Scale vs. scope economies and the AT&T-Time Warner merger deal

I've been watching with interest the unfolding news on the proposed merger between AT&T and Time Warner. The Washington Post has a useful primer Q&A here:

AT&T, the nation's second-largest wireless carrier, is buying Time Warner, the storied media titan that owns HBO, CNN and TBS. In an unprecedented step, the deal is going to combine a gigantic telecom operator — which also happens to be the largest pay-TV company — and a massive producer of entertainment content.

In ECON110, one of the topics we cover includes media economics. The economics of media companies is of interest because it illustrates a bunch of economic concepts, and because their interaction leads to some seemingly-counterintuitive real-world outcomes.

For instance, media content (e.g. movies, television shows, music albums) is subject to substantial economies of scale - the average production cost per consumer of media content falls dramatically as you provide the content to more consumers. This is because the cost of producing content is relatively high, while the cost of distributing that content (especially in the digital age) is extremely low. Large economies of scale (in distribution) tend to favour large media companies over small media companies, since the large media company can distribute to a larger audience at lower cost per-audience-member. In other words, each item of media content gives rise to a natural monopoly.

However, consumers demand a variety of media content, and variety is difficult (and costly) to produce. Every different item of content requires additional scarce inputs (e.g. quality actors, sets, scripts, etc.), and the more novel the item of content the more expensive it will generally be to create. This leads to what is termed diseconomies of scope - the more different items of content that a media company produces, the higher their average costs. Diseconomies of scope (in production) tend to favour smaller media companies that focus on specific content niches.

So, the combination of these (economies of scale and diseconomies of scope) leads to an industry that is characterised by several large media companies producing 'mainstream' content (and usually formed by mergers of previously smaller media companies), as well as many smaller niche providers. If we focused only on the economies of scale, we would be left wondering why the smaller providers continue to survive alongside their larger rivals. It also explains why the offerings of the large media companies are often pretty bland when compared to the offerings of the smaller players - producing something that isn't bland is too costly.

Which brings me to the AT&T-Time Warner merger. This introduces a new element into play. Time Warner is a content provider, and a distributor through traditional media channels (television, etc.). AT&T is not a media company (at least, not yet), but would greatly enhance the potential distribution of Time Warner content. That in itself isn't problematic, and would simply follow previous media mergers focusing on increasing the gains from economies of scale.

The main problem is that AT&T is a gateway to consumers (and a gateway from consumers to content), and that means that the merged entity could significantly reduce competition in the media market. Media consumers value variety (as I noted above), but this merger might make it more difficult (or costly) for AT&T consumers to access that variety. The WaPo article linked above notes:

Here's where it starts to get really interesting. AT&T could charge other companies for the rights to air, say, "Inception" on their networks, or for the use of the Superman brand. Left unchecked, AT&T could abuse this power and force other Web companies, other cable companies, other content companies or even consumers to accept terms they otherwise would never agree to.

One of the things that AT&T might also do is make it costlier for their subscribers to access other content. Of course, they wouldn't frame it that way - they would instead offer a discount on accessing Time Warner content (which effectively makes other content more expensive and shifts consumers towards the Time Warner content).

What happens next? Federal regulators are looking into the deal, and depending on who you read, President-Elect Trump will either block the deal (which markets are anticipating and which he noted during the campaign) or not (based on the makeup of staff within the administration). From the consumers' perspective, let's hope that Trump follows through (this may be the only Trump campaign promise I would make that statement for!).

Voting paradoxes and Arrow's impossibility theorem

In ECON110, we don't have nearly enough time to cover the theory of public choice as well as I would like. We do manage to cover some of the basics of the Condorcet Paradox and Arrow's impossibility theorem. Alex Tabarrok at Marginal Revolution recently pointed to this video by Paul Stepahin, which looks at several voting paradoxes. Given the events about to unfold in the U.S., it seems timely. Enjoy!



[HT: Marginal Revolution]

Book review: Who Gets What - and Why

Alvin Roth won the Nobel Prize in Economics in 2012 (along with Lloyd Shapley) "for the theory of stable allocations and the practice of market design". So, I was glad to finally have time to read Roth's 2015 book, "Who Gets What - and Why". I wasn't sure what to expect from this book, having previously only read some of Roth's work on kidney exchange, and was pleasantly surprised that the book covers a lot of fundamental work on the design of markets.

In introductory economics, we usually start by focusing on commodity markets - markets where the goods that are being offered for sale are homogeneous (all the same). In commodity markets, the decision about 'who gets what' is entirely determined by price - the consumers that value the good the most will be buyers, and the producers with the lowest costs will be sellers. This book (and indeed, much of Roth's most high-profile research) focuses instead on matching markets - markets where price cannot perform the role of matchmaker by itself. As Roth notes early on in the book:

Matching is economist-speak for how we get the many things we choose in life that also must choose us. You can't just inform Yale University that you're enrolling or Google that you're showing up for work. You also have to be admitted or hired. Neither can Yale of Google dictate who will come to them, any more than one spouse can simply choose another: each also has to be chosen.

The book has many examples, but I especially liked this example of the market for wheat, and how it became commodified:

Every field of wheat can be a little different. For that reason, wheat used to be sold "by sample" - that is, buyers would take a sample of the wheat and evaluate it before making an offer to buy. It was a cumbersome process, and it often involved buyers and sellers who had successfully transacted in the past maintaining a relationship with one another. Price alone didn't clear the market, and participants cared whom they were dealing with; it was at least in part a matching market.

Enter the Chicago Board of Trade, founded in 1848 and sitting at the terminus of all those boxcars full of grain arriving in Chicago from the farms of the Great Plains.

