Coordination in Two-Sided Markets: Open Networks in the TV Industry

Transcription

1 Coordination in Two-Sided Markets: Open Networks in the TV Industry Hans Jarle Kind Norwegian School of Economics and Business Administration Tore Nilssen University of Oslo Lars Sørgard Norwegian School of Economics and Business Administration January 8, 2010 Abstract The purpose of this article is to analyze how a change in the role of the distributor in the TV industry, a two-sided market serving both advertisers and viewers, a ects the equilibrium outcome. The starting point is the present situation in many countries, where the distributor sets end-user prices and the TV channels set advertising prices. We compare the outcome from such a market structure with a situation where the TV channels set both advertising Thanks to Esther Ann Bøler for research assistance. Parts of this research have been funded by xxx. 1

2 prices and end-user prices. It is shown that a shift to such a market structure, called open network, leads to lower end-user prices and higher advertising prices. We also nd that consumers are better o and the joint pro t of the TV channels and the distributor is higher with open networks. 2

3 1 Introduction Distributors in the TV industry - such as cable operators and satellite operators - have a price-setting role in many countries. They set prices to the end users for access to content, and in that respect act as retailers for the TV channels. However, the distributors role may change quite dramatically in the near future. One development is the growth in broadband Internet connections for private households that makes it possible for TV channels to bypass the traditional distributor. In some countries, for example in Norway and Denmark, we have also seen a debate about whether TV channels should have direct access to the viewers in the existing networks and thereby directly set end-user prices for their own products. This suggests that distributors role in the TV market may change from setting prices to end-users to simply becoming providers of access to TV content for consumers. The purpose of this article is to investigate how such a transition towards an open network will a ect pricing in the TV industry. The TV industry is an example of a two-sided market, serving both advertisers and viewers. The two groups exert externalities on each other: advertisers exert negative externalities on viewers who dislike being interrupted by advertising, while viewers exert positive externalities on advertisers who like the attention of viewers for their advertisments. These externalities constitute a challenge for a TV channel in setting its advertising prices and viewer prices, since there is a need to coordinate these prices. In the present market structure in most countries, viewer prices are set by the distributor bringing TV content to viewers homes. While this may have the potential bene t for the industry that TV channels do not have to compete in these viewer prices, the disadvantage is that viewer prices and advertising prices are less coordinated this way. A transition to an open network helps in this respect: At the cost of competition in viewer prices, TV channels are better able to accommodate the externalities between viewers and advertisers since they now set both prices. There are thus costs and bene ts associated with such a change. In our analysis below, we show that a transition to an open network would lead to higher joint

4 pro ts for the TV channels and the distributor. Interestingly, we nd that this change in market structure would also bene t consumers. This is so even though the distributor is allowed to set access prices and thereby in ict high end-user prices. To capture the mechanisms at work, we employ a simple model with one distributor and two TV channels. We present two versions of the model. In both versions, the TV channels set advertising prices non-cooperatively, while access prices, consisting of a xed fee and a price per unit, are set jointly by the TV channels and the distributor in order to maximize their joint pro ts. In one version of the model, called market structure D, the distributor sets end-user prices. This mirrors the present situation in many countries. In the other version of the model, called market structure T, end-user prices are set noncooperatively by the TV channels. This mirrors the open network market structure. Thus, the only di erence between the two versions is how prices are coordinated. Obviously, a shift to an open network leads to a competitive pressure on enduser prices. To mitigate this e ect, the distributor and the TV channels agree on access prices to be paid by the TV channels that are higher the closer substitutes the channels products are, that is, the larger the competitive pressure is. The TV channels respond by setting lower advertising prices, since this leads to a reduction in the audience and thereby a reduction in the channels access costs. Coordination of advertising prices and end-user prices through the access prices can therefore not lead to a rst best outcome for the rms. Rather, it leads to end-user prices that are too low and advertising levels that are too high. Despite the distortion of prices in an open network, it turns out that both consumers and rms are better o in an open network than in a market structure where the distributor sets end-user prices. To understand why, consider the case where the two products are independent in viewers demand. In this case there is no horizontal coordination problem, only a vertical coordination problem within each vertical structure. When the TV channels set both end-user and advertising prices, they behave as if they maximize joint pro ts when their products are unrelated. This avoids any double marginalization problem associated with di erent rms setting advertising and end-user prices and therefore also bene ts consumers. If the dis- 1

