Monday, May 31, 2004

Cable Unbundling

Many have argued recently that the federal government ought to issue more intrusive regulation of the cable industry. Specifically, people have said that cable companies should allow customers to choose which channels they want to purchase. If all you want to watch is the Home and Garden Channel, MTV, and C-Span, you should be able to buy those three channels and nothing else.

Glenn Reynolds has endorsed this idea, while John McCain has colorfully complained that cable consumers "have all the choice of a Soviet election ballot." Conservative pro-family groups like the idea of refusing to buy vulgar or distasteful programming. But it's not just conservatives: The idea is supported by a broad and bipartisan swath of people across the country.

The metaphor of the grocery store is common. Brent Bozell has said, "If you go to the 7-Eleven to buy a quart of milk, you are not forced to take a six pack of beer, too." Similarly, a New Jersey columnist pretended that groceries were bundled as well: "I want milk and bread; they offer a "basic" bundle of milk, bread, cola, pizza, artichokes, lima beans, tampons, and beer. I can't get milk and bread without getting all the rest."

I haven't studied this issue in any detail. Still, a key distinction occurs to me: Groceries and most industries involve products that impose a significant marginal cost. If you have twelve average-priced items in the cart and add 100 more at the average price, you've added a lot of cost to the grocery store. Or, if you buy only a pack of gum, you've imposed a lot less cost on the store than the person who fills a cart to the brim.

This doesn't apply to the cable company. The signal is already there in the wire, whether you watch nothing at all or whether you buy three TVs and leave them on 24 hours per day. Cable, like other communications industries, has high fixed costs (i.e., the cost of running cable into your house in the first place) and practically zero marginal cost (i.e., it costs nothing more if you watch an extra program or channel). That's why the grocery metaphor just doesn't work here.

* * *

Normally, economic theory would say that an industry should price at marginal cost. But here that would be zero, or next to it, and this would leave the fixed costs uncovered. It would be impossible to supply cable on those terms.

There are several possible solutions: Ramsey pricing, in which the people who are going to demand the product regardless are charged proportionally more. Or, price discrimination, as airlines do when charging more for business travelers than for families on vacation or funeral-goers. Or, fully distributed cost pricing, in which each product or service contributes on some proportional basis to the fixed costs.

But cable companies have trouble following any of those schemes. Ramsey pricing is notoriously difficult without closely-tailored knowledge of price elasticities of demand. Price discrimination is also difficult, because the cable company might have difficulty pinpointing those customers who have a higher willingness to pay than anyone else. Plus, like most industries, they have trouble preventing sharing (unlike airlines, which require ID for that very reason). Fully distributed cost pricing is incoherent, because there is no agreed-on way to specify which services actually "imposed" the fixed costs in the first place, much less in what proportion.

So cable companies have settled on bundling as an option. You can buy two or three tiers of service, each with a distinct price and each with a distinct package of services.

Interestingly, newspapers have chosen essentially the same approach as well. They have high fixed costs (i.e., the costs of hiring reporters and editors, paying the bills, etc.), but very low marginal costs (i.e., the cost of printing an extra copy of the paper). So they bundle together an entire package of every type of news story that someone might want to read in a given day -- politics, human interest, local stories, sports, comics, TV schedules, classifieds, etc. Anyone who wants some piece of that package enough will pay the newspaper's subscription price.

But you can't expect the newspaper to satisfy each individual reader's idiosyncracies. Take the fact that I never read the sports section, and that I would be happy to have a newspaper without it. If I demanded that the newspaper carrier actually remove the sports section from the paper every day, I would be causing an extra cost to the newspaper. Thus, I should have to pay more, not less.

The same is probably true here. It would create a higher cost each time that a customer wants to block a channel, because the cable company has to go to extra trouble. It is as if it literally cost the grocery store more for you to leave 20 items behind rather than buying a full cart.

Again, I haven't studied this issue at all, but my instinct is to say that unbundling here is a very bad idea.

UPDATE: Read Arnold Kling's excellent essay on this topic.

35 Comments:

Anonymous Anonymous said...

Bundling was a large part of why I dropped my satalite service; The bundles were set up so that in order to get the five or six channels I actually had any desire to watch, I'd have had to subscribe to 150, at great expense.

I don't buy the notion that bundling reduces costs to the provider, by the way; The receiver is computerized, and stores a list of channels you are authorized to watch, out of the many channels you are receiving. Further, the system is already set up with an individualized automated purchasing option for pay per view events. The added cost of allowing customers to put together their own custom bundles would be essentially zero, as all the technology is already in place, a sunk cost.

The key consideration is, I believe, that cable companies aren't just getting paid by viewers for content. They're also being paid by advertisers for access to viewers' eyeballs. Bundling, while it might not be opitimum for the viewer, is better for the advertisers.

10:31 AM  
Anonymous Anonymous said...

The cable companies should charge a standard cost for delivery of service. Since, as noted, their marginal costs are low, they do not need to charge for them, but simply include them in a standard price for service. Then the consumer should be allowed to pick among bundles of channels (discounted for their bulk) or various single channels. The world is moving in this direction. Look at the music industry. You can buy a whole CD by an artist, or these days, you can buy just the single song you want off that CD by downloading the mp3 from iPod or similar services.

