October 28, 2002
AOL-Time-Warner and the Coase Theorem

More than a generation ago Ronald Coase set out the principle--called a "theorem" for reasons I don't understand--that whenever a market fails to reach an efficient outcome, it is because of some failure of the bargaining process--either somebody holds out for more than the others are willing to pay, or there are just too many people to get everyone into the room to make the deals, or there is just not enough time for bargaining to an efficient solution to take place. (Hence the Coase Theorem-derived principle that one should construct and assign property rights to make Coasian bargaining as easy and as cheap as possible.)

The big place where the economy is threatening to fail to attain its efficient frontier today is in the intellectual property wars: consumers want a lot of high-quality entertainment and information cheap, but one set of producers makes money by selling bandwidth and another set of producers makes money by selling content. Bandwidth-sellers want consumers to be able to make whatever use they want of what they download. Content-owning firms want to charge consumers through the nose for what they own now and what they will produce in the future.

AOL-Time-Warner, SONY, and a few others are on both sides of these intellectual property wars. So--because they are all part of one organization pulling together for the common good--it should be easy for AOLTW to resolve these problems within itself and get to an efficient Coasian bargain, right?

<sarcasm>Right...</sarcasm>


A TV House Divided: ...The strong feelings at AOL Time Warner's networks and studios have already influenced the company's progress. Six months ago, company executives said Time Warner Cable's chief executive, Glenn A. Britt, discussed the feasibility of a 30-second fast-forward button as part of its video-recorder services. But executives from Warner television studios and Turner Broadcasting argued against it, some calling it "the 30-second ad-skip button." Mr. Britt decided to drop it, people in the meetings said.

"I was delighted," Jamie Kellner, chief executive of Turner Broadcasting, said. (A spokesman for Mr. Britt said he never seriously considered a specific button for skipping commercials, noting that Time Warner Cable also sells advertising.)

In an interview last week, Richard D. Parsons, AOL Time Warner's chief executive, said he was confident the company's divisions could come together. "We should be able to steal the march on the rest of the industry because we have all the pieces inside," he said. "All of our guys know that where we are going to find growth in this business is by finding ways to deliver the stuff that we have created to an expanded audience." Still, Mr. Parsons said, persuading the divisions to work together is only part of the challenge. "If this doesn't work, it will be because neither we nor anybody else has found the right business model that works for the consumer," he said...

The New York Times Sponsored by Starbucks

October 28, 2002

A TV House Divided

By DAVID D. KIRKPATRICK

The future of television has finally arrived really. Now begins the haggling over who gets control, and negotiations with the highest stakes are taking place inside AOL Time Warner.

Under fierce competition from satellite services, the Time Warner cable division is racing to sell new features that give viewers more control over what and when they watch. Its new digital services can let subscribers order any of an array of films and network programs whenever they want and even turn set-top boxes into personal digital video recorders that make it easy for viewers to fast-forward through commercials.

Time Warner had begun offering the services in a number of cities the last several months, and this fall it is making movies and some network programs available on demand in New York, its biggest market.

But as Time Warner Cable promotes the services especially the one that can skip commercials its plans are colliding with the interests of networks and studios, which own the rights to the most popular shows. Both live off programming schedules and advertising sales. At many, including AOL Time Warner's own Turner Broadcasting and Warner Brothers divisions, executives consider the idea of skipping the commercials to be a threat.

The negotiations among divisions of AOL Time Warner are part of the early rounds of a broader contest over television that is unfolding as satellite and cable companies haggle with networks and studios. The satellite and cable companies say they are giving viewers what they want, but networks and studios sometimes feel they are being robbed.

AOL Time Warner is moving faster than any other cable company. As one of the largest companies on all sides of the business in cable systems, television production and operating networks it is situated to reconcile the competing interests. How it fares at selling the digital services could influence the shape of the industry. The company has already shown it can use its power to change Hollywood, when Warner single-handedly brought down prices to jump start sales of DVD's.

But AOL Time Warner's efforts are also a test of the premise behind its conglomeration of many different businesses. In a recent speech defending the company's potential, the chairman, Stephen M. Case, called new "personal television" services a crucial example of "cross-divisional innovation" already under way. "No company is better positioned to drive, and benefit from, personal television," Mr. Case said. Making it work could demonstrate the company's ability to foster cooperation among its largely autonomous and sometimes antagonistic divisions.