The Chicago Board of Trade made wheat into a commodity by classifying it on the basis of its quality (number 1 being the best) and type (winter or spring, hard or soft, red or white). This mean that the railroads could mix wheat of the same grade and type instead of keeping farmer's crop segregated during shipping. It also meant that over time, buyers would learn to rely on the grading system and buy their wheat without having to inspect it first and to know whom they were buying it from.

So where once there was a matching markets in which each buyer had to know the farmer and sample his crop, today there are commodity markets in wheat...

Of course not all markets can easily be commodified, which means that many markets remain matching markets. And in a matching market, the design of the market is critical. The book presents many examples of matching markets, from financial markets, to matching graduate doctors to hospitals, to kidney exchange. Roth also discusses signalling, a favourite topic of mine to teach, and which is of course important in ensuring that there are high-quality matches in markets.

On kidney exchange, it is interesting to read an economist who isn't substantially pro-market (e.g. kidneys for transplant should be traded in markets, at market prices). Roth recognises that there may be valid objections against fully monetising some markets (such as kidney exchange). He writes (the emphases are his):

Such concerns about the monetization of transactions seem to fall into three principal classes.

Once concern is objectification, the fear that the act of putting a price on certain things - and then buying or selling them - might move them into a class of impersonal objects to which they should not belong. That is, they risk losing their moral value.

Another fear is coercion, that substantial monetary payments might prove coercive - "an offer you can't refuse" - and leave poor people open to exploitation, from which they deserve protection.

A more complex concern is that allowing things such as kidneys to be bought and paid for might start us on a slippery slope toward a less sympathetic society than we would like to live in. The concern, often not clearly articulated, is that monetizing certain transactions might not itself be objectionable but could ultimately cause other changes that we would regret.

Overall, the book is a really good complement to learning about the commodity markets that we look most closely at in introductory economics. Many economists (myself included) probably don't spend nearly enough time considering the design of markets and largely take the role of prices in allocating resources as a given. This is definitely a highly recommended read.

The Great Walks may be free, but they are not free

My blog's been a bit quiet the last couple of weeks while I've been buried in exam marking. Now that marking is done, I can start to post on some things I had put aside over that time. Starting with the controversy over comments made by Department of Conservation director-general Lou Sanson, reported here:

It may be time to start charging for the use of the country's Great Walks, Department of Conservation director-general Lou Sanson says.

Foreign tourists could pay $100 and New Zealanders $40 to cope with a huge increase in trampers — especially overseas travellers — and their effect on the environment, he suggested.

Sanson said the country's Great Walks brand had "exploded" but this popularity had created some problems...

In March, he took the United States ambassador to the Tongariro Alpine Crossing — a 19.4km one-day trek between the Mangatepopo Valley and Ketatahi Rd in the North Island.

"Every time we stopped we were surrounded by 40 people. That is not my New Zealand. We have got to work this stuff out — these are the real challenges," Sanson told the Queenstown Chamber of Commerce yesterday...

Introducing differential charges on the Great Walks was one potential mechanism to alleviate pressure, Mr Sanson said.

"We have got to think [about that]. I think New Zealand has to have this debate about how we're going to do bed taxes, departure charges — we have got to work our way around this.

"I think a differential charge [is an option] — internationals [pay] $100, we get a 60 per cent discount."

The New Zealand Herald then ran an editorial the next day, entitled "Turnstiles on wilderness is not the answer". The editorial raised some good practical issues with charging a fee for trampers on the Great Walks:

Would rangers be posted to collect cash, or check tickets that would have to be bought in advance? How would they be enforced?

It also raised an important issue about the perception of the service provided by DoC:

A charge changes the way users regard it. The track and its surrounds would cease to be a privilege for which they are grateful, and become something they feel they have paid for.

They will have an idea of the value they expect and rights they believe due for their expense. They may be more likely to leave their rubbish in the park. The costs of removing litter and cleaning camping areas may quickly exceed the revenue collected.

However, the editorial ignored the fundamental issue of providing goods and services for 'free'. If something comes with no explicit monetary cost associated with it, that does not mean that it is free. Economists recognise that there are opportunity costs (because in choosing to do a Great Walk, we are foregoing something else of value we could have done in that time), but this is about more than just opportunity costs.

When a good or service has no monetary cost, there will almost always be excess demand for it - more consumers wanting to take advantage of the service than there is capacity to provide the service. Excess demand can be managed in various ways - one way is to raise the price (as suggested by Sanson). Another is to limit the quantity and use some form of waiting list (as is practiced in the health sector). A third alternative is to degrade the quality of the service until demand matches supply (because as the quality of the service degrades, fewer people will want to avail themselves of it).

The latter option doesn't sound particularly appealing, but it's the option that Sanson is most against, and would be the necessary consequence of the laissez faire approach the Herald editorial advocates for. Sanson already notes one way that the quality of the Great Walks is affected, when he notes "Every time we stopped we were surrounded by 40 people". If you want to take a Great Walk in order to experience the serene beauty and tranquillity of our natural landscape, the last thing you want is to be constantly mobbed by selfie-taking dickheads. The quality of the experience degrades the more people are on the Great Walks.

Pricing might not be appetising to some, but at least it would manage the demand for the Great Walks. Providing lower prices to locals is, as I have noted previously, an appropriate form of price discrimination that I remain surprised that we don't see more of in New Zealand. Of course, that doesn't negate the practical concerns raised in the Herald editorial. But if we want to maintain the quality of the experience on the Great Walks, this is a conversation that we should be having.