The economics of transitioning to digital media markets

The transition from traditional media markets to digital markets was one of the dominant threads of discussion during last week’s conference.

Executives from traditional media firms who are trying to manage this transition disagreed on the best approach. This was not surprising given the complexity of the problems they face.

Here are three pictures that illustrate some of the challenges for firms that operate in multiple media markets.

This first picture shows traditional markets on the left, channels might be print, or radio and television, either broadcasting or cable.  Firms earn revenue from advertising, subscriptions, or a combination of the two.

Firms face a downward sloping demand curve because an increase in price reduces the amount of advertising or subscriptions they sell, and vice versa.  The shaded rectangle is the amount of revenue the firm generates (price x quantity  = total revenue).

On the right is a digital market where the channel might be a website on the Internet. The firm faces a downward sloping demand curve, but prevailing prices are much lower. The firm is forced to charge a fraction of its price in the traditional market.  The online audience is much larger but the total amount of revenue, shown by the shaded box, is much smaller.

Prices are lower in the digital market because of the volume of identical or close to identical media content – audiences easily can switch to a substitute if the firm raises prices.  In addition, most online advertising revenue is generated on about 50 websites, according to the Interactive Advertising Bureau.  Everyone else competes for small shares of the remaining revenue.

This next picture shows what happens as audiences continue to shift from traditional channels to digital channels. The shift is illustrated by the new demand curve in the traditional channel, which now generates considerably less revenue than before.  Even if the audience increases in the digital channel, competition keeps prices low.  The shaded box on the right shows there is not enough revenue to make up for losses in the traditional channel.

This last picture shows what can happen if a firm starts to raise digital prices because audiences find its content especially appealing.  Intense competition in the digital market might create a price ceiling, illustrated by the kinked demand curve.  When prices reach the flat portion of the demand curve, additional increases mean the firm will lose all of its customers.

The risk of this happening drives the debate about charging for access to websites.  That debate was present at the conference, and will be discussed in future postings.

But the larger point is that operating in different channels requires different strategies.  Three strategies were discussed at the conference.

One was a classic differentiation strategy - provide content tailored to the interests of different market segments – or niche audiences.

Another was a cost-reduction strategy.  Reduce costs by creating economies of scale, republish the same or similar content in different channels.  This is often referred to as convergence.

The third strategy is based on moving away from intensely competitive digital channels. Firms are trying to find less competitive channels where audiences and advertisers are more likely to pay for differentiated content.

Thinking About Buying Cable a la Carte

The Federal Communications Commission is making serious noises about new regulations for cable television, including allowing subscribers to buy channels one at a time. This idea is likely to have strong superficial appeal for anyone paying for channels that they never watch -- a group that may include most cable subscribers.

But, as Joe Nocera points out in his New York Times column, if a la Carte programming becomes a reality, subscribers are likely to regret it on the morning after. He writes artfully about the politics and likely effects of a la Carte, but leaves some larger questions untouched.

The proposal is supported by consumer groups, groups worried about sex and violence, and FCC Chairman Kevin J. Martin. This is one of several major regulatory changes being considered. The FCC is also revisiting rules on cable ownership, access to cable channels for producers of independent programs, and rules barring companies from owning newspapers and broadcast stations in the same market.

But the change in subscriptions would have the most immediate effect on consumers. Nocera does a nice job explaining why a la Carte programming would leave many subscribers paying more than they do now.

Fewer Subscribers Will Increase Cable Prices

Networks charge cable operators a fee based on the number of subscribers. Cable operators can spread the cost of, say, The History Channel across everyone who pays for the bundle that includes this channel, even if many don't watch programs about history. That keeps each subscriber's cost below the amount that would be charged if only those who watch The History Channel subscribed. This is true even for for channels with wide appeal, Nocera reports:

"Take, for instance, ESPN, which charges the highest amount of any cable network: $3 per subscriber per month. (I’m borrowing this example from a recent research note by Craig Moffett, the Sanford C. Bernstein cable analyst.) Suppose in an à la carte world, 25 percent of the nation’s cable subscribers take ESPN. If that were the case, the network would have to charge each subscriber not $3, but $12 a month to keep its revenue the same."

The proposal faces stiff opposition in congress. This is probably because legislators don't want to risk the wrath of voters if predictions like the one for ESPN prove correct.

Do Market Economics Favor a la Carte?

