Media rely on different combinations of revenue from consumers and advertisers to pay production costs and earn a profit. Reliance on either revenue source is determined by the characteristics of the media good, and by consumer and advertiser demand for the good.
Consumers select media products that meet needs such as entertainment or information for decision-making. Advertisers in turn select media that reach potential customers for the advertised products.
Individual consumers use a mix of media products to meet a range of needs, but the mix is dynamic (Lacy 2000). Changes in existing media products, or the introduction of new products, can change their media mix.
Consumers select media products because of embedded characteristics, such as speed of delivery and quantity or quality of information (Litman 2006). Different media, such as television, newspapers, and the Internet, have different proportions of desirable characteristics. Consumers use these characteristics to select a mix of products that gives them maximum utility within the constraints of time and income (Litman 2006).
Changing patterns of consumption mean some forms of media lose revenue that others gain. These changes can be understood with models of media economics. These models are used below, first to examine the costs of producing and distributing media content, and strategies for raising revenue to cover those costs. Then cost and revenue interactions are examined. Third is a discussion of how interactions are affected by competition and by new media technologies.
Media products – be they printed, broadcast, or published on a website – have two important economic characteristics. First, significant costs must be paid to produce the first copy. First-copy costs usually increase with the sophistication of the product because skilled workers must collaborate to creatively use specialized equipment.
Second, it is difficult to tell in advance how many copies consumers will demand. Many media products are “experience goods” – consumers must experience the product before they know if it meets their needs. For instance, consumers must read a book to find out if they enjoy the story. Some media products also have characteristics of “credence goods” – consumer evaluation is imperfect even after the good is experienced. Reputation is particularly important for credence goods, such as news reports.
Together, these characteristics require that media producers pay substantial first-copy costs without knowing how many additional copies consumers will actually demand. The problem is complicated by expensive production technologies, such as printing presses. These investments create substantial fixed costs which must be paid regardless of the number of copies produced.
Total production costs are a combination of fixed costs, high first-copy costs, and relatively small variable costs of producing each additional copy. This means average costs of production actually decline as the number of copies increases, creating economies of scale. The change in cost from producing one additional copy, or marginal cost, is less than the average cost. Marginal cost will only increase if the number of copies produced begins to strain production capacity.
Traditional microeconomic rules state that firms maximize profits by setting the price of their product equal to marginal cost. But media firms will fail if they set prices equal to a marginal cost that is less than average production costs. Producers must either attract an audience willing to pay average production costs, or find alternative financing. Ludwig (2000) calls this “the essential economic problem of the media.”
This problem varies with the characteristics of the medium. For instance, first-copy costs are less for books than for studio films, so publishers can earn a profit with smaller audiences than film producers. Distribution costs also vary. Only one copy of a television program needs to be broadcast, but separate copies of a newspaper must be distributed to each subscriber.
Nonetheless, many media must find a source of revenue beyond consumers to succeed economically. This source is often advertising (Ludwig 2000). This solution creates interdependence between demand for a media product and advertiser demand to reach the audience for that product. Media producers must balance the interests of their audiences and the interests of advertisers trying to reach potential customers in those audiences. Producers use different strategies to strike this balance and reduce uncertainty about how many copies of a product consumers will demand.
All media have at least one of two physical characteristics of public goods. Nonrivalry in consumption exists if multiple consumers can use the same product without using it up. Nonexcludability exists if consumers cannot be prevented from accessing the good. Media products are nonrival, and many are nonexcludable. Determining demand for public goods is difficult because they can be consumed without payment. Governments supply pure public goods, which are nonrival and nonexcludable, such as national defense.
Broadcasting is an example of a similar media product. Consumers cannot be excluded from radio and television broadcasts if they have a receiver, so there is no way to charge them for the product. Instead, broadcasting is supported by advertisers or by the government. The financers determine the quantity and characteristics of broadcasts in line with their desire to reach particular audiences. Expensive programs can use established formats, story lines, or actors to create mass appeal and attract support from multiple advertisers (Dimmick & McDonald 2001). Inexpensive programs can appeal to smaller audience segments because they only require support from a single advertiser.