The strong feelings at AOL Time Warner's networks and studios have already influenced the company's progress. Six months ago, company executives said Time Warner Cable's chief executive, Glenn A. Britt, discussed the feasibility of a 30-second fast-forward button as part of its video-recorder services. But executives from Warner television studios and Turner Broadcasting argued against it, some calling it "the 30-second ad-skip button." Mr. Britt decided to drop it, people in the meetings said.

"I was delighted," Jamie Kellner, chief executive of Turner Broadcasting, said. (A spokesman for Mr. Britt said he never seriously considered a specific button for skipping commercials, noting that Time Warner Cable also sells advertising.)

In an interview last week, Richard D. Parsons, AOL Time Warner's chief executive, said he was confident the company's divisions could come together.

"We should be able to steal the march on the rest of the industry because we have all the pieces inside," he said. "All of our guys know that where we are going to find growth in this business is by finding ways to deliver the stuff that we have created to an expanded audience."

Still, Mr. Parsons said, persuading the divisions to work together is only part of the challenge. "If this doesn't work, it will be because neither we nor anybody else has found the right business model that works for the consumer," he said.

A major uncertainty hanging over the debate is that no one knows exactly what people will want from their televisions and how much they will pay for it. Some broadcast executives argue that people watch to relax: many viewers prefer to sit passively in front of whatever happens to on even the commercials just as many people do not bother to hit the mute button or channel-surf through commercials.

Some analysts say AOL Time Warner and other cable companies have already stumbled by overestimating the nation's couch potatoes. Since 1996, cable companies have spent more than $55 billion on reworking their systems to be able to offer various two-way digital services. Time Warner, the second-largest cable company, has invested aggressively, upgrading more than 98 percent of its systems. But of the more than 70 million people with access to digital cable, only about 15 million subscribe, and only about 3.5 million Time Warner customers do.

Industry analysts and executives say that the main reason for the slow demand is that, until the last several months, digital cable simply meant 150 channels, with no qualitative difference but more difficult to navigate. Time Warner and the other cable companies are betting that on-demand and video-recorder features will make digital cable irresistible even to viewers who turn up their nose at the smorgasbord of channels.

The cable companies are also fighting with fast-growing satellite services, which are courting subscribers with set-top boxes including built-in digital recorders like TiVo and ReplayTV devices, made by SONICblue. The recorders also make it push-button easy for viewers to store programs or movies to watch later as well as to fast-forward over the commercials. (AOL Time Warner and other media companies are suing ReplayTV for copyright infringement, in part because the device can skip all commercials automatically, without a viewer even pressing fast forward.)

To keep up, Time Warner Cable has made it clear that it will soon offer some similar services. "Our customers have been telling us they want movies and other entertainment programming when they want it, with full VCR functions like stop, rewind and fast forward," Mr. Britt said last spring.

Time Warner began testing the VCR-like digital recorder service in Rochester in late August, followed soon after by tests in Green Bay, Wis., and Austin, Tex.

Time Warner is selling pay-per-view movies on demand in 32 of its 34 markets. It also is offering monthly subscriptions providing access to all of films and programs of HBO, its sister company, on demand for about $6 in about a dozen markets. In many, Time Warner offers access to programs from certain networks, including Discovery, A & E and Biography, at no additional charge beyond a digital subscription.

Mr. Britt said that since the company began testing subscriptions to HBO on demand in Columbia, S.C., last summer, for example, half the digital subscribers with HBO have elected to pay an extra monthly fee to get HBO on demand. What's more, the number of digital subscribers rose more than 10 percent, far faster than elsewhere, he said.

Rivals have similar plans. In Philadelphia next month, for example, AT&T Comcast is to begin offering about 200 movies and 800 hours of programming on demand, including NBC news programs, local sports events and HBO movies and shows.

Some networks and studios are participating in part to make sure they do not get cut out as the services evolve. Mr. Kellner, of Warner's Turner Broadcasting division, said he did not think the networks and studios were worried enough yet. He warned that the race between the cable and satellite companies would spread commercial-skipping technologies much faster than normal consumer demand.

That could be devastating for the networks and studios, Mr. Kellner said. Until now, consumers have in effect paid much of the cost of network programming by watching the commercials, which account for all the revenue at the broadcast networks and more than half the revenue on basic cable. "If you take that away, who will pay for the programming?," Mr. Kellner asked.

What's more, networks depend on their schedules to build new shows, by putting them on after hits.

Mr. Kellner said the networks and studios needed to wrestle with the cable companies, satellite companies and others to make sure they get paid for the value they lose, perhaps through some industrywide fund.

