Since Samuelson (1958), the economic literature has considered that production in the media industries (films, TV programs, music, etc.) is characterized by high fixed costs and economies of scale. For instance, the costs of creating a TV program are high, but the incremental cost of physical distribution to an additional consumer is very low or even nil. Broadcast television should therefore exhibit large economies of scale.
Economies Of Scale In Media Markets
We say that a firm enjoys economies of scale when a proportionate increase in every input by a given percentage yields an increase in output by a higher percentage. A looser (and weaker) definition states that there are economies of scale when a firm’s average cost of producing output decreases as the output increases (the former definition implies the latter, but not the reverse). Finally, the degree of scale economies at given level of output is defined as the ratio of average cost to marginal cost (which also represents the elasticity of output with respect to the cost of production). With this last definition, there are increasing returns to scale if the degree of scale economies is strictly greater than 1.
Media industries are characterized by large fixed costs and small marginal costs; therefore, the degree of scale economies is much greater than 1. A fixed cost is a cost that does not vary with the level of output, and which can be avoided by cessation of production. In the media industries, the fixed costs accrue mainly due to the creation of content (articles for newspapers; films in the movie industry; recordings in the music industry; programs in the television industry; etc.), which yields a first-copy fixed cost (i.e., the cost of the first copy). Promotion costs are also sometimes considered as fixed, that is, independent of the number of units actually sold or of the size of audience. For instance, in the music industry, it is sometimes argued, producers make some initial promotion, which leads to first sales and triggers word-of-mouth between music fans. To be more precise, the cost of content and the promotion costs are not exactly fixed, but rather sunk; the difference between a sunk cost and a fixed cost being that the former cannot be avoided by cessation of production.
Variable costs in media industries accrue due to the copies of the content that are produced and distributed to end consumers. However, the marginal costs of copies are in general very low, in particular compared to the initial fixed costs. Moreover, with the ongoing digitization of content (e.g., the digitization of music), marginal costs of copies are almost zero. Actually, most of the costs of distribution of content could be considered as fixed; for instance, broadcast networks for free-to-air TV involve mainly fixed costs.
As an illustration of this cost structure – high fixed costs, and low variable costs – consider the music industry. According to Vogel (2001), production costs for popular albums are greater than $125,000 and marketing costs can reach $100,000. The total sunk cost for those albums (around $200,000) has to be compared with the marginal cost of a copy, which is around $2 to $3. In the movie industry, in 2005, the Motion Picture Association of America (MPAA) member company average theatrical costs were $60 million for negative costs (the sunk cost of the first copy), $32.4 million for advertising and $3.8 million for copies (movie prints); hence, variable costs of copies represented only 4 percent of total costs.
The Relation Between Programming Costs And Expected Audience
Empirical studies have shown that, very often, the more successful a TV program or a movie, the more it has cost (see, in particular, Litman 1983 and Ravid 1999). The existence of a relation between production costs and audiences is also recognized in the economic literature. For television, Spence & Owen (1977) think that it may be necessary to increase production budgets to draw larger audiences. Owen & Wildman (1992) consider that a program’s production costs can influence its potential audience: “The cost of producing a television program is independent of the number of people who will eventually see it. (The production cost, however, may very well influence how many people will want to see it.)” More generally, there is anecdotal evidence that, in many media industries, operating at small scale is not impossible.
How can the idea of economies of scale be reconciled with empirical evidence that larger budgets for content lead to larger audiences? The idea is that, while there are economies of scale with regard to the actual audience or number of copies sold, the fixed cost of a film or a music recording can be higher when a larger demand is targeted by the producer. Otherwise stated, once the content has been produced, its cost cannot depend on the number of consumers, but ex ante the fixed cost of production can increase with the targeted demand. Thus, for instance, we might observe that films with large budgets draw more audience than films with small budgets.
A higher fixed cost of production can increase the expected audience through two different channels. First, the quality attributes of the content can influence demand; higher investments in quality would then lead to a higher demand. For instance, a higher number of journalists can improve the quality of the information proposed by a newspaper; or a higher number of cameras can improve the image quality of a movie. Second, some inputs can have the ability to attract a large audience.
