Market Model Patterns of Change

John McDonald

Dr. Guerman Kornilov

ECO 550: Managerial Economics and Globalization

Saturday, January 28, 2012

Describe the industry and explain the general pattern of change of the particular market model.

The industry I chose to research is the movie rental industry. An industry, which at one time was dominated by Blockbuster Video, has gone through enormous change over the past five to ten years. Blockbuster Video had very little competition when brick and mortar stores were the only way to rent movies. Hollywood Video was their only national competitor; however, they did compete with many regional and local movie rental companies. New technology, along with multiple competitors, have changed the way consumers purchase movie rentals and other video.

Once considered a monopoly by many, Blockbuster Video fought the many pressures affecting brick and mortar stores today. The company had stores on every corner, which resulted in high costs. Once the industry started evolving with new technologies, these stores became sunk costs for the retailer. Online-only retailers who enjoyed much lower costs than the brick and mortar stores were able to profitably charge customers a lower rate; however, at the same time, Blockbuster Video was saddled with the high costs of labor as well as the physical stores. It was not long before Blockbuster’s costs became too much for the retailer, as they were forced into bankruptcy.

Today’s market landscape looks much differently than it did when Blockbuster Video was at its peak. Many more competitors fight for the consumer’s dollar; however, there are still a few dominant companies that stand out among them. These include Netflix, Redbox, Apple, and Amazon.

Hypothesize the basic short-run and long-run behaviors of the model in the industry you have chosen in a “market economy.”

Blockbuster became an almost instant hit with its brick and mortar stores. Customers could, for the first time, rent a movie and return it to the same store for a much lower price than the price of purchasing a copy of the title.

In the short run, Blockbuster was able to be a “one-stop shop” for video rentals and in its later years, began tweaking its inventory positions to feature “Guaranteed In-Stock” new releases. Due to the first sale doctrine, Blockbuster was able to rent a single video or DVD purchase multiple times, which made it a very lucrative business. This attributed to its substantial growth into over 7,000 stores and 60,000 employees at its peak in 2009 (Blockbuster, LLC., 2011). At this point, Blockbuster Video enjoyed a monopoly position in the market; however, a newcomer called Netflix started to change the landscape of the market.

In the long run, Blockbuster Video did not have a sustainable model due to the fact that Netflix was able to drive down the costs of doing business by delivering DVD’s directly to the customer’s door. Netflix continued to eat away at Blockbuster’s share as Blockbuster was saddled with high costs from its brick and mortar operations such as labor and real estate, while lagging behind in the changing technology of streaming content. Netflix was able to run a much leaner operation due to having a centralized distribution warehouse and much fewer employees!

About the same time as Netflix started really grabbing market share, Redbox started chipping away at Blockbuster’s market share as well. Their self-service kiosks made renting movies much easier than having to make another stop at Blockbuster. Also, technology was changing the way consumers viewed video. Although the DVD was still extremely popular, consumers started viewing streaming movies over the Internet. While Netflix has done a good job of slowly transitioning more and more of its movie library to streaming video, Blockbuster was caught flat-footed.

Facing an enormous amount of costs associated with its brick and mortar stores and a huge labor budget, Blockbuster could no longer compete with Redbox or Netflix. “Blockbuster has been losing money and market share for years as Netflix, Coinstar Inc.'s Redbox and other services gained popularity. Netflix subscribers have grown from 1 million in 2002 to 15 million in 2010. Redbox, meanwhile, operated 26,900 kiosks as of the end of June. Wedbush Securities analyst Michael Pachter predicts that number will exceed 28,000 by the end of September” (Anderson, 2010).

In the short run, Netflix is holding its own, mostly due to its adoption of streaming its videos over the Internet, as well as having its low-cost, finely tuned DVD distribution system. However, the industry is once again going through an enormous change with more and more consumers wanting to consume video over the Internet.