But what is good for cable subscribers and good for congress may not be good economics. A basic principle of market economics holds that people should only pay for things they want. If people have to pay for things they don't want, it creates distortions in the distribution of goods and the use of resources to produce those goods. Consumers end up getting more than they really want of some things, and not enough of others.

This argument suggests we may be getting too much programming about history, and too much programming about sports. (You decide which networks we don't get enough of.)

Sophisticated supporters of a la Carte are likely to make this argument, and it will carry some weight. That is because the argument holds true unless cable programs fall into the category of goods that are exceptions to some general rules of market economics.

Of Search Engines, Ad Prices, and Blind Sales

A report that Google and Yahoo are losing ad sales to an upstart might, at first glance, raise doubts about the search giants’ understanding of the advertising business. However, a closer look suggests the famously smart people at Google and Yahoo know exactly what they are doing.
The article in Monday’s New York Times reports a new company, Quigo Technologies, convinced Fox, ESPN, and Cox Enterprises to abandon the search giants as providers of text advertising. These ads appear beside your search results in response to the words you are searching for.
Quigo, unlike Yahoo and Google, tells advertisers where ads appear on the web and allows advertisers to buy ads on specific sites, the Times reports.
It may seem odd for search giants to conceal this information because advertisers target people likely to buy their products. So most advertisers want to appear on websites with content that attracts large numbers of people potentially interested in their products – if you sell sporting goods, you want to be on the big sports sites.

How Search Advertising Works

According to Advertising Age, the search giants make most of their money from these text ads.
Advertisers buy key words, and their ad appears when those words are typed in a search engine. The advertiser only pays if someone clicks on an ad. Advertisers bid a certain amount for each click, and that determines how often and where their ads appear.
The search giants display the ads on their pages and on innumerable other web sites participating in their advertising programs. The advertiser knows how many clicks it paid for, but not where the clicks came from.
If advertisers knew ads were appearing on sites they want to target, wouldn't they buy even more ads? So why is this information concealed?

Concealing Information Increases Ad Revenues

I am indebted to Roy W. Kenney and Benjamin Klein , authors of a 1983 article in the Journal of Law and Economics (cite below), for this explanation:

Advertisers consider some web sites to be better than others. They may be attracted by the large number of sites available through Google and Yahoo, but most advertisers would probably like to select some sites and ignore the rest.
But advertisers cannot select sites, so they must instead estimate the average value of a click from all sites, desired or not. Many people who click on an ad will not buy anything. And sites with small amounts of traffic probably have smaller proportions of buyers among those who do click on ads.
So the best sites will generate large numbers of clicks and many more likely buyers. Another way to think of this is that average sales per click will be much higher on the desirable sites.
If advertisers could identify the desirable sites they would bid more for those, and advertising would be concentrated there. But Google and Yahoo would be forced to sell ads for much less on the undesirable sites, and their total advertising revenue would decline.

Two Alternatives

What if Google and Yahoo instead offered to sell advertisers web sites in groups -- or bundles -- and included some less desirable sites in each bundle? Buyers would look for bundles they considered bargains, and only bid for those. The search giants would be forced to sell ads on the remaining bundles for less than buyers would pay if they did not know what bundle they were getting.
Another alternative would allow buyers to experiment, buying ads on a variety of sites to see which sites produced the best results. Advertisers would make adjustments after their initial purchase, asking the search giants to redirect ads to sites generating the most sales. But this would be costly for the search giants. It would also have the same effects on ad prices and revenues as the other alternatives.

A Change is (Probably) Gonna Come

The existing arrangements also make it possible for Google and Yahoo to distribute ads differently than expected. For example, an ad on 1,000 blogs might generate 1,000 clicks, but few buyers. The same ad on a few big news sites might generate the same 1,000 clicks and deliver far more potential buyers. Google and Yahoo are asking buyers to trust that this is not happening.
The Times article also reports some buyers are worried about click fraud. This happens when people click on ads just to generate revenue for the sites where they appear (Google and Yahoo share some of the revenue with the site).
The article says Google is planning to give advertisers more information about where ads appear. The search giant is feeling competitive heat from companies like Quigo. It will be interesting to see what happens next.

(The cite for the Kenney and Klein article, "The Economics of Block Booking," is Journal of Law and Economics, Vol. 26, No. 3. (Oct., 1983), pp. 497-540.)