Monday, January 12, 2015

How did Blockbuster's CEO solve the double marginalization problem?

Hal Varian's (Chief Economist at Google) tells the story of Blockbuster (a video "rentailer") and its distributors who suffered from "double marginalization" or "the double markup problem." In other words, competition between firms selling complementary products results in a price that is too high and output that is too low:
Consider, for example, video tape rental industry. Prior to 1998, distributors sold video tapes to rental outlets, which proceeded to rent them to end consumers. The tapes sold for around $60 apiece, far in excess of marginal cost. The rental stores, naturally enough, economized on their purchase, leading to queues for popular movies.

The old contractual form suffered from double marginalization.  This means that upstream distributors set a single price and the downstream rentailers took this upstream price ($60) as a marginal cost and priced videos at the point where MR=$60.  Since 60 was far in excess of MC (almost all of the costs of video production and video rentailing are fixed), this resulted in video rental prices that were too high and output that was too low.

The Blockbuster CEO recognized this as a problem and proposed a solution:

In 1998 the industry came up with a new contractual form: studios provided video tapes to rental stores for a price between zero and $8, and then split revenue for rentals, with the store receiving between 40 and 60 percent of rental revenues.

Consider how the new pricing scheme changed the incentives of the video rentailer.  Now the marginal revenue from renting one more video was only 50% of the old marginal revenue, but the price was only 7.5% of the old upstream price.  Now the rentailer produced up to the point where (50%)MR=(7.5%)$60.

.. these contracts increased revenue of both studios and rental outlets by about 7 percent and consumers benefitted substantially. Clearly, the revenue sharing arrangement offered a superior contractual form over the system used prior to 1998.

 This arrangement is subject of course to verification of the downstream revenue by the upstream distributor.  New "smart" cash registers at Blockbuster made this possible:

The interesting thing about this revenue-sharing arrangement is that it was made possible only because of computerized record keeping. The cash registers at Blockbuster were intelligent enough to record each rental title and send in an auditable report to the central offices. This allowed all parties in the transaction to verify that revenues were being shared in the agreed-upon way. The fact that the transaction was computer mediated allowed the firms to contract on aspects of the transaction that were previously unobservable, thereby increasing efficiency. 


More of Hal Varian's insights about economics (there are some good stories here) can be found in his popular columns.  He is most famous to MBA's for saying that "marketing is the new finance," urging the Quants, who used to go into finance, go into marketing instead.

HT:  Vlad Mares

4 comments:

  1. From 1995 to 2010 my family owed an independent retail store that sold designer dresses for special occasions. Dresses ranged in price from $500 to $5000. While I received, on average a 55% gross margin on the dresses, the real money was made on accessories and undergarments for the dresses. There were, at that time, six stores within an hour’s driving distance from my shop that sold similar items. I believe that our “strategic game” was the “simultaneous-move” game. While we kept tabs on the competition, we did not create our pricing or advertising strategies on what the competition was doing. This was a service business and we were serving women with means, a non-loyal, fickle clientele. Some of our dresses were in larger department stores for less money. We did not change our price to meet department store prices. Rather we held our ground and counted on our quality of service, fine seamstress and other intangibles to create a rather fine profit margin and the store was successful for many years.

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  2. While this post described the effects that took place in the Blockbuster stores, it doesn’t address another issue that also impacted and likely forced the new shared-revenue type arrangement. Because they were pricing videos at higher prices ($60), the distributors had priced them out of the consumer price range. Their entire market was strictly video rental chains like Blockbuster. However, by lowering the price they charged Blockbuster, the movie companies also were able to expand the consumer purchase market by selling videos at prices we are used to today. This same issue surfaced a couple years ago, when Redbox (a video rental kiosk company) was sending employees to Walmart to buy DVDs for its kiosks. The movie companies were practicing a form of price discrimination in which they charged retailers a price set for consumers and Redbox a higher price for the rental industry. However, as this article explains, Redbox simply found that it could be the consumer and bypass the higher prices. http://www.businessinsider.com/redbox-employee-buys-100-dvds-at-wal-mart-to-stock-kiosks-2009-12

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