5 tributor sets end-user prices, on the other hand, there is no vertical coordination. It sets higher end-user prices than those that maximize joint pro ts, because it does not take into account the negative e ect of high end-user prices on the advertising revenues. Our results hinge on the TV channels and the distributor being able to jointly set access prices and thereby in uence end-user prices and advertising prices. such e cient bargaining is not possible, for example because the rms are restricted to using lump sum fees with no per-viewer elements, these rms are worse o with an open network if products are su ciently close substitutes. The reason is that, with close substitutes, competition between the TV channels leads to low end-user prices, and this makes it more pro table for the rms to have horizontal rather than vertical coordination. The rms are thus jointly better o with a market structure where the distributor sets both end-user prices. Media industries in general, and the TV industry in particular, have been the subject of a number of important studies in recent years. Some of these studies - such as Gabszewicz, et al. (2004), Anderson and Coate (2005), and Kind, et al. (2007, 2009) - have emphasized how important it is to take the view that these industries are two-sided markets, serving both content consumers and advertisers, two groups that exert externalities on each other. In the present paper, we bring this discussion a step further, by taking into account the fact that TV viewers are served through distribution of TV signals to the households. 1 What we nd is that the industry s two-sidedness creates a need for coordinating viewer prices and advertising prices that is not present in one-sided industries. Accordingly, there is less scope for the distributor, or retailer, having control of prices to consumers when the industry is two-sided. We are, of course, not the rst to discuss vertical relations between TV channels and TV distributors. 2 One strand of the literature focuses mainly on the e ects of 1 The distribution is through either digital terrestrial TV, direct broadcast satellites, or cables. Since the recent digitization of the TV industry, analog free-to-air transmission has declined. 2 Incidentally, vertical relations are an issue also in Barros, et al. (2004), but they focus on relations between media rms and advertisers, rather than between media rms and distributors, as we do here. 2 If

6 exclusive distribution of premium content, and there is no or very little discussion of the role played by advertising on the issue of exclusive distribution; see Armstrong (1999), Stennek (2007), Hagiu and Lee (2008), and Weeds (2009). In a slightly di erent vein, Crawford and Cullen (2007) and Crawford and Yurukoglu (2009) discuss a TV distributor s bundling of TV channels; again, the role of advertising on TV is not studied. In markets with two-sidedness where, at the same time, distribution plays a key role, such as most media industries, it is crucial to understand the interplay between the externalities between user groups on the one hand and the way the services are delivered and priced on the other. The only other paper we know of discussing the role of distribution in a two-sided market is by Bel, et al. (2007). In contrast to us, however, they focus on a situation where one rm is vertically integrated, controlling both the distribution and the program production. They do not, as we do here, compare the two regimes of distributors and TV channels setting end-user prices. Our vision of TV distribution is as an intermediary between content consumers on one side and the two-sided TV industry on the other. An alternative picture, has the distribution industry itself as a two-sided market, with consumers gaining from the presence of more content providers in a distributor s portfolio, and content providers gaining from an increase in a distributor s customer base. An example of this latter approach is the work of Economides and Tåg (2009). They view internet service provision as a two-sided market and nd arguments in favour of net neutrality on the Internet. Our work can be related to this by noting that also content provision on the internet is a two-sided market, with advertisers on internet sites exerting a negative externality on consumers, while these consumers exert a positive externality on the advertisers. Our results can be interpreted, in the Internet setting, as arguing against net neutrality, exactly because of these externalities between advertisers and content consumers. By giving up on net neutrality, content providers and Internet service providers are better able to do that coordination of prices that these externalities call for. With our focus on relations between producers and their distributor, we con- 3

7 tribute to the more general literature on vertical relations, as surveyed by, e.g., Katz (1989) and Rey and Tirole (2007), by taking up an issue particularly pertinent to two-sided markets: a rm in a two-sided market has a need to coordinate its prices to its two user groups. Such coordination is di cult if control over end-user prices for consumers is with the distributor. The rest of the paper is organized as follows. In Section 2 we present the rules of the game and our model. In Section 3 we solve the game for the market structure where the distributor sets end-user prices, while we in Section 4 solve the game for the market structure with open networks. The outcome in those two market structures are compared in Section 5, and in Section 6 we o er some concluding remarks. 2 The model We consider a setting with two competing TV channels earning revenues from advertising and consumer payments. The level of advertising in TV channel i is denoted A i ; and consumer demand is denoted C i, i = 1; 2. The TV channels transmit their contents through a distributor, i.e., a downstream rm that the upstream TV channels must go through to reach the viewers. We compare two di erent market structures. In market structure D, the distributor is the price setter in the end-user market, receiving a price p i 0 from each viewer. At the same time, TV channel i receives a price f i? 0 for each viewer from the distributor and a xed fee F i? 0. TV channel i sets a price of advertising r i on its own channel. This market structure mirrors the one which at present is observed in most TV markets, where the distributor sets prices to end-users. In market structure T, the distributor has no price-setting role. Instead, TV channel i sets a price p i to viewers for watching its programs. The payment from TV channel i to the distributor is equal to w i? 0 per unit and a xed fee W i? 0. We label this the open network market structure. Advertising prices are assumed to be quite exible, since TV channels can easily change those prices. On the other hand, end-use prices are expected to be less exible 4

