Economic Foundations for Entertainment, Media, and Technology

Production and Cost in E&M IndustriesSpring 2001 (4)Professor W. Greene

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

The Production Function Output Inputs – The factors of production The “process”

Labor

Capital

Materials?

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

Multiple Stages in Production

Players

Capital

EquipmentF(x)

Capital

Equipment

Labor

F(x)

TV Sports

What’s better for this process, one firm or two?

The game

The TV broadcast

The viewer

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

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

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

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

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

Technical Advance Cost Reduction Digital setup in newspapers

Product innovation: Adult orthodontics Rapid, disruptive product innovation Seagate disk drives

Satellite delivery of electronic content (Cablevision?)

Output

Average total cost

t1

t2

t3

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)

Multistage ProductionFinancial Services Professional Sports Publishing

Back office Team sports Author

Large scale Advertising andPublisher

content assembly

Retail banking Broadcast to homes Retail distribution

New Football LeagueNFL XFL

Labor Pool

NFL Draft

LA CLE

NY CHI

ABC NBC CBS FOX

Homes

Other inputs

Labor Pool

WWF/NBC

Homes

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?

Integration of Firms

MarketsFinancial Services Professional Sports Traditional

Publishing

Final Consumers

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

Conglomerate Mergers

MarketsFinancial Services Professional Sports Traditional

Publishing

Why do this? Why do we observe this?

Economies of Scope?

MarketsFinancial Services Professional Sports Traditional

Publishing

Sports broadcasting and newspaper

“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?

Horizontal Integration

MarketsFinancial Services Professional Sports Traditional

Publishing

What objective?

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

22 2 2

Vertical Integration

MarketsFinancial Services Professional Sports Traditional

Publishing

Final Consumers

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

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

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)

AOL Time Warner AOL

Internet service providerInstant 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?

Cablevision

The Wiz

Clearview Cinemas

Radio City Enter.

Optimum Online

Rainbow Media

Madison Square Garden

Knicks

Rangers

Liberty

CSC Holdings and Optimum TV: The cable system

Lightpath

Homes

Businesses

Rupert Murdoch

MarketsFinancial Services Professional Sports Traditional

Publishing

Mogul take all?

Profits and Losses

Simple Cases: Electronic Commerce

Average Total Cost

Average Variable CostAverage Fixed Cost

Amazon

EToys

Amazon: P > AVC, P < ATC

EToys: P < AVC (RIP, April 6, 2001)

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

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