Unlike the Blockbuster model, where they were able to leverage the first sale doctrine, streaming video is a different business. The movie studios have gotten smarter and licensing negotiations between the likes of Netflix and other content providers have been nothing short of brutal. Mounting licensing costs from the studios has caused a huge increase in Netflix’s costs, one reason why, several months ago, they made a very poor move to raise their subscription costs. Eventually, they ended up retracting the increase, but not before losing millions of customers and angering many more.

Netflix still has a huge subscriber base in the neighborhood of eighteen million customers. In the short run, they have the ability to continue to transition from the DVD business into a streaming content business. As we have seen by their stock performance and their mistakes over the past year, this is becoming a very difficult transition for them. One positive thing about Netflix is their strong customer base, and that alone may help them weather the storm ahead.

Meanwhile, the transition to streaming content helps to level the playing field for Netflix's rivals.

“Several competitors that sell or rent digital content -- such as Apple, Amazon, Hulu and Vudu (owned by Wal-Mart Stores) could emerge as serious threats to Netflix. Amazon could pose a formidable challenge, with its huge customer base and desire to sell digital content to compensate for lost sales of DVDs, hardcover books and other physical media. The Seattle company sells digital video content and is more than capable of opening a streaming rental storefront as well” (Corty, 2011).

In the long run, there are simply too many “what-if’s” to make a determination on where this market will go. With the tech industry churning out new products and innovative content what seems like every week, the landscape of this market could simply be described as a moving target.

Analyze at least three (3) possible areas for the industry that could lead to transaction costs, and explain each in detail.

The first, and probably the largest impact on cost on the industry will be licensing fees for the rights to stream the content. For example, “Netflix recently signed a five-year deal with entertainment channel Epix for the streaming rights to films from the Paramount, MGM and Lionsgate studios. The deal reportedly is costing Netflix as much as $200 million a year, and makes the studios' movies available for streaming 90 days after they are first shown in the pay-tv window -- which is usually several months after the DVD release” (Corty, 2011). This is where streaming content providers are going to have some trouble. The timeline from when the movie hits DVD until the time it can be streamed is too long.

Another source of rising costs will come in the form of computer hardware. As more and more people begin streaming movies over the Internet, these companies will have to invest heavily into bandwidth, allowing an ever-increasing number of videos to be streamed from their sites.

A third source of rising costs within the industry will become the fight against piracy. While online piracy is already a concern for many of the music and video studios, the proliferation of such piracy will add to increased costs and lower revenues for those companies in the streaming content business. For example, “According to the Institute for Policy Innovation, more than $58 billion is lost to the U.S. economy annually due to content theft, including more than 373,000 lost American jobs, $16 million in lost employees earnings, plus $3 billion in badly needed federal, state and local governments’ tax revenue” (The Motion Picture Association of America, 2011).

Speculate about the behavior that could result from these transactions and propose at least two (2) strategies for dealing with them.

The industry’s costs associated with licensing fees will become a contentious battle between the studios and the industry players. As I pointed out earlier in this paper, these contracts can, and usually will be, valued in the hundreds of millions of dollars. It will be extremely important that the companies measure consumer demand and make sure they are purchasing the right content at the right time.

Secondly, the industry players will need to be extremely cunning, and aggressively negotiate the licensing contracts. This is where the profits will be!! If they can be successful at negotiating down the costs of licensing, I believe they will be profitable in the industry. On the flip side, if these companies do not have a good read on consumer demand, spend too much licensing the wrong content, or are not in a proper position to negotiate the lowest costs possible, the impact could be huge on future profits.

Collect costs, revenue data, or other data from the industry that you deem relevant. Explain how you would modify the data in order to make it relevant to decisions a manager must make.

Unfortunately, the majority of the costs that this industry bears are the licensing fees. These fees are typically kept under wraps because each company negotiates its own terms. However, if we look at earnings numbers, we can get an idea of how influential each of the major players are in the industry:

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As you can see above, Apple and Microsoft both have a commanding lead in EBITDA. Granted, they have more sources of revenue than Amazon and Netflix, but it gives you an idea of the amount of cash they have available to fund these hugely expensive licensing deals. If you look at the past several quarters, you will see a pronounced decline in Netflix stock.