In particular, “talent” inputs might be a source of the relation between production costs and targeted audience. For instance, in the movie industry, talent inputs (such as producers, actors, or scriptwriters) are used along with inputs of production work (lighting engineers, cameramen, etc.) and capital inputs (scenery, special effects, etc.) to produce movies (e.g., see Crandall 1972). These “talents” are responsible for a large part of the quality of content. But they also have an impact on the information processes that guide demand. Indeed, most media goods are experience goods; that is, their quality can be assessed only after consumption. Because they can be recognized by consumers after the production phase, “talents” are able to attract demand.
Thus, the notion of talent is not only related to the “artistic” character of inputs. There are also artistic inputs that play a part no different from that of ordinary work inputs, because they are not directly known to consumers. For example, designers in the luxury industry, because they are unknown to the general public, are remunerated independently of the success of the products they define. Likewise, most actors are not “stars,” insofar as their participation in a film has no statistically identifiable impact on audiences. For instance, De Vany & Walls (1999) identified only 19 stars in all North American actors and film producers during the period 1984 –1996 (i.e., talents that had a statistically significant impact on success).
Insofar as they contribute directly to the production of demand, stars can, after achieving a degree of autonomy, impose modes of remuneration that reflect a sharing of created value rather than payment for a job done. This trend, now distinct in the television industry, has been clearly observed in the case of the film industry.
In the case of cinema, it seems that stars have progressively managed to capture most of the surplus they generate. In a study on a random sample of 180 films released between 1991 and 1993, Ravid (1999) found that while stars increase the box-office takings of films, they capture the income thus created and finally play no part in its financial success. In the case of US broadcast television, Woodbury et al. (1983) analyzed a sample of 99 series programmed in the US in 1977 and 1978 on the three national broadcast networks, ABC, CBS, and NBC. These authors showed that the producers of these series were remunerated in accordance with the “popularity” of the programs they had made (i.e., the ex post actual audience). For example, if a program drew a larger audience than expected, the network distributed part of the surplus to the producer. For Woodbury et al. (1983), the network tried to maintain good relations with these producers in order to obtain new programs, and relinquished part of the surplus in order to ensure good performance from them.
Economic Implications Of Economies Of Scale
The presence of strong economies of scale has strong implications with regard to market competition and pricing strategies.
In a market characterized by large economies of scale, competition is unlikely to emerge. Indeed, competition forces would drive prices to marginal costs, and firms would not recover their fixed costs and would make large losses. Therefore, in the medium or long run, only two types of market structures can emerge: either the market is dominated (or monopolized) by one firm, or firms differentiate and target different market segments (again, some firms are likely to be dominant in each segment). This latter pattern corresponds well to media industries, where consumers value variety.
The presence of economies of scale also has implications in terms of pricing. Since media services or products are characterized by high fixed costs and low marginal costs, with cost-based pricing firms would make losses. If a firm has market power, which is what we can expect, different pricing or commercialization strategies are possible (see Shapiro & Varian 1998 for more details).
First, the firm can price-discriminate, that is, it can sell the same good (or similar goods) at different prices, according to the quantity sold, the consumer’s characteristics, or various sale clauses. A common example of price discrimination in media industries is the sale of books in different formats (hardcover vs paperback). Versioning is a form of price discrimination that consists in creating different versions of a good, and inducing each group of consumers through the appropriate pricing scheme to choose the version that was intended for them. For instance, for a DVD, a collector’s edition can be commercialized along with a standard edition to target the consumers who have a high willingness for the DVD.
Second, because marginal costs are very low (or even nil), the firm can sell its goods as a bundle. When consumers have very heterogeneous preferences for the different goods, bundling can increase profit.
Finally, the cost structure in the media industries facilitates piracy. Indeed, the cost of a copy is very low or even nil, not only for the producer, but also for the end-consumer.
- Crandall, R. (1972). FCC regulation, monopsony, and network television program costs. Bell Journal of Economics, 3, 483 –508.
- De Vany, A., & Walls, W. D. (1999). Uncertainty in the movie business: Does star power reduce the terror of the box office? Unpublished working paper. University of California, Irvine.
- Litman, B. R. (1983). Predicting success of theatrical movies: An empirical study. Journal of Popular Culture, 16, 159 –175.
- Owen, B. M., & Wildman, S. S. (1992). Video economics. Cambridge, MA: Harvard University Press.
- Ravid, S. A. (1999). Information, blockbusters, and stars: A study of the film industry. Journal of Business, 72(4), 463 – 492.
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- Vogel, H. L. (2001). Entertainment industry economics: A guide for financial analysis, 5th edn. Cambridge, UK: Cambridge University Press.
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