Of course the cable companies and the owners of the channels would like to sell you stuff that you don't need. But stores also like charging higher prices, and Wal-Mart has shown that by charging lower prices -- and thus getting more business -- you actually make more money. So if a cable provider would take the route I suggested, I think they would find themselves with happier consumers, and happier consumers mean more business. After all, if I am not happy with cable TV, I can do without it alltogether. In fact, if I were the only person in my household, that is probably what I would do.

You mentioned that you have to buy newspapers as a package. News is not quite as analogous as you think. More analogous would be purchasing magazine subscriptions. Now, how would you like it if when you purchase your "First Things" magazine, you had to buy a package that also included "People," "Sports Illustrated," and even "Playboy"? This would be unacceptable.

The best solution for all involved is to offer packages (as is done now), and to offer single channels. The packages could be discounted (like a magazine subscription is discounted versus a single copy) to create incentive to buy them, but people could get just TLC and TCM if that's all they want.

JMB

12:03 PM  
Anonymous Anonymous said...

I thought the reason it's not done is that there's no accounting program available yet which could handle this.

I mean, what happens if people decide to drop it after a month?

Maybe they would have to sign up for certain stations for a year?

I'd really like the option of paying for what I use. And the market will set the price in the end, won't it? They can charge more for the popular channels?

Or what about offering different packages, possibly semi-custom?

There's a lot of different options.

Sandy P

12:28 PM  
Anonymous Anonymous said...

The grocerty store example only works if it's too inconvenient to shop a competitor. Likewise if you want a parallel with the cable TV dilemma, you have to bundle a potentially objectionable product (although beer might work for some). So to use your example, if the sole 7-Eleven is on Padre Island when the bridge was closed and it bundled a sample pack of cigarettes, or soft porn magazine, or gangsta rap music cd with every purchase of bread or milk, the store could tell a customer who objects to the bundling to drop the unwanted items in the trash or donation box. But if the customer objects to enabling tobacco, porn or offensive music that solution doesn't work. Personally, I object more to enabling MTV and the semi-porn music video channels than the lack of choice in shaping the packages. BTW I pay extra just for the Independent Film Channel, why couldn't I just swap it for MTV?

On the other hand, the newspaper example may not work for the print version, but is ideal for the electronic one. If I want sports and entertainment, but I am fed up with the biased news reporting and one-sided op-ed page of a local daily such as the Austin-American Statesman (just to pick a name out of the air)I can get those and only those features I want online and actually cancel my subscription.

9:21 PM  
Anonymous Anonymous said...

I hope you won't treat this as an unfriendly reply. I work for a cable company, albeit a very small one. There's alot of misunderstanding about how the cable TV business works (or sometimes doesn't), and the big cable companies have made their PR problem even worse by having poor customer sevice standards and high prices. But here are some basic things you need to understand about how it really is.
1. Cable companies don't get to decide HOW they can sell channels. That is entirely controlled by the cable networks. We have a contract with every network we place on cable (CNN, ESPN, etc). Almost every one of those contract require that in order to carry their channel at all, you have to bundle it with other channels. For example, my company would like to add a second regional sports channel because customers want access to a certain pro baseball team. However, the cost is so great that if I add it, I would have to raise everyone's rates. So I decide I'd like to sell that channel as a separate product for a break even cost of, say, $2.50 per month. Now the baseball fans wouldn't even blink at that cost. However, the network won't even consider letting us do that. They want to be on EVERYONE's TV's, not just the people who actually want to watch their channel. So unless something changes and networks are forced to allow individual or "ala-carte" carriage, the whole point is moot, and is certainly outside of the control of cable operators.
2. The technology exists today to make ala carte a reality, but only in the digital realm. However, not all customers want to deal with the technology of a digital box. They want it as simple as possible. That's why analog cable is still around, even though its inferior in many ways. The industry will grow out of this obstacle, however, as those older, techno-phobic generations pass on. But it won't change significantly for 20-30 years.
3. In an ala carte world, its likely you would pay MORE than you do now. Think of it this way: you're CNN. You have two sources of revenue...the ads you sell, and the money the cable operators pay you in monthly per-subscriber fees. You sell ads on the basis of how many households your channel is in. If you went to an ala carte system, half of the households might choose NOT to buy CNN. So you can't sell as many ads as a result. How do you make it up? You raise the price you charge the cable company. So while CNN might only cost my company 25 cents per sub per month today, it might have to to 50 cents per sub or more under alacarte. And CNN is not an expensive channel. Think of what a more pricey channel like ESPN might cost you under this new scheme. If the operators cost for every channel doubled, and they even broke even per channel, you could get only half of the channels you have now for the same price.

Again, I work for a small community-owned cable company that is non-profit in nature, so I hope you will take this information as unbiased and truthful. I think the home entertainment industry is going to undergo a massive change in the next 20 years or so. But the cable operator won't be able to enable that change by itself...the other pieces of the industry will have to change as well

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