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This is due, in part, to some very big licensing deals that are about to be renewed. Also, the consumer trend is heading toward current broadcasting. “Netflix and Disney announced a one-year agreement in December for streaming rights for library (noncurrent TV season) content from the ABC network and cable properties ABC Family and Disney Channel” (Corty, 2011). The short length of the deal (one year) and a price rumored to be as much as $150 million, is another sign that Netflix will have to pay much more in the future for more current content, especially if other companies in the market make serious pushes into streaming content. These are reasons why there is some hesitation with Netflix at the current time. Their stock is well off their 52 week high, and continues its downward trend.

As a manager, I would look at my company’s share of streaming data and compare it to my competitors. In this business, I believe that volume speaks louder than anything else. My share of the marketplace would decide how I went about negotiating a licensing deal. If I were a company who had the majority share, my negotiation tactics would be extremely ruthless, as I know the studios would want big volume. On the other hand, if I were a smaller company, I would still negotiate hard, but may want to look a little harder at the content side than the company that has the majority share.

While it would be important with any of the companies in this industry, I believe that the type of content you buy can be especially important for companies with a smaller share. For instance, Netflix has limited cash in hand and must decide how to provide the best content at the best price for its customers. They will need to look a little harder at content, and determine where the best deals are to spend their money. A hard look into their customer base and their viewing habits would be a good place to start. At that point, they can cater their content to their subscribers and put their dollars to the best use possible.

Explain the major factors that affect the degree of competitiveness in your industry. Use the data to develop at least three (3) measures (e.g., productivity measures) to show how the industry is evolving.

One of the first measures that show the degree of competitiveness in the industry is price. This can range anywhere from a subscription based plan that companies like Microsoft (Roku) and Netflix use, to a per-item plan that is more relevant to what iTunes uses. In the short run, I see prices staying at their current rates while companies in the industry build up their supplies of content and negotiate licensing arrangements with the studios. As the studios become more comfortable with the way the industry is shaping, and they begin to realize a steady revenue stream, I see prices begin to fall in the longer run.

Subscription content is another measure of competitiveness within the industry. While Apple can provide the most content due to its enormous cash flows, other providers are buying up the licensing deals that they are able to afford.

While I do not necessarily see the industry evolving into companies who offer niche programming, I do believe there is room for several players. At this point, I do not see how anyone is going to put a dent in Apple’s market share; however, I do see the industry evolving into different programming areas. For example, in the streaming media industry, the major networks are not major players; however, if you think about the structure of their business, you will understand that they already have licensing agreements in place.

I see a future where I pick up a tablet or mobile phone, and open up my Fox or ABC application for the consumption of my streaming media. Since these agreements are already in place, why not expand on that and make the content available immediately on the network applications. There are tie-ins with advertising and consumer preferences that are already in place. I believe it would be a more seamless transition for not only the customer but also the studios.

Cited Works

Anderson, M. (2010, September 23). Blockbuster Bankrupt: Video Chain Files For Bankruptcy Protection . Retrieved January 29, 2012, from Huffington Post - Business: http://www.huffingtonpost.com/2010/09/23/blockbuster-bankrupt-vide_n_736072.html

Blockbuster, LLC. (2011). Company Overview. Retrieved January 29, 2012, from Blockbuster Corporate: http://blockbuster.mwnewsroom.com/Company-Overview

Corty, M. (2011, February 11). Time to Sell Netflix? Retrieved January 29, 2012, from MSN Money: http://money.msn.com/stock-broker-guided/time-to-s\ell-netflix-morningstar.aspx

Michaels, R. J. (2011). Transactions and Strategies: Economics for Management (1st Edition ed.). Mason, OH, USA: Cengage Learning.

The Motion Picture Association of America. (2011). MPAA STATEMENT ON STRONG SHOWING OF SUPPORT FOR STOP ONLINE PIRACY ACT. The Motion Picture Association of America. Washington, D.C.: MPAA, Washington, D.C