Friday, October 16, 2009

Are cable companies stealing from over-the-air channels? Are antenna companies?

You may have seen the ad campaign by over-the-air TV channels arguing that local TV’s future is in jeopardy. The CRTC has responded to the over-the-air channels’ cries of hard times with a 50% increase in the fee (the “Local Program Improvement Fund (LPIF)”) that cable companies pay to the CRTC, to be transferred to local channels.

But the LPIF increase is really only the opening salvo into the broader debate over carriage fees, with CRTC hearings now set for December. Of course, local stations want carriage fees. Together with the LPIF they amount to a small scale “TV station bailout.” Over-the-air stations argue that the fact that cable companies rebroadcast their signals without a charge is fundamentally unfair; their argument is that cable companies are getting content for nothing in return. In truth, over-the-air stations benefit from the rebroadcast of their signals. They make money based on ad revenues, which in turn is based on viewership. Rebroadcasting by cable companies increases viewership, and therefore increases the value of the product (ad time) that they sell. A company that sells antennas also makes money delivering over-the-air stations’ content, without paying the stations anything. Do the stations think they deserve carriage fees from antenna companies, too?

Rogers’ response has been to change their pricing scheme to explicitly pass along the entire LPIF fee (both the increase and the fee from before) to consumers, and start their own ad campaign. But if they make more profit charging the extra fee now, why didn’t they pass on the LPIF before the increase? In fact, those costs were probably included in the old price, to the extent that doing so was optimal for Rogers. Effectively they are increasing prices by three times the cost increase, by adding both the new and old LPIF fees to the final bill. Many have argued that a likely explanation for this substantial price increase is to agitate consumers in advance of the fight over carriage fees. After all, is a price increase of three times the cost increase plausible, just on profit maximization grounds, and not thinking about politics?

One way to get a handle on the issue is by using basic microeconomics. To know how much a firm will increase prices in response to a cost change, we need to know how sensitive its customers are to price increases. Mayo and Otsuka, in their 1991 RAND Journal article, report a price elasticity (measuring the price sensitivity of customers) of 1.5 for basic cable in urban areas. Transferring that number to Rogers, that means that a one percent increase in price costs Rogers 1.5 percent of its customers. Textbook microeconomics tells us that the optimal mark-up in response to an increase in cost, if the elasticity is 1.5, is exactly a factor of three times the cost increase. From that perspective, maybe Rogers’ response is simple profit maximization, and not some long term political goals.

However, a lot has changed since 1991, and now cable companies face many new forms of competition from alternative TV providers, especially satellite providers. Better alternatives mean customers are probably more sensitive to Rogers’ prices, so a one percent increase in price is likely to cause a greater reduction in Rogers’ customer base than the 1.5 percent in the Mayo and Otsuka study. If demand is more sensitive to changes in price, the optimal pricing response to an increase in marginal cost is reduced. It therefore seems unlikely that the Rogers price increase is driven purely by textbook microeconomic motives, and more likely that something else is involved.

Thinking about the stations’ side, the simple economics of these local stations is that they purchase programming on the speculation of future ad revenue. Downturns in the ad market naturally lead to shortfalls for local broadcasters. (It also lowers the value of airtime, making on-air pleas for support less expensive.) If this downturn is making them ask for more from the regulators, the natural question to ask is, are they planning a rebate to the cable companies in good times? After all, if broadcast over-the-air is a viable business model, then in good times their ad revenues will once again exceed the cost of their programming. If fairness is the key issue, as CTV has said, do cable companies deserve a cut of the ad revenue in exchange for the visibility that the cable companies offer?

In the end this isn’t about fairness. Over-the-air stations want carriage fees because they think it will improve their bottom line. Cable companies don’t want to pay them because they know, like any microeconomics course will tell you, that even a firm with market power can’t pass all cost increases on to consumers indefinitely, as they appear to suddenly be doing with the LPIF. But both sides had better be careful of the possible negative impact. If over-the-air carriage fees become burdensome, cable companies might push to offer their customers packages without those stations. New HDTV antennas are both inexpensive and very effective, and channels like CTV broadcast a high definition signal to everyone for free over-the-air (unless the stations take up my idea of charging carriage fees there, too!).

