Showing posts with label business. Show all posts
Showing posts with label business. Show all posts

Saturday, December 15, 2007

Movie theaters vs distributors

A YouTube video is worth more than a thousand words. The website of the National Association of Theatre Owners, the other NATO, greets its visitors with an animated feature of theater food singing “Let’s all go to the lobby to get ourselves a treat.” (Watch it below.) No MGM lion or flashy presentation of digital theaters, no: animated pop-corn bags and cups of soda practically begging you to buy food when you go to the movies.

This funny detail is telling of how hard it is for theaters to turn a decent profit from ticket sales alone. With admissions at $10 and an endless series of blockbusters, what gives? At the risk of spoiling this movie, the answer lies in the distribution of power between distributors and exhibitors.

Let's have a look at the revenues and costs per patron of Regal Entertainment, the largest movie exhibitor in the US. (Data from the company's financial statements.) The average price of a ticket in 2006 was $6.98, $3.67 of which went to pay for the film’s rental and advertising, leaving the theater with $3.31 ($6.98 - $3.67) in gross operating margin. Food and beverage sales, on the other hand, brought $2.82 per patron, but cost Regal just $0.42, resulting in a gross operating margin of $2.40 per head from concession sales.

Chart 1 (click to enlarge)

Regal also incurred operating costs, corresponding to labor and capital shared by the movie and the concession operations (rent, salaries, depreciation and amortization, etc.). I impute 20 percent of those costs to concessions, which is probably an overestimation – after all, the pop-corn stand uses much less than 20 percent of the space, personnel and equipment. After including overhead costs, Regal lost $0.82 on every ticket sold, whereas it made a $1.36 margin on concessions. (See Chart 1.)

Given that the exhibitors’ profitability depends so critically on popcorn and Milk Duds, I wonder why they don’t market concession treats more aggressively. In most theaters patrons have access to the concession stand only after they have purchased and validated their movie ticket. Theaters could increase revenues by setting up sale points in front of the box office, not behind. In addition to feeding people who are standing in line to buy a ticket, those stands could generate sales from passers-by who have no intention to see a movie – I find it a bit odd, but many people seem to enjoy extra buttery popcorn and movie nachos even when they’re not distracted by a screen. I also wonder why, in general, theaters don’t sell movie merchandise – caps, T-shirts, Spiderman masks, golf balls with Gollum’s face on them, what have you.

The breakdown of profits I showed above does not imply that selling movie tickets is a ruinous business. Remember: the unit profit from tickets is negative only after including overhead costs. Because those costs are largely invariant to the number of patrons, higher attendance would increase the average unit profit from admissions Cheaper tickets would raise patronage -- and the highly profitable concession sales that come with it. Unfortunately (for theaters) distributors have the upper hand.

Seven companies controlled the release of the top 20 films in 2007, which made up 44 percent of annual box office revenue as of December 15. The exhibition industry is on the opposite end of the concentration spectrum: the largest theater operator owns just nine percent of all sites; the second largest exhibitor owns about five percent. Theaters are in no position to choose who they rent films from.

Adding to their bargaining power, distributors derive an increasing share of their revenues from the rental and sale of DVDs. In a not too distant future, distribution could bypass theaters entirely. A recent paper in the Journal of Marketing estimated that film studios could increase revenues by 16 percent if films were simultaneously released in theater, on rental DVD and video-on-demand, with a three-month window to DVD retail. On the flip side, theater revenues would drop by 40 percent: a death sentence.

As a result, distributors are able to control ticket prices. The exhibitor would gladly set lower rates to increase patronage -- and the lucrative concession business that comes with it. The distributor, on the other hand, only cares about ticket sales, so it enforces an admission rate that is above the exhibitor’s optimum. (A related question is why ticket prices are uniform, but that may deserve a post of its own. In the meantime, read Tyler Cowen’s blog post at Marginal Revolution.)