8 since end-users typically write contracts for some period of time. In line with this, we set up a three-stage game and let advertising prices be set at stage 3 and enduser prices at stage 2. Access prices F (or W ) and f (or w) are determined through negotiations between TV channels and the distributor, and such negotiations might take place only once a year. Thus, we let access prices be set at stage 1. Any joint price setting by TV channels and the distributor of prices to end-users and advertisers would be a violation of antitrust rules. We therefore let end-user prices and advertising prices be set non-cooperatively at stages 2 and 3, meaning that each rm sets those prices to maximize own pro ts. Access prices, on the other hand, are set jointly by the rms. In particular, the variable access price f (or w in an open network) is set such that industry pro ts is maximized. The xed fee F (or W in an open network) is then simply a way to transfer pro ts between TV channels and the distributor, and determined by each player s bargaining power. Summarizing, in market structure D, the rules of the game are: Stage 1. The access prices F and f are set jointly. Stage 2. The distributor sets the end-user prices (p 1 and p 2 ): Stage 3. The TV channels set advertising prices (r 1 and r 2 ) non-cooperatively. The rules of the game in market structure T are similarly given by: Stage 1. The access prices W and w are set jointly. Stage 2. The TV channels set the end-user prices (p 1 and p 2 ) non-cooperatively. Stage 3. The TV channels set advertising prices (r 1 and r 2 ) non-cooperatively. We follow Kind et al. (2007, 2009) and let consumer preferences be given by the following quadratic utility function: U = C 1 + C 2 h(1 s) (C 1 + C 2 ) 2 + s 2 (C 1 + C 2 ) 2i : (1) The parameter s 2 [0; 1) is a measure of product di erentiation; the viewers perceive the TV channels products as completely unrelated if s = 0 and as perfect substitutes in the limit as s! Utility function (1) is due to Shubik and Levitan (1980). The merit of using this utility function is that market size does not vary with s. Our qualitative results would go through also with a standard quadratic utility function, but then an increase in s would both reduce the size of the 5

9 Consumer surplus depends not only on the price that the consumers are charged for the TV channels, but also on the level of advertising. To capture this dependency, we let the generalized price for watching channel i be given by G i p i + A i, where measures the consumers disutility of the ads. Consumer surplus can thus be written as CS = U (G 1 C 1 + G 2 C 2 ) : From the consumer surplus we can derive the demand for each media product i = 0 and solving: C i = 1 2 (2 s) (A i + p i ) 4 (1 s) + s (A j + p j ) ; i; j = 1; 2; i 6= j: (2) 4 (1 s) There is a total of n advertisers interesting in buying advertising space at the two TV channels. Advertiser k has the following pro t function: k = (A 1k C 1 + A 2k C 2 ) (r 1 A 1k + r 2 A 2k ) ; (3) where is a measure of the e ect of a unit of advertising per viewer exposed to it, A ik is the quantity of advertising purchased by advertiser k at TV channel i, and r i is the advertising charged by TV channel i for one unit of advertising. Maximizing (3) with respect to A 1 and A 2 ; subject to (2), we nd demand for advertising at TV channel i: A i = n (1 p i ) 2r i + s(r i r j ) 1 + n 2 As this expression shows, the number of advertisers merely serves to scale the total advertising demand. are set, we set n = 1 in the following. (4) In order to focus on the role of how end-user prices We also simplify further by setting the parameters and, determining how strongly advertising a ects advertisers and viewers, respectively, at values that facilitate algebra. Formally, we state: Assumption 1: n = = = 1. market and increases the substitutability between the TV channels. See Motta (2004) for further discussion. 6

10 With this simpli cation we have: 4 Remark 1: Joint pro ts for the distributor and the TV channels are maximized for p = p opt 1 and A = 2 Aopt 0 (such that G opt = 1 ) for any s 2 [0; 1). 2 3 The distributor sets end-user prices In case D, the distributor sets the end-user prices. pro ts of the distributor () and TV channel i ( i ) are given by = With this market structure, 2X (p i f)c i 2F and i = r i A i + fc i + F; i = 1; 2; (5) i=1 where f? 0 and F? 0 are the per-viewer fee and the xed fee, respectively, that a TV channel receives from the distributor. At stage 3, each TV channel chooses its advertising price. i rise to the reaction function r i (r j ) = 1 + f p i sr j ; i; j = 1; 2; i 6= j: 2 (2 s) = 0 gives Note that dr i(r j ) dp i < 0: an increase in p i reduces the audience and thus advertising demand on channel i, which in turn necessitates a lower advertising price. Secondly, we have dr i(r j ) dr j < 0: the higher is the advertising price on channel j; the less advertising will that channel have, and the more attractive will it be for the viewers. This makes the rival (channel i) relatively less attractive, such that it will have to reduce its advertising price. This implies that advertising prices are strategic substitutes = 0, we nd that prices at the nal stage are given by r i = (4 3s) (1 + f) 2 (2 s) p i + sp j ; i; j = 1; 2; i 6= j: (6) (4 s) (4 3s) 4 Note that only the relative value = matters. Speci cally, we would have A opt > 0 if = > 1 (while A opt = 0 would be optimal also when = < 1). Putting the two equal to unity is merely a matter of normalization. 5 This is a mechanism that is present in other models of the media market, see for example Nilssen and Sørgard (2001), Gabszewicz et al. (2004), and Kind et al. (2009). 7

