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?



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