Thursday, February 22, 2007

Defining Markets

One rarely has the opportunity to witness the formation of a monopoly, but that’s what will happen if satellite radio broadcasters XM and Sirius are allowed to complete their proposed merger. But is it really a monopoly? On the surface, this appears to be a classic example of “merger to monopoly.” XM and Sirius are the only two providers of subscription satellite radio services, so any merger should yield a single monopoly producer of that particular kind of service.

The central issue is the definition of the market. If the market is defined narrowly—satellite radio entertainment providers—then monopoly is exactly what will result. However, in a more broadly defined market, a combined XM–Sirius would not be a monopoly. For example, we could delineate the market to be all suppliers of audio content broadcast into cars (which would include the other radio providers now referred to as “terrestrial radio”), or even the market for all audio music, news, and entertainment sources (which would include Internet radio and downloads from websites like iTunes). In these broader markets, even a single "monopoly" satellite radio firm would face a great deal of competition.

The debate over this proposed merger will center around its impacts on competition and consumer welfare. If the market is narrowly defined, the traditional complaints regarding monopolies are legitimate: reduction in consumer choice, sub-optimal production of content, damping of innovative activities, and, of course, higher prices. However, the firms argue that consumers will benefit from efficiencies resulting from combined operations—their press release claims annual cost savings of up to $7 billion per year and outlines other expected synergies. Of course, it should be noted that both companies have been operating for over 5 years, but neither has generated a profit yet despite growing revenues and significant efforts to expand their subscriber bases.

There are several significant obstacles to the completion of this merger. In 2001, satellite television providers DirecTV and the Dish Network proposed a merger that was eventually blocked by antitrust authorities. Many observers see the XM–Sirius merger as the audio equivalent of the DirecTV–Dish Network deal. A further complication exists because when the two companies were originally licensed, the FCC explicitly forbade one company from owning both satellite broadcasters. The proposed merger will require FCC and Justice Department approval and will likely attract the attention of Congress, so the companies must be hoping that regulators will take a fresh look at the market and competition.

Discussion Questions

1. Can you think of other instances in which a firm dominates a narrowly defined market, but faces competitors from a more broadly defined market?

2. The most famous recent antitrust case was the Microsoft case. In that case, Microsoft argued that even though it dominated the market for computer operating systems, it was still vulnerable to competition from other forms of software. This is a similar argument to the one being made by XM and Sirius. Looking back on the last few years, how much merit did Microsoft's argument have? Does the rise of firms like Google and YouTube mean Microsoft's market power has eroded?

3. Sirius and XM argue that there are economies of scale that make the provider of satellite entertainment a natural monopoly, like the local power company. On the other hand, price wars between the two services may be just as much to blame for their failure to make money. If you were a regulator, what guidelines for pricing could you establish to allow the combined company to realize the economies of scale without gouging consumers on price?

Harold Elder is a professor of economics at the University of Alabama. His research and teaching focuses on applied microeconomics, including law and economics, public sector economics, and a range of public policy topics. He regularly teaches Principles of Microeconomics in the College of Commerce and Business Administration and is the advisor for his university's master's and Ph.D. programs.

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Wednesday, February 14, 2007

Should the Music Industry Abandon DRM?

Regulators around the world, most notably in Norway and other European countries, have recently expressed concern that the Digital Rights Management (DRM) on the iTunes Music Store inhibits competition, both in the online-music retail industry and in the market for music players. DRM is the software system that ensures that purchased songs cannot be freely copied. The theory is that Apple’s Fairplay system of DRM means that users who make purchases from the iTunes Store can only play those songs on Apple’s iPod. This locks them in to purchasing iPods today and in the future. If this happens to enough people, entry by others into either music selling or music-player manufacturing may be difficult.

Apple’s CEO and co-founder, Steve Jobs, recently posted an essay on the subject. It is very well written and its economics are very clear. Jobs first points out that in order to prevent unauthorized copying of songs, music publishers require iTunes to use a DRM system that is uncompromised (i.e., one that isn’t hacked so that DRM features are removed). Apple considers that the only way they can achieve the level of security required of them by the music publishers is not to license Fairplay to others. With both of these conditions present, Jobs argues, it is out of Apple’s hands, and so competition authorities should look elsewhere.

But Jobs goes on:

  • Are iPod owners really locked in? No, he shows that on the average iPod, only 3% of music is purchased from the iTunes Store. What this means is that very few users are locked in to the iPod, and when it comes down to it, they have chosen to do so because they could always have got their music like most other people (from buying CDs, which he mentions, and illegal downloads, which he doesn’t).
  • Why not let music play without DRM? Jobs says, “Fine with me.” Indeed, 90% of music sales are DRM-free now.

Indeed, he says, blame music companies. Apple wants a freer world:

So if the music companies are selling over 90 percent of their music DRM-free, what benefits do they get from selling the remaining small percentage of their music encumbered with a DRM system? There appear to be none. If anything, the technical expertise and overhead required to create, operate and update a DRM system has limited the number of participants selling DRM protected music. If such requirements were removed, the music industry might experience an influx of new companies willing to invest in innovative new stores and players. This can only be seen as a positive by the music companies.