11 Equation (6) shows that channel i s advertising price is decreasing in p i ( dr i dp i < 0), as we should expect from the reaction function r i (r j ). Furthermore, we see that dr i dp j > 0 for s > 0: an increase in p j reduces channel j s audience and therefore its advertising price r j, and with advertising prices being strategic substitutes this increases r i. Finally, note that dr i df > 0: the higher is the per-viewer price that the channel receives from the distributor, the more does it gain from having a large audience and so, if f increases, it will charge a higher advertising price and sell less advertising space in order to attract a larger audience. We will in the continuation put a cap on f to ensure that it is not so large that advertising is brought down to zero. In particular, we assume that f < f := this in fact holds in equilibrium. (2 s)(6 s) (10 s)(4 s) and will later verify that At stage 2, the distributor chooses those p 1 and p 2 that maximizes, taking (6) into account. Our problem has a unique symmetric solution, so we can omit subscripts. The end-user price can be written as Combining (2), (4), (6) and (7), we have p = s f: (7) 2(6 s) r = 1 2 (4 s) (6 s) f; A = 2 s 4 (4 s) 10 s 4 (6 s) f; C = 6 s 8 (4 s) 1 f: (8) 8 The mere fact that the advertising volume is decreasing in the per-viewer fee ( da df < 0) allows the distributor to set an end-user price that is increasing in f. Additionally, a higher f means that the distributor s perceived marginal costs increase. This magni es the positive relationship between p and f; and implies that there might exist a double marginalization problem if f > 0: Not surprisingly, we therefore nd that the generalized viewer price, G = p + A = s + 1f > 2 4(4 s) 4 Gopt ; is higher than the one maximizing joint pro ts (G opt = p opt = 1=2). At stage 1, f is set such as to maximize aggregate pro ts for the distributor and the TV channels. However, it is often argued that a per-viewer fee f 6= 0 is di cult to sustain because of problems of commitment: if the distributor and the TV channels have agreed on a particular f, the distributor may have incentives to 8

12 meet with one of the channels in order to renegotiate the agreed-upon fee; see, e.g., Rey and Vergé (2008, Sec ) for a general discussion, and Armstrong (1999) and Stennek (2007) for analyses of TV distribution with no per-viewer fees. We therefore start out with considering the case where f is xed at zero. Remark 2: Suppose that the wholesale contracts consist of a xed fee only ( f = 0). Then advertising volumes are decreasing in s ( da ds prices are independent of s ( dp = 0). ds < 0), while end-user The result that the end-user prices are independent of the substitutability between the media products, is in stark contrast to what we typically nd in one-sided markets. To understand this seemingly counter-intuitive results, note that the TV channels attract viewers by having a limited volume of advertising on its own channel. The closer substitutes the TV channels are, the more they compete in having few advertising slots (and the higher will the advertising prices be). 6 This, in turn, a ects the end-user prices. A more limited volume of advertising makes the media products more attractive for the viewers, and the distributor can exploit this by not setting lower end-user prices. We now turn to the case where, at stage 1, rms pick f in order to maximize joint pro ts. As noted in Remark 1, joint pro ts are maximized if there is no advertising (A = A opt = 0) and p = p opt = 1=2. This outcome is in general not achievable since rms are not allowed to collude on prices. However, at stage 1, they can, through their choice of f, in uence subsequent decisions on both advertising levels and enduser prices. It should be noted, though, that the rms face a trade-o when they set f: Equations (7) and (8) make it clear that a positive f will move the end-user price in the wrong direction and the advertising volume in the correct direction compared to rst-best industry-optimum, and vice versa for a negative f. At the outset it is therefore not clear what is the optimal sign of f. Intuition might nonetheless lead us to expect that f should be positive. The reason for this is that a positive f both has a harmful and a bene cial e ect on the distributor s pro t; on the one hand it tends to reduce his pro t margin, which is 6 This result was rst shown in Barros et al. (2004). 9

13 bad, but on the other hand it also reduces the advertising volume, which is good for the distributor. At the same time a slightly positive f is unambiguously positive for the TV channels. 7 Setting d ( ) =df = 0 we nd f = f 2 (6 s) (2 s) (4 s) 4 + (8 s) 2 2 0; f ; By inserting for (9) into (7) and (8), we have: df ds < 0. (9) Proposition 1. When the per-viewer fee f is set so as to maximize joint pro ts for the distributor and the TV channels, i.e., f = f > 0, then a) end-user prices and advertising levels are above industry optimum ( p > p opt and A > A opt ), and b) the closer substitutes are the TV channels products, - the lower is the access price ( df ds < 0) - the lower are end-user prices ( dp ds - the higher are advertising prices ( dr ), and ds - the larger are the audiences ( dc > 0). ds < 0) and advertising levels ( da ds < 0) The property that dc > 0 is well known from one-sided markets: a closer substitutability between goods increases the competitive pressure and thus also ds consumption. However, the result that the viewer price p is increasing in the substitutability is in stark contrast to what we typically nd in one-sided markets. The intuition is the same as with Remark 2 above. The TV channels attract viewers by having a limited volume of advertising on its own channel. A more limited volume of advertising makes the media products more attractive for the viewers, and the distributor can exploit this by setting higher end-user prices. Proposition 1 shows that end-user prices and advertising levels are closer to rstbest industry optimum the higher is s:this has the following interesting implication: 7 To see these e ects for the two groups of agents, we di erentiate their pro ts with respect to f to nd d df = 4 s 4(6 s) f 1 d(1+2) 4, and df = s 46 13s+s 2 2(6 s)(4 s) f. From these expressions 2(6 s) 2 we immediately see that it must be optimal to set f positive; a small increase in f from f = 0 yields a net increase in industry pro t equal to 2 s 2(6 s)(4 s) : 10

