Tuesday, September 21, 2010

D is for Demand: Sources of Success of 3-D Movies

According to the Wall Street Journal, 2009 was the first year since 2002 where sales at the U.S. box office beat those of DVD releases by passing the $10 billion mark. The success of Avatar has certainly ramped up the industry with its worldwide revenue of more than $2.7 billion; such an amount is comparable to the GDP of a small but affluent country like Barbados! Also interesting is the recent trend in increasing ticket prices: Prices of domestic movie tickets, according to the Los Angeles Times, have increased by more than 10% in the first few months of 2010. Specifically, not only is a 3-D movie ticket sold with an average surcharge of $4 over the 2-D ticket prices, 2-D tickets are also up by roughly 4%. Similar to books and cars, the market for movies is monopolistically competitive. Every movie is a separate product that faces competition from a multitude of similar but not identical products, namely, other movies. Entry of new products normally puts a downward pressure on the prices of existing products and the average market price overall. So, the question is: Why, despite the increased competition, have prices gone up for both formats? Why are people willing to pay significantly more to go to the movies?

Just as in the case of many other goods, the demand for movies is sensitive to the changes in ticket prices. The extent of sensitivity, which economists term price elasticity of demand, can be different for different movies because it is determined by a number of factors such as availability and prices of similar goods (substitutes), the number of consumers, and tastes and habits. The demand for goods that have many close substitutes is typically more elastic than for goods with fewer substitutes. The reason for this is that when the price increases, consumers have the option to buy other similar and potentially less expensive products. For example, when the ticket price of a traditional movie increases, more viewers are likely to decide to watch the film on DVD. This is especially true as improvements in technology have made such substitutes as DVDs, Blu-Ray Discs, On Demand products, and streaming Netflix accounts easily available. Thus, generally increasing prices of movie tickets might not boost revenues, as the decrease in sales (quantity demanded) may wipe out any gains that would arise from the price increase. But if this is the case, then how can we explain the fact that movie theaters are receiving record-breaking revenues while ticket prices are increasing?

For a long time, 3-D films have not made any noticeable impact on the industry, but James Cameron’s inventive cinematography created a new product, a dramatically different viewing experience, which shook the entire market for entertainment. Movie theater technology was updated to accommodate mass screenings, and other directors and studios followed suit. Since Avatar’s release, 3-D movies have generated more than one-third of all domestic movie revenue. At least some of the factors responsible for the price elasticity of demand for movies have changed. It is hard and relatively expensive to replicate a 3-D experience outside of the movie theater. Thus, the 3-D format has fewer close substitutes, as home theaters with 3-D capabilities are still rare and quite expensive to install, which lures more viewers out to 3-D screenings despite more expensive tickets. The demand for 3-D movies is, therefore, less elastic, which creates the opportunity for the producers and movie theaters who deliver these products to the consumers to charge higher prices.

At the same time, the 2-D and 3-D markets are intertwined as the number of movie theaters and seats is limited, at least in the short-run. Thus, the story would not be complete without taking into account theater operators’ decisions about prices and allocation of seats. The necessary reduction in the number of rooms where 2-D movies are shown shifts the supply of 2-D to the left, which drives the price of that traditional format up despite the reduction in its demand. So, ultimately, rising prices of both formats have different (although related) explanations. If the industry experiences more consumer interest in its new products, like we see with Avatar, the result is growing revenues along with higher average prices.

While it is possible that the spectacular success of Avatar was a sort of surprise attack on the consumer followed by a box office record, the systemic changes it brought to the movie industry suggest that the effects will be longer-lived. Due to the advent of the 3-D movie format that can show in regular theaters, more movies are money-makers now than before. This situation is likely to persist for some time until affordable home theaters catch up in quality and increase the competitive pressure on the movie theaters.

Discussion Questions:

1. Similar to how Napster was used as an illegal medium to download music, online services are emerging for downloading movies in theaters not yet released for home viewing. How might this affect the price elasticity of demand for movie ticket sales? How might 3-D movies be protected from this type of piracy?

2. The “second law of demand” implies that price elasticity of demand is greater in the long run. How and why might moviegoers’ behavior change in the long-run? What would this mean for theater owners?