The big picture is that technological change is empowering consumers. With the growth in streaming video over the internet, over-the-air channels and cable companies need to be careful not to price themselves right out of the future of TV.

Tuesday, October 6, 2009

Demons, Dragons and Eclipsing Recessions

Many ancient cultures believed that solar eclipses were the result of a dragon or some other demon trying to devour the sun. Since the loss of the sun would be catastrophic, community members would often perform some ritual to either drive the demon away or help the sun fight back. In China, we are told, people would bang pots and drums to try to frighten the dragon away. In India, they would immerse themselves in the local river to help the sun fight off the dragon. These, and other practices, were always successful at bringing the sun back. Better still, they worked quite quickly and were likely reasonably cheap to perform.

Of course, today, we know that the solar eclipse has nothing to do with dragons or demons and that the rituals the ancient people performed had nothing to do with the sun’s return. We enlightened moderns scoff at such silly beliefs and rituals. In economist-speak, we know the difference between correlation and causation; that is, the sun’s return may have occurred as the ritual was being performed – the sun’s return is correlated with the performance of the ritual – but the sun did not return because the ritual was performed. Unlike people in the past, we know that the sun would have returned regardless of whether or not the ritual was performed. The ancient people, of course, didn’t really want to take that chance. The rituals were cheap to perform and, no doubt, by the time the community had noticed that the eclipse was happening and had assembled for the performance of the ritual, it wasn’t long before the sun was returning. Why risk the chance that the sun would never come back?

There are many others cases throughout history in which correlation and causation are confused. The patent medicine vendors and snake oil salesmen of the eighteenth and nineteenth centuries profited from this confusion. The concoction of alcohol, water and herbs sold as a cure for “what ails you” had no curative properties whatsoever. However, by the time the patient felt ill enough to use the foul-tasting mix and repeated its use for the prescribed amount of time, the illness had gone away: correlation not a cure.

In the twenty-first century, we have banished dragons and demons from the natural world; however, we have not banished them from our lives. A modern demon that obsesses us today is the economic recession. All of us became aware of this demon devouring our wallets and portfolios about a year ago. To drive the demon away, we didn’t bang pots and drums or submerge ourselves in rivers; instead, we relied on government stimulus packages for the cure. Much as in ancient times, the community leaders are now all declaring these packages to have been successful. While the recession dragon hasn’t gone completely, it is receding. With continued stimulation, it will be gone for good.

The question is, of course, is all of this causation or correlation? In a system as complex as the global economy, it is never easy to sort out causation and correlation. Further, accurate data on stimulus spending is not always easy to find. As the Canadian Parliamentary Budget Officer notes, it is difficult to tell how much of the infrastructure money in the government stimulus package has actually been spent. The suspicion is that little spending has actually occurred yet. In the US, information from the webpage suggests that about $35 to $40 billion of infrastructure monies in the US stimulus package have been spent. The relatively modest amounts of infrastructure spending to date make it difficult to believe that many jobs have been created or that this spending has pulled these economies out of recession. Of course, politicians, like the ancient leaders and patent medicine vendors of the past, are more than happy to take credit for the recovery. Stimulus has worked!

If stimulus spending has not caused the recovery, we need to ask how this happy correlation between stimulus packages and recovery occurs. The explanation is this: It typically takes quite some time for all of us to notice that a recession has occurred. In the current recession, it was almost a year before the seriousness of the economic downturn became apparent. Once the recession is identified, political leaders and policy makers require time to formulate their policy / stimulus package and pass the legislation authorizing the spending. Further time passes while a bureaucracy is set up to approve projects and distribute stimulus money. Once the stimulus money begins to flow, so much time has passed that, for reasons completely unrelated to the stimulus spending, the economy is already coming out of the recession. It’s much like the patent medicine that “cures” your illness. Like the patent medicine vendors, political leaders declare victory and we go on believing in the importance of stimulus spending for fixing recessions.

Not surprisingly, politicians today, much as the leaders of old, don’t want to risk not stimulating the economy. After all, the stimulus money is not theirs and any perceived delay in economic recovery is politically costly. Unfortunately for all of us, the cure for driving away the recession demon is not an hour or so of our time spent banging drums or wallowing in a river. For the tax payer of Canada the cost is tens of billions of dollars; for the taxpayer of the US, it’s hundreds of billions of dollars. No cheap cure, that.