14 Corollary 1. At the optimum per-viewer fee f = f, total industry pro t is higher the closer substitutes are the TV channels products. The intuition for Corollary 1 is as follows. The distributor partly internalizes the competition between the TV channels, since it sets the end-user prices for both channels. However, the distributor cannot control advertising volumes, and these are too high from the industry s point of view. The reason is that the TV channels sell the amount of advertising space that maximizes their own operating pro ts, without taking into account how this reduces income for the distributor. This is a negative vertical externality, but the stronger is the competition between the TV channels, the less advertising will they carry. Tougher competition between the TV channels thereby reduces the strength of the negative vertical externality, and increases aggregate pro ts. 4 Open Networks In case T, with open networks, pro ts of the distributor and the TV channels are equal to = w(c 1 + C 2 ) 2W and i = (p i w)c 1 + r i A i + W; (10) where w is the price that the distributor receives from a TV channel for each viewer. Note that the access price w is modeled as a variable cost for the TV channels, while the per-viewer fee f in the previous section is modeled as a variable cost for the distributor. At stage 3, each TV channel chooses its advertising price. i the reaction function = 0 yields r i (r j ) = 1 w sr j ; i; j = 1; 2; i 6= j; (11) 2 (2 s) where we again note that advertising prices are strategic substitutes ( dr i(r j ) dr j < 0). Solving the rst-order conditions for the two TV channels simultaneously implies that r i = 1 w ; i = 1; 2: (12) 4 s 11

15 At stage 2, the TV channels set subscription fees. The reaction function is now given by p i = 2 (1 s) + (2 s) w + sp j ; i; j = 1; 2; i 6= j: (13) 2 (2 s) We thus have the standard result that end-user prices are strategic complements ( dp i(p j ) dp j > 0). Solving (13) simultaneously for i = 1; 2, and dropping subscripts because of symmetry, we nd that the outcome of the second stage is which further implies that p = 2 (1 s) 4 3s + 2 s 4 3s w (14) r = 1 4 s (1 w) ; A = s s + s2 (1 w) ; and C = (1 w) : 2 (4 3s) (4 s) 4 (4 3s) (4 s) (15) This implies that the end-user price that the TV channels set at stage 2 is increasing in the access price w, but at a lower rate: margin (p dp dw 2 (0; 1), so that the price w) is reduced when w is increased. With a higher end-user price, there is also naturally a lower audience, and thus a lower demand for advertising and a lower price of advertising. Note also from (14) that (provided w > 1) p is decreasing in s and approaches w as s! 1; competition presses the end-user price down to marginal costs if the consumers perceive the TV channels products to be perfect substitutes. In such a case the industry is bound to earn revenue solely from advertising. The reason why advertising is pro table even when the TV products are close to perfect substitutes is (as noted above) that advertising prices are strategic substitutes, implying a relatively mild form of competition; see Kind, et al., 2009, for a thorough discussion. Let us again, as we did in the analysis of case D above, consider the case without per-viewer fees, i.e., where w = 0; so that pro ts are shifted between the distributor and the TV channels solely by the use of the xed fee W. In addition to the argument for this case put forward earlier, an open network with no per-viewer fee has a strong resemblance to the current regime in internet provision, net neutrality, as discussed in teh introduction. As will be noted later, our analysis may have a bearing on the current debate over the virtue of net neutrality. We have: 12

16 Remark 3: Suppose that the wholesale contracts consist of a xed fee only ( w = 0). Then advertising volumes are increasing in s ( da ds prices are decreasing in s ( dp < 0), with lim ds s!1 p = 0. > 0), while end-user Competition between the TV channels implies that end-user prices are too low and advertising levels too high compared to industry optimum (p < p opt ; A > A opt ) when w = 0 and s > 0. Equations (14) and (15) further imply that dp dw da dw > 0 and < 0 for w = 0. This suggests that, when the per-viewer fee can be set freely, w should be positive in order to maximize joint pro ts. This is con rmed by solving max ( ) ; which yields where w = w Ms 4 (4 3s) (2 s) s s 3 > 0; M := 1 4 (2 s) (4 3s) (4 s) + s 4 : Inserting for (16) into (14) and (15) we further nd that dw ds > 0; (16) p = 1 2 Ms 2 (4 3s) ; r = 1 2 M 4 (4 3s) + s 2 (4 3s) ; (17) A = 1 4 Ms2 4 (4 3s) + s 2 ; and C = 1 8 M 4 (4 3s) + s 2 2 : (18) Using equations (16) - (18) we can state: Proposition 2. When the access price w is set so as to maximize joint pro ts for the distributor and the TV channels, i.e., w = w > 0, then a) end-user prices are too low and advertising levels too high compared to industry optimum (p < p opt and A > A opt ) for s > 0; b) the closer substitutes are the TV channels products, - the higher is the access price ( dw ds > 0) - the lower are end-user prices ( dp ds ( da > 0) ds - the lower are advertising prices ( dr ds < 0) - the smaller are the audiences ( dc ds < 0). < 0) and the higher are advertising levels 13

