Saturday, November 19, 2016

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

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

1 comment:

  1. Hal Varian is impressive. Interestingly, his career as an economist was inspired by a sci-fi novel:

    "In Isaac Asimov's first Foundation Trilogy, there was a character who basically constructed mathematical models of society, and I thought this was a really exciting idea. When I went to college, I looked around for that subject. It turned out to be economics."