Much of the concern over DRM systems has arisen in European countries. Perhaps those unhappy with the current situation should redirect their energies towards persuading the music companies to sell their music DRM-free. For Europeans, two and a half of the big four music companies are located right in their backyard. The largest, Universal, is 100% owned by Vivendi, a French company. EMI is a British company, and Sony BMG is 50% owned by Bertelsmann, a German company. Convincing them to license their music to Apple and others DRM-free will create a truly interoperable music marketplace. Apple will embrace this wholeheartedly.

An excellent point. That should smooth relations with them nicely.

Discussion Questions

1. A strong argument is made in most introductory economics classes that a strong system of property rights is important for economies to function smoothly. While it is easy to assign property rights to private goods like land or cattle, it is more difficult in the case of public goods—goods that are nonrival and nonexcludable. If you post a downloadable MP3 on a public webpage, it essentially becomes a public good. DRM attempts to make a good excludable that would otherwise be nonexcludable. However, as Jobs points out, DRM also makes it more difficult for consumers to enjoy music any way they like. If you were designing the legal framework in which music could be bought and sold, what kinds of property rights would you assign, and how would you protect and enforce them?

2. Several web commentators have noted that security isn't the reason the DRM software used by iTunes hasn't been hacked—it's the fact that there is a loophole so wide you could drive a proverbial truckload of CDs through it. Specifically, there's nothing preventing you from buying something on iTunes, burning it to a CD, and then importing the files as MP3s that can be played on any player. How does the existence of this well-known workaround affect the arguments of European governments?

3. Jobs suggests that the two options available to Apple are to use Fairplay or not to have encrypted music. However, suppose Apple chose to offer multiple DRM formats on the iTunes Store and let customers choose which DRM format they wanted to use. That would (a) allow iPod users to choose what they want to get locked in to; and (b) allow owners of other music players to purchase from the iTunes Store. What would the costs and benefits of this be for Apple?

Joshua Gans is a professor of economics at the University of Melbourne. He has previously blogged on this issue here and here.


Monday, February 12, 2007

Fueling Protests and Cars

Tortillas—a central component of the Mexican diet—have been a source of recent uproar in Mexico. Rising tortilla prices fueled protests in Mexico City two weeks ago. Many people in Mexico earn only $5 per day, and with the price of tortillas approaching $0.45 per pound, protests were inevitable.

Tortilla prices may be fueling the protests, but it's the growing demand for corn among American ethanol producers that's fueling the rise in tortilla prices. As more and more ethanol plants come online in the U.S., the number of buyers in the corn market increases, putting upward pressure on corn prices. Rising corn prices mean rising input prices for tortilla makers and rising tortilla prices for consumers. So does fueling your Honda Accord with ethanol-laced gasoline take tortillas off the plates of Mexicans? The answer depends on the time horizon: the short run or the long run.

Three characteristics in the market for corn make it highly competitive. First, there are many corn producers in the United States, Mexico, and the rest of the world. Second, corn tastes about the same no matter which farmer sells you the corn. Third, there are few barriers to new corn producers entering the market in the long run.

In the short run, however, firms cannot exit or enter the market. Rising ethanol production in the U.S. creates a higher demand for corn. The market demand for corn shifts to the right from D1 to D2, increasing the price of corn from P1 to P2. Corn producers react to the higher price by producing more corn (moving from q1 to q2). The higher demand for corn also causes corn producers to earn an economic profit.

How does this affect the tortilla market in Mexico? Corn is a major input for tortillas—as corn prices rise, the cost of tortilla production rises. The supply of tortillas shifts to the left from S* to S**. The price of tortillas increases and the quantity of tortillas consumed decreases. The reduction in tortilla supply causes the price of tortillas to rise sharply in Mexico because tortillas are essential to the Mexican diet (the demand for tortillas is fairly inelastic). As a result, the financial burden of higher corn prices falls on tortilla consumers more so than the producers.

Fortunately, as the Los Angeles Times reports, help is on the way for the people of Mexico. In the long run, firms may exit or enter the market. Unusually high short-run profits in the corn market will undoubtedly cause more farmers to plant corn in the long run. As they do, the supply of corn will shift to the right from S1 to S2. As more farmers plant corn in the long run, profits return to normal and the price of corn falls. In the long run, as the diagrams suggest, it's possible that the higher demand for ethanol will have no effect on corn and tortilla prices.

Click here for another Aplia perspective on food prices and ethanol.

Discussion Questions

1. How would a price ceiling at P* affect the Mexican tortilla market?

2. Should the Mexican government subsidize tortilla producers until corn prices fall back to previous levels? How would a subsidy—or voucher—for tortilla consumers affect the tortilla market in the short-run?

3. Are Mexicans worse off or better off due to the increase in U.S. ethanol production?

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Tuesday, February 06, 2007

Minding the Gap

In his latest Yahoo! Finance column, Charles Wheelan asks, "If we succeed in raising the incomes of the poor, does it matter if incomes at the top are rising even faster, making us a more unequal society overall?" In fact, many people care less about the absolute value of their earnings and consumption than they do about how much they earn and consume compared to their neighbors. Wheelan also points out that two very different approaches to income inequality can pose a similar threat to economic prosperity. One society's insistence on equalizing incomes can stifle economic growth, just as another's disregard for a rapidly widening gap between rich and poor can hamper growth as well. Read Wheelan's column to find out more.