Another manifestation of the power of distributors is the terms of exhibition contracts. Most agreements between exhibitors and distributors call for a sliding percentage of box office revenues. For example, a contract may specify a 90:10 split during the first week (10 percent for the exhibitor), 80:20 the second week, 70:30 the third week, and so on. In case a film does not perform up to expectations, the distributor also has the right to a certain minimum payment. That the distributor shares an increasing share of the revenue goes against the exhibitor, because demand for a film falls sharply over the weeks.

Chart 2. Movie-going market share (percentage of American population that attended a movie)
by week, between 1985 and 1999 (click to enlarge)

Last, but not least relevant, distributors control the timing of releases. Because the distributor earns most of its revenue over the first two or three weeks of the movie’s screen life, openings are tightly spaced -- at any rate, too tightly spaced from the theater’s point of view. The glut is apparent over the summer and on holiday weeks, when underlying demand is strongest (see Chart 2, from Orbach and Einav, 2007). And the trend seems to become stronger over time: 33 films are opening this December, compared with 21 over the same period in 1999 (data for 1999 come from Einav’s Stata data file).

The obvious solution to the conflict of interest between exhibitors and distributors is vertical integration. But a 1948 decision by the Supreme Court forbids it. The ruling followed an antitrust lawsuit between the federal government and the big studios. One of the objectives of the court was to allow exhibitors to select which movies they would show. In retrospect, and putting it kindly, the ruling fell short of meeting its goal.

An alternative strategy would be to join forces. An exhibitor with significant market share at the national level would have bargaining power against distributors. From a regulatory standpoint, a merger between theaters can pass an anti-trust test. Courts are usually concerned about the effect of industry concentration on the price, quality and selection of the final product. But a merger between theater chains need not raise such concerns if the merged company divests from local markets where it otherwise would have a monopoly.

Most recently, the ruling in the antitrust case between Whole Foods-Wild Oats and the Federal Trade Comission went along those lines. The government argued that integration of the two retailers would increase prices and reduce the quality of their foods. The court eventually decided in favor of the defendants – the reasoning was that, locally, the presence of other stores guaranteed a reasonable level of competition.

Some mergers have actually taken place in the recent past. Cinemark purchased Century Theaters in August of 2006; and AMC merged with Loews Cineplex in 2005. The latest move in the industry seems to be increasing the quality of the movie-going experience. As recently as December 7, AMC reached an agreement with Imax to buy 100 of its screens and digital equipment. Three other big chains –Regal, Cinemark and Carmike – are also investing in Imax technology, albeit at smaller scales. The idea, I can only imagine, is to charge a higher price for Imax shows.

My prediction is that, not too long from now, theaters will become advertising venues. They will show only big budget films with lots of special effects -- the kind that's really worth seeing on a giant screen and generates lots of DVD sales. Theaters will have the Beowulfs, Spidermans and Pirates. And, of course, they’ll always have Paris… I mean… popcorn.

Further reading and resources:

  • Einav (2007) Seasonality in the U.S. motion picture industry (pdf)
  • Orbach and Einav (2007) Uniform prices for differentiated goods: the case of the movie-theater industry (pdf)
  • National Association of Theatre Owners (html)
  • Vogel (2001) Entertainment industry economics: a guide for financial analysis (Google book)

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Friday, October 26, 2007


The Economist gets it wrong when claiming that “social networks lose value once they go beyond a certain size.” (Social graph-iti, October 20th.) The British weekly says that the large scale of the networks makes it difficult to restrict one’s contacts to a select group.

But Facebook consists precisely of a web of small overlapping communities. Users only befriend the people they choose. Increasing the size of the overall network does not necessarily affect the composition of any given community. And if people are “spammed by random friend-requests,” an infrequent event by my reckoning, they only need to decline.

The “snob” effect to which The Economist refers occurs only in venues where individuals can’t avoid some form of interaction with the rest of the users. Examples of this would be upscale restaurants or clubs, where increased patronage is bad for everyone: the business loses its exclusive image, and patrons are annoyed by the presence of riffraff.

