M Sandra Bullock $ 77M = $20M + 15% x Studio net (45% ) + Misc TV, DVD, etc. George Clooney ? Net so far $231M - ? Promotion and advertising ? Probably $50M - $100M Other distribution ? Such “first dollar” guaranteed box office deals for actors are becoming rare, the Hollywood Reporter said, because studios now want to recoup all the costs for expensive productions before sharing the profits with talent. Bullock’s co-star George Clooney, Gravity director Alfonso Cuarón and producer David Heyman are also believed to have “back end” pay deals. http://www.independent.co.uk/arts-entertainment/films/news/gravity-star-sandra-bullock-set-to-earn-70m-windfall-for-oscarnominated-film-9157448.html

40. Budgets and Box Office Revenues

41. CD Costs and Profits Breaking Down Music Costs Consumer Retailer $6.20 Record Label $10.80 .75 1.40 2.15 .86 1.08 1.29 .70 1.94 .59 1.36 1.36 2.55 .97 Marketing and Promotion Sales and Distribution Overhead and Distribution CD and Booklet Manufacturing Artist Development Royalty to Recording Artist Royalty to Composer and Lyricist Operating Profit Labor Distribution Rent (Shopping Mall) Operating Profit Cooperative advt. and Discounts Fixed CostsVariable CostsSunk CostsOperating Profit

42. Production and Cost Functions? Most of the marginal cost of something sold for download from iTunes is the royalty. E.g., the 99 cent single track triggers about 70 cents in royalties.

43. 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

44. Economies of Scale in E&M • Cablevision • Professional sports • Publishing/Movies – Backlists of titles • Casinos • Movies • Television

45. Economies of Scope • Cost effect • Cost(Q1,Q2) < Cost(Q1,0) + Cost(0,Q2) • Cablevision and Newsday • Applications • Cable TV, Internet • Mobile phone network • Basketball, Hockey teams • Not the effect behind vertical integration • News media owning the sports team?Sky News motivation for owning Manchester United

46. Technological Advance (Marginal) Cost Reduction Digital setup in newspapers Synthesized instruments in Broadway Musical Orchestras Digital distribution of movies Less Cost Reduction in Performance Industries: Baumol’s Cost Disease of the service sector Live theater, Orchestra, Education

47. Search Technology - The Long Tail • Reduces the marginal cost of distribution and promotion. • Locate the world market for small or obscure goods – books - information • A result of the Internet and search technology.

49. Labor Saving Technological Change in Card Games in Casinos

50. Digitizing Entertainment – Technical Advance in Delivery of Existing Forms • Music • MP3 - affects distribution, not creation • Pop music without musicians. • Literature: • E-books – Kindle (Amazon), Nook (B&N) • E-zines (Slate.com) • Web based news services (NYTimes.com) • Movies: • Creation – digital equipment, Pixar animation • Distribution – digital transmission without film • Distribution – mode Netflix • Exhibition – digital projection (expensive)