17 Tougher competition (higher s) leads to a higher access price, but also to lower end-user prices p. An increase in s has two e ects on p: a direct one which is negative, as noted above, and an indirect one through the access price w, which is positive. The direct e ect is the dominant one. Thus, we obtain a result of the same avour as seen in Kind, et al. (2009) in a model where distribution was not incorporated: More similar TV content implies that the TV channels must rely increasingly on advertising as a source of revenue. Note from equation (16) that w = 0 at s = 0. Each TV channel is in this case a monopolist in its own market segment, and chooses end-user prices and advertising prices that maximize both individual and aggregate industry pro ts (p = p opt = 1=2 and A = A opt = 0). For higher values of s there will be a deviation between equilibrium prices and equilibrium advertising levels compared to industry optimum, and more so the higher is s: It can thus be shown that: Corollary 2: At the optimal access price w, total industry pro t is lower the closer substitutes are the TV channels products. It might seem surprising that w is set so low that p < p opt for s 2 (0; 1); by having w somewhat higher than w, the TV channels would set end-user prices closer to industry optimum. The same would be true for advertising levels, since A > A opt and da=dw < 0: However, the larger is s, the lower will the TV channels pro t margin (p w) be. This in turn gives the TV channels incentives to sell more advertising space (by setting a low advertising price) even though this reduces the size of the audiences. Put di erently, the stronger is the competition between the channels, the stronger is the horizontal externality between the TV channels which generates too much advertising. Setting w such that we always have p = p opt would therefore excessively increase viewers generalized price and excessively reduce the number of viewers when the TV channels products become closer substitutes. It is therefore optimal to set w such that p < p opt. It should be noted, though, that this does not prevent the generalized price from being an increasing function of s: dg ds = M 2 s 3 (8 3s) 4 (4 3s) + s 2 > 0: (19) 14

18 5 A comparison Let us now compare market structures D and T. In market structure D, the distributor sets the end-user prices. This way, the two TV channels viewer prices get coordinated, but at the cost of not being coordinated with advertising prices. We might say this market structure exhibits horizontal price coordination, but not vertical coordination. In market structure T, TV channels themselves set end-user prices, ensuring that these prices are coordinated with the advertising prices, but at the cost of the two TV channels viewer prices not being coordinated with each other. We might say this market structure exhibits vertical price coordination, but no horizontal coordination. These di erences in price coordination lead to large di erences in outcomes in the two market structures. We consider rst a case where the variable fees are zero, f = 0 or w = 0, with the corresponding xed fee F or W being set in order to shift pro ts between the distributor and the TV channels. The curves D and T in Figure 1 show total industry pro t in market structures D and T, respectively. Market structure T must necessarily be the most pro table one at s = 0, which depicts a case where each TV channel is monopolist in its own market segment so that those advertising and enduser prices maximizing individual pro ts also maximize aggregate pro ts. When s approaches 1, on the other hand, end-user prices are pressed down to marginal costs at zero, due to competition, when they are controlled by the channels, i.e., in market structure T. So for s close to 1, market structure D, where end-user prices are coordinated by the distributor, is superior from the industry s point of view. 15

19 I II Π,Π I Π 0.2 II Π s Figure 1: Aggregate industry pro ts when variable fees are xed at zero. In market structure D, where TV channels control advertising prices only, they do not take properly into account that a high advertising volume reduces the consumers willingness to pay for watching TV. In Section 3 we thus showed that it is optimal (from the industry s point of view) to give the TV channels a positive variable income per viewer (f > 0) and thus inducing them to carry less adverting. The extent to which there is excessive advertising is, however, smaller the tougher is the competition between the TV channels, i.e. df < 0, as shown above. ds In market structure T, competition forces the TV channels to set the end-user prices closer to the (perceived) marginal costs the better substitutes they are. In order to reduce the extent to which competition more or less eliminates pro ts from the viewer side of the market, the variable access price w should therefore be increasing in s: dw ds > 0. Of course, a comparison between f and w must be done carefully. While the fee f in market structure D is a payment per viewer to TV channels from the distributor, who in returns gets revenue from end-user payments, the fee w in market structure T is a payment per viewer to the distributor from each TV channel, who in return gets the viewer-payment revenues. Even though f and w vary in opposite directions as s increases, this di erence is more apparent than real. Consider the variable, i.e., per-viewer, net payment from the distributor to a TV channel; this is f > 0 in market structure D and w < 0 in market structure T. In both cases, this net 16