On the contrary, Facebook becomes more useful as it grows. The larger the network, the more likely it is to find a welcome addition to one’s exclusive circle of friends.

Andreas Kluth, the author of that article in the weekly newspaper, was kind enough to reply to my comments:

I agree with you about the web of small overlapping communities, although my point was that other platforms, such as Ning, are more explicitly built to enable those. But my bigger point, which I could not fit into my word-count, is this: Facebook can choose to become a money machine by aggregating its communities to turn them into valuable audiences, but then it would become like those restaurants you mention. Or it could restrict itself to enabling micro-communities, but then it would be much less valuable as a business.

Oh, so Mr. Kluth’s point is that businesses will not pay much for advertising unless their ads can reach lots of eyeballs. With its current structure of small communities, Facebook is bound to never make much money. I don’t completely disagree with Mr. Kluth. But the value of the company doesn’t reside as much in its sheer size as it does in the closeness among the members of its communities.

The key difference between Facebook and, say, MySpace, is that on Facebook most people actually know and, to some extent, trust their friends -which makes it an ideal venue to implement the internet version of word-of-mouth advertising. This is how it would work. Companies would pitch their products and services to Facebook users who have lots of friends, and then would ask those users to let them place an ad on their home page. (The ads could take the form of a message on a public wall, or some other “cool” widget, to prevent the social network from becoming “too commercial.”) The idea is that the user is personally endorsing the product or service, not selling it. Because of the mutual trust, her friends would be likely to check out those ads. Moreover, most Facebook friends share common interests, backgrounds or socio-economic characteristics, which would make the ads highly targeted. Ads with a high “click-on” rate and a targeted audience would sell at a premium over ads on other internet sites.

On the other hand, as Mr. Kluth points out, the audience of those ads would be much smaller than, say, on Yahoo, since they would reach relatively small communities. So I don’t know whether this strategy would be enough to turn Facebook into a money-making machine.

The Palo Alto start-up seems to be taking steps to boost its revenues. It will soon unveil a new system that “will let advertisers visit an automated Web site to place targeted ads on Facebook and elsewhere,” reports the Wall Street Journal. It remains to be seen whether this new system or its partnership with Microsoft will turn out to be the company’s particular goose of the golden eggs.

In the meantime, everybody is in the dark regarding how much Mr. Zuckerberg’s brainchild is worth. At a conference on “Graphing social patterns,” reports The Economist, panelists valued the Palo Alto start-up at $100 billion. Microsoft places its value at just $15 billion -the software giant bought yesterday a 1.6 percent stake in Facebook for $240 million. That’s still more than 100 times its projected revenues for 2007 –a lot for a company that has not returned a profit in three years. I wouldn’t take any of those estimates at face value.

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Friday, August 31, 2007

Jamón, jamón

2008 might be the year when jamón leaves the confines of the Iberian peninsula and becomes a mass consumption good in the US and China. This blog post will walk you through an analysis of what is likely to happen to the price, quality and international penetration of the precious cured meat.

This week newspapers in Spain reported that China is about to lift the ban on imports of jamón. The Economist anticipated that the stuff would become legally available in the United States in 2007 (to the best of my knowledge the Department of Agriculture has not relaxed the regulation yet). [UPDATE (11/14/07): The first 300 legs of jamón arrive in New York today.]The vision of a sudden, massive increase in demand has Spanish consumers fretting about a price raise –and producers rubbing their hands. This blog post will walk you through an analysis of what is likely to happen to the price, quality and international penetration of the precious cured meat.

For this type of problem, it helps to think about what will happen to the demand for the product, and then its supply. To avoid getting off-course narrow down the drivers of changes in supply and demand to these three: Preferences, Endowments and Technology (PET).

As with any other good, an increase in demand just by itself will increase the price of jamón. The question is whether that shift in demand will actually happen and how large it will be. Preferences for pork in China are different from those in the Mediterranean. The Chinese consume most of their pork either fried or in stews and soups. Spanish ham is always eaten cold, as an appetizer, or as a cold cut in sandwiches, none of which are part of the Chinese habits and culture.