Mixed public goods have only one characteristic, nonrivalry. Newspapers, magazines, and cable television are products that can restrict consumer access. Subscriptions can be used to collect advance payments that reduce uncertainty about the future size of the audience and how many copies to produce. However, many excludable media products still rely on advertising to pay some costs.
With both pure and mixed public media goods, the degree of influence that consumers or advertisers have will vary. For instance, a product with many advertisers is less likely to be influenced by the preferences of a single advertiser because its economic success is not at stake, and vice versa.
Windows For Content
Some media products, such as music and films, are not time-sensitive. Unlike news, they remain attractive to consumers for extended periods. If these products meet two additional conditions they can be sold repeatedly to different groups of consumers for different prices. The first condition is excludability. The second condition is that consumers can be separated into groups based on the maximum they are willing to pay for the product. This maximum is called a reservation price. When both conditions are met, the same product can be sold to different groups of consumers at different prices. If the sales take place in different markets, each market is called a window (Owen & Wildman 1992).
For example, films released first in theaters attract consumers with the highest reservation prices. This may be followed with a release on restricted cable television channels to viewers with lower reservation prices. Eventually, the film may appear on advertising-supported cable or broadcast channels. Additional distribution windows were created by home video and the Internet.
Foreign markets are another window for episodic television or film. However, national differences such as language or culture may reduce the utility that foreign audiences receive. For example, a movie with subtitles may attract smaller audiences than a movie using the audience’s native language. Foreign windows require a cultural discount – producers must lower their price because audiences have lower reservation prices. Video sequences that cut across language barriers – such as chase scenes, or explosions – can reduce the size of the cultural discount.
Producers can use price discrimination in the same market if they sell different versions of a product (Varian et al. 2004). Cellular telephone providers vary prices according to the type and amount of service demanded by different groups of consumers. DVDs can offer a film, or a more expensive version with features such as extended commentary.
Bundling Media Products
Bundling is used to sell groups of cable television channels, but the strategy has applications across a variety of media products. Bundling allows media producers to place consumers with different tastes and reservation prices in a group. The producer sells the group a bundle of different products for the same price.
The strategy requires low cost for supplying additional units of a media product. If one consumer has a high reservation price for films, and a low reservation price for history programs, but a second consumer has opposite preferences, sales can be increased by selling both consumers a bundle of film and history channels (Owen & Wildman 1992). This is why cable television channels are sold in tiers instead of being offered for individual sale. Newspapers and magazines bundle a variety of information in print to attract consumers with different interests. This strategy can easily be transferred to the Internet.
Interactions between costs and revenues are also influenced by competition between producers of substitute media products. Firms compete by reducing prices, or by differentiating products to make them less substitutable. Differentiation of media products often involves embedded characteristics such as content quality or speed of delivery. However, differentiation increases production costs and can be imitated. This means profits from product differentiation are influenced by market structure. Firms with limited competition can set prices well above production and distribution costs, earning substantial profits that could be used for product differentiation. Firms in competitive markets must set prices close to cost, limiting their ability to differentiate.
For example, economies of scale limit newspaper competition, allowing some newspapers to charge monopoly prices. The financial commitment model predicts that newspapers that do face competition will increase newsroom spending, improving the quality of coverage in order to make themselves less substitutable and maintain market share (Litman & Bridges 1986; Lacy 2000).
Thousands of magazines in the US compete in crowded market segments, and have little power to raise prices paid by readers or advertisers. To survive, publishers must produce articles targeting the interests of readers whom advertisers want to reach. Newspapers are adopting similar tactics as readers and advertisers migrate to newer forms of media.
Cable television and telephone providers can reach very large markets with continually decreasing average costs. These natural monopolies therefore have regulated prices and service. These firms had few incentives to differentiate before new technologies, such as satellite television and cellular telephones, threatened their monopoly status. This is part of the reason why Asian nations that lagged behind in developing telecommunications now have technology more advanced than the US.
Public financing offers an alternative to reliance on advertisers and consumers. Governments can make grants directly to media producers. Another alternative is financing from dedicated taxes, such as the tax on television receivers in some European nations. Public financing is used to support broadcasters, filmmakers, publishers, and other media producers.