20 payment is falling in s: the tougher competition for viewer is, the less revenue can be had from viewers, and the more compensation must come from advertising revenues, which in both cases are under the TV channels control; see the left panel of Figure 2. Bargaining between the distributor and the TV channels could make it possible to set w such that the end-user prices in market structure T are as high as in market structure D (p T = p D ). However, recall from Section 3 that p D > p opt : Inserting for f into (7) and w into (14) we accordingly nd that aggregate industry pro t in market structure T is maximized by setting w so low that p T < p D : Thereby, excessively high end-user prices are avoided, with the result that D + D 1 + D 2 > T + T 1 + T 2, no matter how close substitutes the TV channels are. 8 The main reason for this result is the enhanced possibilities for coordination of advertising prices and viewer prices, and therefore more control over the externalities involved between viewers and advertisers, that the open network allows relative to the market structure where the distributors sets end-user prices. The right panel of Figure 2 illustrates this by showing total industry pro t always being higher in market structure T than in market structure D. Figure 2: Access prices and aggregate pro ts Also the consumers would gain from a shift to open access, since open access has lower end-user prices. This is not surprising, since end-user prices, in the case 8 Note that there are no negative vertical externalities with open networks, and that the negative horizontal externalities are partly internalized under e cient bargaining. Under market structure I, on the other hand, there will always exist negative horizontal as well as vertical externalities. 17

21 of open access, are set competitively instead of by a price-coordinating distributor. We can state: Proposition 3: A shift from market structure D (distributor setting end-user prices) to market structure T (open network) increases both total industry pro t and consumer surplus. Under market structure D, both consumer surplus and total industry pro t are increasing in s (see Proposition 1, showing that dg = dp + da < 0; and Corollary 1, ds ds ds respectively), while the opposite is true under market structure T (see Corollary 2 and equation (19)). Both the industry and the viewers thus have less to gain from a shift to open access the closer substitutes are the TV channels products. In market structure D, where the distributor sets the end-user price, the TV channels only choice variable is the advertising price. Stronger competition between the TV channels (more substitutable products) therefore implies that they must adjust the advertising price so as to reduce the advertising. Proposition 1 consequently shows that the advertising volume is decreasing in s. Under market structure T, on the other hand, the TV channels compete both in end-user prices and advertising prices. Since competition in advertising prices is weaker than competition in end-user prices, Proposition 2 shows that the advertising volume is increasing in s in this case. Additionally, the generalized price is lower - and thus the number of viewers higher - under market structure T than under market structure D. This explains why the advertising volume is higher under market structure T than under market structure D if the TV channels products are su ciently close substitutes, as illustrated in the lefthand-side panel of Figure 3. As a nal comparison of the two market structures, and extending the analysis of Kind et al. (2009) to incorporate distribution, the righthand-side panel of Figure 3 shows the relative importance of consumer payments for the industry,! := pc pc + ra : If the TV channels products are completely unrelated (s = 0), then there will be no advertising in market structure T : all revenue will be earned from the end-user 18

22 market. However, the stronger is the competition between the channels, the less important will consumer payments be as a source of revenue. It is worth stressing, though, that if the access price were equal to zero (w = 0), competition between the TV channels would drive revenue from the consumer side of the market down to zero in the limit as s approaches 1; the only reason why the rms in the industry are able to make the larger part of their revenue directly from the viewers even for high values of s is that w has a positive value. In market structure D we have the opposite picture; the end-user prices are coordinated by the distributor and become increasingly more important as a source of revenue as s increases, since the TV channels then compete away most of their potential advertising revenues. If the TV channels products are su ciently close substitutes, consumer payments will therefore be relatively more important in this market structure than in market structure T. Summarizing, we have: Proposition 4: A shift from market structure D (distributor setting end-user prices) to market structure T (open network) leads to a lower advertising volume and relatively less dependence of advertising revenue when the TV channels products are su ciently di erentiated, and vice versa when they are not A I 0.96 ω ΙΙ ω Ι 0.02 A II s 0.80 s Figure 3: Advertising levels and revenue shares. 19