3. The explanation offered here is based on the assumption that 2-D and 3-D movies co-exist in the market for entertainment. Do you agree or disagree? What would be an alternative approach to explain the rising average prices of movie tickets?


Thursday, September 02, 2010

Cherry Picking: An Economist’s Guide to Used Cars

After recently moving, I needed a used car that was both well maintained and reasonably priced. However, there was a problem: I am not a car expert. The prospect of finding a cherry, or a used car that’s worth its price, among the thousands of available cars in my area seemed a little daunting. Fortunately, by turning my search into an economic exercise, I was able to demystify the process and ease my nerves about making such a significant investment choice.

Used cars have been a popular topic in economics since George Akerlof (who eventually won the Noble Prize in Economics for his work on the subject) described how the market for used cars can be affected by imperfect information. A key premise in Dr. Akerlof’s work is the idea of asymmetric information: a scenario where one party has access to information that the other party does not. In his most famous paper on the subject, “The Market for Lemons: Quality Uncertainty and the Market Mechanism,” Akerlof argues that in any market where rational people are met with asymmetric information, eventually the only goods for sale will be those that are not worth buying. Economists use the term adverse selection to describe this idea. When a market suffers from adverse selection, skepticism affects the prices that buyers are willing to pay. The downward pressure on prices drives out the high-quality sellers. Ultimately, the only sellers left at a given price level will be those of low quality. When buyers eventually realize that the only cars available are of low quality, they will decide not to buy any cars at all. Now you can understand why I was feeling a little overwhelmed about the whole process of buying a used car.

Thankfully, the research didn’t end there. Joseph Stiglitz (who shared in Dr. Akerlof’s Noble Prize) developed the notion of screening as a method to get around the difficulties of asymmetric information. Screening is a way for both sides of a deal to use what they already know to learn about hidden information. By reducing the level of asymmetric information, Stiglitz argued that you could avoid situations of adverse selection. Knowing this, I started to put together some tools that would help me to screen my potential sellers.

I first used car-pricing guides to give me a general sense of when a seller was giving a fair price. If I couldn’t trust a seller to give an honest price, I certainly couldn’t trust the seller to be honest about other aspects of the car. I also requested reports that outlined what work had been done on the cars. In addition, I asked my car-savvy uncle to help me spot work that may have gone unreported. When requesting these reports, I judged the sellers’ reactions. Those with high-quality cars had nothing to fear from the increased inspection, while nervous sellers made me nervous. One desperate seller attempted to drop his price by nearly 20% when I told him I’d be back in a day with my uncle. Needless to say, we didn’t make it back to look at that car!

With patience, I found a nice prospect at a dealership that didn’t typically sell used cars. As it turned out, the previous owner had traded in her commuter car for a discount on something a bit more…luxurious. Before it was accepted as a viable trade-in, the car had to pass an inspection by the dealership, in addition to the standard state inspection. The dealer was also happy to meet my uncle and answer any questions he had about the vehicle. By exhibiting a willingness to provide as much information as possible on the car’s history, the dealer was using a technique called signaling. Michael Spence (who also shared in Dr. Akerlof’s Noble Prize) developed an explanation of how signaling is used by the person with more information in a particular deal to inform the other side about quality. In his willingness to let me explore the potential problems of the car, the dealer was trying to signal that he was confident about its quality and that it was worth my investment.

The inspections checked out, and the asking price was right on target with what my pricing guide suggested—I had found myself a car! By using my head and applying a little economic theory, a seemingly impossible task turned out to be fairly easy and nearly fun. Spread over about a week and a half, the process took about 15 hours. Only time will tell if it was worth the temporal and monetary investment, but, after a month of driving the car pretty vigorously, I’m confident that I found a cherry.

Discussion Questions:

1. How could car sellers that are really confident about the quality of their cars guarantee value? Why are used car sellers hard-pressed to offer such guarantees?

2. Signaling is a helpful tool when a transaction suffers from asymmetric information. Can you think of how signaling is used in the job market? What are some ways that prospective employees can use signaling to their advantage?

3. How do markets for products besides cars (like books or classes offered) suffer from asymmetric information? What tools have you have used to make more informed choices?

Labels: ,