Video rentals and economics

In November, video rental giant Blockbuster LLC announced the closure of its last store, marking the demise of yet another industry hastened by technology.

It provides an apt occasion, therefore, to reflect on the lessons in economics that one might derive from this industry.

The video rental business was done in basically by the rapid advances in streaming technology that give rise to new firms such as Netflix and Amazon providing instant access to movies. This new technology eliminated the need to go to a store to rent a movie and then again to return it.

I still remember the advent of video cassette recorders (VCR) in the early eighties. Families would rent out a VCR along with a few movie cassettes and make an entertainment night of it.

By the late nineties, the VCR got replaced by the digital video disc or DVD player. People now began owning their own DVD players, putting an end to the group-watching experience of the eighties.

Bolly versus Holly The above story of ownership and use of such devices was the same in India and the US. Consumers in India, at least in urban areas, lagged behind their American counterparts by a few years at the most.

However, when it came to the marketing and distribution of video cassettes or DVDs, the story panned differently in the two countries.

In the US, most video cassettes or DVDs were available on rent from a few national chains. The small mom-and-pop stores that existed were the exception, largely catering to niche markets such as off-beat movies, foreign flicks or simply good old porn. And there weren’t any pirated movies.

In India, small stores, by contrast, were the norm. The ubiquitous neighbourhood ‘video parlour’ stocked the entire gamut of movies, including pirated copies of the latest releases.

So, why this difference?

One reason, of course, was the stringent intellectual property protection laws and their equally strong enforcement in the US.

But the structure of the market also played no less an important role. In the US, large video rental firms — the likes of Blockbuster — had the means to strike deals with Hollywood studios and film distributors to acquire official versions of movies.

On the other hand, the corner video store guy in India did not have the wherewithal to negotiate with distributors and movie studios. But given our lax intellectual property laws, he could make enough by coolly rented out pirated versions.

The message here seems to be that the existence of enforceable property rights in the US spurred the growth of a market dominated by a few large firms, which simultaneously didn’t need to resort to piracy.

In other words, big can sometimes be beautiful — at least from the perspective of movie producers!

Sorting out consumers Next, let’s consider another interesting aspect in which video rentals markets differed — notice I’m being forced to use past tense while referring to this industry — in the two countries.

In India, you typically knew the owner of your local video store. In this personalised world of informal transactions, you rarely paid a late fee.

In the US, however, video rental stores thrived on the dreaded late fee. They often made a third of their revenues this way.

Moreover, the late fee was a boon in another way. It provided a means to sort the consumers into different groups, thereby engage in the practice of price discrimination or charging differently to different segments of the market for the same product.

Now, here is some theory.

When a firm charges a single price to all consumers, some end up paying less than what they would have been willing to pay for that good.

This difference between what they pay and what they are willing to is called consumers surplus.

While being a benefit to the consumer by virtue of his or her being a part of the market, the goal of a firm is to appropriate as much of the above surplus as possible. But the problem is consumers don’t walk into a store and declare the maximum that they would be willing to pay to for the goods.

Hence, sellers need to find ways of making consumers sort themselves into different groups according to their willingness to pay. They could sell different quantities (bulk discounts) or qualities (different classes of airline travel) at different prices, besides offering stuff such as discount coupons.

Late fees A late fee is normally viewed as a deterrence instrument — a punishment to ensure people return things on time. But let me give an illustration of how a firm can use late fee as an instrument for indirectly segmenting the market.

Imagine two types of consumers — those who have very high value for their time (say, corporate executives) and those who don’t so much, take college students.

Also, assume that both set of consumers are aware of something unexpected coming up, which might lead to their returning a video rental late and ending up paying the penalty. Hence, it is reasonable to assume that everyone’s aware of the probability of being late at the time of renting — though no one intends to be late!

Since the video store owner knows this, he could reduce the rental price. The lower price will, then, induce people to rent more videos. If the consumers include many executives who being terribly busy tend to forget, then the store could make a lot of money through late fees.

The best strategy in this case would be to set a high late fee — much higher than the rental price of a video. This will, first of all, ensure that students who value money more than time would keep returning the videos on time so that the store’s inventory is not substantially affected. They will also tend to rent more videos given its low basic price.

Secondly, the stores will make a lot of money through the high late fees from corporate executives who are prone to returning late.

Such a price scheme was, in fact, followed in the video industry in the late nineties. Some firms would charge late fees 60 per cent or so more than the video rental price.

Needless to add, this strategy isn’t restricted to just the video rental industry. Research in the US shows competing credit card companies using similar strategies.

But I would guess there are few that have used such creative marketing to extract more consumer surplus from us buyers than the video rental industry.

That industry may no longer be around, but the lessons in economics it provides might remain relevant for all times.

(The author teaches microeconomics and game theory at Louisiana State University)

COMMENT NOW