Discussion Questions

1. According to Wheelan: "If the gap between rich and poor gets too large, and if those at the bottom feel they have no meaningful route to the riches at the top, then the fabric of society will fray, or even come unraveled entirely." Income inequality alone will not necessarily contribute to violence and disorder. What role does income mobility—the extent to which people move up and down the income scale—play? The New York Times has an interesting interactive graphic that offers a glimpse of income mobility in the United States.

2. "You have money spent on guarding stuff rather than making stuff." According to the World Bank study Wheelan cites, how does crime in Brazil impact economic growth? According to Wheelan, Brazil suffers not only from income inequality, but also from a lack of income mobility. How strong of a role do you think these factors play in Brazil's problems with violent crime? In what way does social disorder divert an economy's resources away from investment and the production of goods and services?

3. How do income redistribution schemes—taxing higher-income people and transferring the revenues to lower-income people—affect work and entrepreneurial incentives? What about economic growth?

4. What does a Gini coefficient measure? What does it mean to say that Brazil has a Gini coefficient of .58 and India has a Gini coefficient of .33? What do Gini coefficients tell us about the experience of the United States between 1970 and 2005?

5. Cornell economist Robert Frank asked Americans which world they'd rather live in: World A, where they earn $100,000 and everyone else earns $85,000; or World B, where they earn $110,000 (a 10% increase in purchasing power compared to World A) and everyone else earns $200,000. Which world did the majority of Americans prefer? Which would you prefer?

6. In thinking about economic policy, what question does philosopher John Rawls ask us to answer behind a veil of ignorance? In answering the question, would you think only about income inequality? What other factors might you consider?

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Monday, February 05, 2007

John, Paul, George, Ringo, Steve, and Ronald

For the past two decades, there has been a legal fight over whether consumers have had a difficult time comparing Apples to Apples. More specifically, Britain's Apple Corps Ltd.—the company started by the Beatles and currently owned by Paul McCartney, Ringo Starr, John Lennon's widow Yoko Ono, and the estate of George Harrison—was at odds with America's Apple Inc., maker of Macintosh computers and iPods, over who had the rights to the Apple name.

It may seem odd to trademark a fruit's name, although no odder, perhaps, than trademarking Sun, Amazon, Staples, or any other noun. But especially in the information age, the value of a brand name can be crucially important. Suppose I wrote a program, called it "Windows Vista," and sold it online for $30. If it looked just the same as Microsoft's Windows Vista, customers might very well be confused as to which one was the genuine article. This confusion would harm Microsoft. Similarly, argued Apple Corps, the existence of Apple Inc. using the Apple name and logo had an adverse impact on Apple Corps' business.

According to Nobel Prize–winning economist Ronald Coase, the appropriate solution in the case of externalities like this is to have a strong system of property rights. As long as the two parties can bargain with one another, an efficient solution will be reached. Today, an efficient solution was reached—although it was hardly cost-free. According to the terms of the deal announced today, Apple Inc. will own the entire Apple trademark, and will "license certain trademarks back to Apple for continued use," according to Reuters.

In many ways, this is a textbook application of the Coase Theorem. The usual example used to illustrate the Coase Theorem is that of a factory and a fishery that operate along the same river. The factory pollutes the river, which has an adverse effect on the fishery. If the two firms act separately, the factory doesn't take the costs of its pollution into account when figuring out the optimal amount to produce. If the fishery buys the factory, or vice versa, then the combined company is hurting itself when it pollutes, and so is more likely to cut back pollution to the efficient amount: that is, the amount where the marginal benefit of additional pollution to the factory is equal to the marginal cost to the fishery. Similarly, now that Apple Inc. owns the rights to both trademarks, it will presumably be careful not to diminish the Beatles' Apple image—if, indeed, being associated directly with iPods would be considered a negative in today's world.

Discussion Questions

1. Apple's Steve Jobs released a statement saying, "We love the Beatles, and it has been painful being at odds with them over these trademarks." If this dispute was essentially friendly, why did it take 20 years, and huge sums in legal fees, to resolve?

2. Many analysts are now predicting a deal that would make Beatles music—which has so far not been available on any online music service—available via Apple's iTunes. According to the Reuters article, "A source familiar with the situation told Reuters at the time that it was 'safe to assume that something sooner rather than later will happen.'" What effect, if any, do you think the prospect of selling Beatles music on iTunes had on resolving the dispute between the two Apples?

3. The two Apples had reached an agreement in 1991 stating that Apple Inc. could use the Apple logo as long as it didn't enter the music business. When Apple Inc. launched iTunes, Apple Corps sued, saying that Apple Inc. had violated that agreement. Apple Inc. countered that iTunes was just a "data transmission service." Do you think iTunes constitutes a move into the music business? Why or why not?

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