23 6 Concluding remarks In this paper we have compared various ways to organize the pricing of TV distribution to end users. One of our ndings is that an open network, i.e., a market structure where TV channels set end-user prices and in compensation pay the distributor access fees, is favourable for both industry and viewers relative to one where the distributor sets end-user prices and in compensation pay TV channels per-viewer fees. We also nd that an open network is more reliant on advertising as a source of revenue when TV channels di er in content. The driving force behind our result is the twosidedness of the TV industry, which has by now been discussed in a number of theoretical and empirical analyses. 9 Because of the externalities that viewers and advertisers exert on each other, there is a gain for a TV channel from coordinating its viewer and advertising prices. Leaving the setting of viewer prices to the distributor makes various TV channels viewer prices coordinated with each other, but this approach is wanting in the coordination of viewer prices with advertiser prices. As our analysis shows, the latter coordination is of paramount importance, for both the industry and the viewers. We have lately seen quite intense discussions of the role of distribution - and the pricing of its services - not only in the TV industry but also in other related industries, such as newspapers and the Internet. In the newspapers industry, many rms have recently abolished paper distribution. Such reliance on electronic distribution means, for most of them, becoming totally reliant on advertising as a source of revenue. Some interesting developments indicate that major newspaper rms try to get control of their distribution also in this electronic age. A case in point is New York Times and its Times Reader, which allows subscribers to download and access the newpaper also when being o ine; see Singel (2009). Internet content, more generally, is currently distributed under a net-neutrality provision, meaning that content will be distributed for free without any access fee being paid by the content provider. Net neutrality has recently been subject to a lot 9 See Gabszewicz, et al. (2004), Anderson and Coate (2005), Kind, et al. (2007, 2009), and Wilbur (2008), as well as the survey by Anderson and Gabszewicz (2006). 20

24 of attention by economists. The study of Economides and Tåg (2009) is particularly relevant here, since they view internet service provision as a two-sided market, with end-users and content providers the two groups exerting externalities on each other. Economides and Tåg nd conditions such that net neutrality is the best regulatory policy. Our analysis complements theirs by stressing that content provision itself, such as the TV industry, is a two-sided market. When this is taken into account, the content provider s need for coordinating its advertising and user prices arises, and net neutrality looses some merit. References [1] Anderson, S. P. and S. Coate (2005), "Market Provision of Public Goods: The Case of Broadcasting", Review of Economic Studies 72, [2] Anderson, S.P. and J.J. Gabszewicz (2006), "The Media and Advertising: A Tale of Two-Sided Markets", in: Handbook of the Economics of Art and Culture (V. Ginsburgh and D. Throsby, eds.), Elsevier, pp [3] Armstrong, M. (1999), "Competition in the Pay-TV Market", Journal of the Japanese and International Economies 13, [4] Barros, P. P., H. J. Kind, T. Nilssen and L. Sørgard (2004): "Media competition on the Internet", Topics in Economic Analysis and Policy 4, article 32. [5] Bel, G., J. Calzada, and R. Insa (2007), "Access Pricing to a Digital Broadcasting Platform", Journal of Media Economics 20, [6] Crawford, G.S., and J. Cullen (2007), "Bundling, Product Choice, and E - ciency: Should Cable Television Networks Be O ered à la Carte?" Information Economics and Policy 19, [7] Crawford, G.S., and A. Yurukoglu (2009), "The Welfare E ects of Bundling in Multi-Channel Television Markets", unpublished manuscript, University of Warwick and New York University. 21

25 [8] Economides, N. and J. Tåg (2009), "Net Neutrality on the Internet: A Two- Sided Market Analysis", unpublished manuscript, New York University and the Research Institute of Industrial Economics. [9] Gabszewicz, J. J., D. Laussel, and N. Sonnac (2004), "Programming and advertising competition in the broadcasting industry", Journal of Economics and Management Strategy 13, [10] Hagiu, A. and R.S. Lee (2008), "Exclusivity and Control", unpublished manuscript, Harvard Business School. [11] Katz, M.L. (1989), "Vertical Contractual Relations", Handbook of Industrial Organization, Vol. 1 (R. Schmalensee and R. Willig, eds.), Elsevier, pp [12] Kind, H.J., T. Nilssen, and L. Sørgard (2007), "Competition for Viewers and Advertisers in a TV Oligopoly", Journal of Media Economics 20, [13] Kind, H.J., T. Nilssen, and L. Sørgard (2009), "Business Models for Media Firms: Does Competition Matter for How They Raise Revenue?", Marketing Science 28, [14] Motta, M. (2004). Competition Policy: Theory and Practice. Cambridge University Press. [15] Nilssen, T. and L. Sørgard (2001): "The TV Market: Advertising and Programming", unpublished manuscript, University of Oslo and Norwegian School of Economics and Business Administration. [16] Rey, P. and J. Tirole (2007), "A Primer on Foreclosure", Handbook of Industrial Organization, Vol. 3 (M. Armstrong and R. Porter, eds.), Elsevier, pp [17] Rey, P. and T. Vergé (2008), "Economics of Vertical Restraints", in: Handbook of Antitrust Economics (P. Buccirossi, ed.), MIT Press, pp

26 [18] Shubik, M. and R. Levitan (1980). Market Structure and Behavior. Harvard University Press. [19] Singel, R. (2009), "NYTimes Reader Shows Graceful Future of Online News", Wired May 11, 2009; [20] Stennek, J. (2007), "Exclusive Quality: Why Exclusive Distribution May Bene t the TV Viewers", Discussion Paper 6072, Centre for Economic Policy Research. [21] Weeds, H. (2009), "TV Wars: Exclusive Content and Platform Competition in Pay TV", unpublished manuscript, University of Essex. [22] Wilbur, K. C. (2008), "A Two-Sided, Empirical Model of Television Advertising and Viewing Markets", Marketing Science 27,