The product may appeal only to sophisticated elites in big cities like Shanghai or Beijing. The situation is similar in America, in the sense that cured meats are not part of mainstream preferences. There is, nonetheless, a significant population of Mediterranean origin, mostly Italian, who may have retained a taste for similar goods, such as prosciutto and luganega.

With regards to endowments, Americans are wealthier than the Chinese, which is relevant because imported jamón is pricey: today the average price per pound on an American store dedicated to Spanish foodstuffs is about $31.

So the fraction of consumers who would buy Spanish ham is higher in America than in China: a difference in endowments is reflected in a difference in the size of the demand shift.

Industry insiders and the media in Spain seem to suggest that the recent shortage of pork meat in China presents an opportunity. But, as we have seen, the Chinese have neither the tastes (preferences) nor the income (endowments).

On the supply side, let us consider the production technology first. (Technology does not apply to the demand side, because it refers to how the good is produced. Likewise, preferences do not pertain to the supply side analysis.)

There exist two basic varieties of jamón: serrano and ibérico. Ibérico, the high-quality kind, is made from pigs of the Iberian breed only. More importantly, for a leg to earn the ibérico denomination, the pig must spend the last several months of its life living on pasturelands, feeding on grass and acorns. Moreover, the pigs cannot roam around just anywhere: farmers need to raise them in a dehesa, an ecosystem endemic to the Iberian peninsula. Serrano ham, on the other hand, may be made from any pig (typically white pigs). The animals eat an authorized commercial compound feed, and are raised in factory-like farms. (Click here, here and here to learn more about varieties and elaboration of the product.)

Due to the differences in pig-raising methods (technology), the production cost per additional unit of jamón serrano is thus lower than that of jamón ibérico.

Significant increases in the production of ibérico may prove impossible, since farmers are using the existing pasturelands for pigs almost to full capacity, and increasing that type of pastures would take decades. On the other hand, increasing the scale of production of serrano is a matter of building new farms or cramming more pigs in existing ones. The endowment of a production factor, in this case land, affects the feasible scale of production.

Given these considerations, we can make two predictions:
1) It is more than likely that new demand would be met by increasing the production of low-quality ham. That is particularly likely in the case of exports to new countries, where consumers cannot distinguish between varieties.
2) If there existed a sizable demand for high-quality jamón from either China or the US, the price of that product would increase significantly. Moreover, the amount available for the national market would diminish. Total production would not increase very much.

Another way supply can increase is by shortening the curing period, which is a way of changing the technology. After pigs are slaughtered, the hams go through several phases of salting, resting and drying. Production time (after slaughter) oscillates between 13 months to 41 months, depending on the size of the leg and the desired quality. The ministry of agriculture imposes minimum curing and storing periods, but the incentive to cheat is great. Producers incur large fixed costs, so increasing the turnover of legs is the least costly way to increase output. Shortening the curing period results in a lower quality of the final product.

Cheating would be more likely early on after the opening of new markets. Risk-averse producers would be naturally reluctant to invest in new facilities before it is certain that there exists increased demand.

The most likely scenario is this: jamón will not become a mass consumption food in either China or the US. Spanish producers will export small amounts, and of the low quality kind, which will continue to be sold at price of gold in gourmet stores and fancy restaurants. The price and output of high-quality ham in Spain will not change very much, and the price and output of the low-quality one will increase somewhat.

If you liked this, you can use your analytical skills by thinking about Steven Levitt’s Shrimponomics or discussing whether Starbucks will take Russia by storm .

What do you think is going to happen to the Chinese demand for jamón? What about the American demand? And the world demand?
I have intentionally left out the possibility that other countries start producing jamón. What do you think would happen then?
Do you know of any other product that is about to experience an expansion in its potential market?
Please post your comments.

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