Public financing can encourage production of content with social benefits that cannot be realized by private firms. For example, news programs that increase knowledge about complex issues may increase the efficiency of democratic political systems. Privately financed producers have no way of making consumers pay for these benefits and may focus on news stories with mass appeal to attract advertisers. Public financing is the only alternative for encouraging such production.
However, effects from these programs are hard to measure, so it is difficult to determine if public financing is providing too much, too little, or just enough of the desired content. The allocation of public funds is often subject to political influence. In extreme cases, publicly supported media are little more than government mouthpieces. In less extreme cases, they may limit content due to political considerations.
Evolution Of Media
Media production, technology, and markets are dynamic, and changes influence interactions between costs and revenues. Firms with a monopoly or few competitors could raise prices above production costs plus a fair return to investors who put their money at risk. These firms earned economic profits, or profits above the amount necessary to remain in business. Media in these markets financed substantial investments in plants and equipment, increasing fixed costs, by producing content with mass appeal to maximize audiences and advertisers. This created opportunities for smaller firms to serve niche audiences with specialized content not available from the larger firms.
However, competition increased as new distribution technologies brought more content into the markets. New production technologies that lowered first-copy costs had a similar effect. These changes allowed new firms to compete away the economic profits enjoyed by existing firms. As prices decreased, firms had to reduce production costs, accept reduced profits, try to limit new competition, or some combination of the three.
For example, in the 1950s cable television was a threat to broadcasters because cable could import signals from outside local markets. Broadcasters pressured the Federal Communications Commission (FCC), which regulates television in the US, to limit the spread of cable (Owen & Wildman 1992). The FCC restricted cable in large markets until the 1970s. As a result, cable was not widely available in the US until the 1980s. Cable allowed viewers to receive frequencies that were difficult to acquire with a television set antenna. This, and changing regulations, encouraged News Corp to purchase local ultra high frequency stations that became the Fox network (Thomas & Litman 1991). Costs were minimized by using programs and movies owned by Fox film studios, and inexpensive reality programs. The network targeted young viewers, eventually acquiring rights to broadcast professional (American) football, which solidified its market position.
Cable made consumers pay to watch programs that were broadcast free. But cable also offered new programs. The growth of cable is an early example of consumer willingness to pay if new technologies offer desirable features not previously available. Consumers adjusted their mix of media, revealing preferences that were not apparent before they had cable. The mass audiences for broadcast television began to fragment, and advertisers followed audiences to new channels and new media. The adoption of cable, and News Corp’s successful exploitation of new markets it created, is one example of a story that repeats with increasing frequency and speed.
Digital production and distribution eliminates large capital expenses such as printing presses and broadcasting towers. Inexpensive software replaces equipment for creating and editing content, which the audience can copy and redistribute.
Digital producers operate with lower fixed costs and can profit with prices below what is economic for firms with higher costs. High-cost firms must cover costs with a diminishing audience or advertiser base. New technologies reduce the cost of collecting specific information about consumer preferences. Google and Yahoo! place ads beside compatible search results, track whether individuals click on the ads, and provide this information at low cost to advertisers. Advertisers only pay if someone clicks on the ad. This highly efficient technology draws revenue away from nondigital media, which must increase spending to find effective responses.
However, digital media still face the essential economic problem that reproductions cost less than the first copy. Varian et al. (2004) identify three variables that help resolve the problem. Creating different versions was discussed earlier. The second variable is switching costs, which exist when it is costly for consumers to switch from one product to another. Email creates switching costs because address changes require notification, and messages may be missed. Companies offer free email to create switching costs, then profit by selling advertising directed to email customers. Social networking sites, such as MySpace, offer free personal web pages with elaborate tools for managing online interactions. This creates switching costs for the site’s users. Newspapers that offer readers free web pages and chat forums are using a similar strategy.
The third variable is network effects, which exist when demand for a good depends on how many other people use the good. Network effects can be direct; demand for social networking increases with the number of users on a site. Network effects can also be indirect; the number of DVDs increases as more people buy DVD players. Switching costs and network effects interact to increase demand for Internet media if production costs are low. As websites add content, the cost of switching to another site increases. As more people use the site, demand to place content there will also increase. YouTube makes it easy to watch or upload videos. As more videos are added, more people watch them, creating a cycle of growth. Google can then sell advertisers access to users while it tracks their activities to refine the efficiency of its operation.
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