Bruce Rosenblum, executive vice president for television at Warner Brothers, said he was eager to work with his sister company Time Warner Cable. As a big provider of network programs, including many hit shows like "Friends," "West Wing," and "ER," Warner's cooperation could eliminate an obstacle to offering its popular shows on demand and potentially increase AOL Time Warner's leverage with the networks.

But, Mr. Rosenblum said, he shared Mr. Kellner's concerns about commercial skipping, noting that Warner has responsibility to producers, writers, directors and actors who receive some of the revenue from its shows.

Still, Mr. Parsons, chief at AOL Time Warner, said he remained confident that networks and studios, inside and outside the company, would see the wisdom of working with cable. He explained: "It is a matter of saying, `people will pay for the convenience, people will pay for the choice. There is an opportunity for us both to enhance and grow our business. And, oh, by the way, if we don't do it somebody else is going to do it, and we are going to be the losers.' "

Posted by DeLong at October 28, 2002 04:46 PM | Trackback

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I enjoyed this real-world work out of the Coase Theorem. Many thanks for an illuminating contemporary example.

Apart from the underlying assumptions of the theorem - well-defined property rights, frictionless bargaining with no transactions costs - it is taken as given that the parties know the pay-off functions. In this case they plainly don't. The margins of uncertainty around estimates of what consumers are prepared to pay and the responses of (perhaps few) competitors are huge, hence the procrastination over decisions. Have we any reason to suppose that a hierarchical solution would lead to a better outcome - better in the sense that gainers could over-compensate losers?

By reports, over the last 20 years central management in several large vertically integrated producers has given freedom to constituent units to outsource components when outside suppliers could supply on better terms than inside units and to sell components to competitors when better terms could be had than from inside customers. Perhaps the same freedoms might be extended within AOL-TW.

Posted by: Bob Briant on October 28, 2002 03:27 PM

Typically, you raise a very interesting point - although corporate infighting is inevitable as profit centers clash, particularly in a new merger like this, the shareholders have a bet in each camp. This should, one hopes, reduce the negotiation friction that bars a settlement.

Suppose they were separate companies: it might be that the "right" solution would involve a huge (and hugely compensated) transfer of "property rights" from one party to the other. Given the uncertainties of the payoffs, this could break the company that guessed wrong.

Since they are now under sole ownership, the excitement is at the level of individual pay packages - still a big deal, but not firm-threatening for the shareholders.

And yet, progress is still painfully slow.

Posted by: Tom Maguire on October 28, 2002 07:05 PM

My experience dealing with some large companies is that they are more successful bargaining with their clients/customers/suppliers than bargaining internally over how revenues should be split up. The battles over how internal costs (overhead, etc.) are attributed to the various operating units and over who gets credit for revenue generation can lead people to behave in ways that are counterproductive to the overall company's interests.

Posted by: Josef on October 28, 2002 07:12 PM

Coase's theorem seems to presuppose a powerful and efficient state which can enforce property rights (after creating efficient ones) and can prevent force and fraud. The idea that this is, or can be laissez faire is nonsense. Someone has to create the market and enforce the rules. At the same time there is an immediate problem. Someone or many someones will try to use the state to extract rents. The state has to be neutural, but at the same time the state becomes property to be bargained for.
This, of course, is above and beyond the problem of information and risk, which are mentioned in the other posts.

Posted by: Daniel Klenbort on October 28, 2002 07:27 PM

>>a big deal, but not firm-threatening for the shareholders<<

No, but the underlying issues are. On the bandwidth side, no one seems very clear on which pipes will carry the flow. ADSL seems like a temporary 'fix' to take advantage of an existing infrastructure. But the future: CDMA, Bluetooth, WiFi, Sattelite. Who knows? Your guess, at this stage, is as good as mine, or that of the AOL executives. But then you and I don't have to put up the money.

And the ISP architecture, many clients/one server, or P2P. Again it's up for graps.

>>"the 30-second ad-skip button."<<

Call this the death of the economic model of TV as we know it. Maybe the analysts had it all wrong from the start, maybe it wasn't the internet that was looking for an economic model, but TV that was looking for a survival strategy in the age of internet. So maybe TV needs to embrace the internet-Google-model, providing something really good free in order to indirectly (and inobtrusively) promote something else. Perhaps this way the quality could get to improve a bit too!

Bottom line, will all that AOL cable only live to become the modern equivalent of the canal boom.

On the economic theory side, could it be that Brian Arthur has as much to offer in understanding this as Ronald Coase does.

Posted by: Edward Hugh on October 28, 2002 10:02 PM

Tom - the disadvantage of having profit centers rather than separate companies lies in just that slowness you commented on.

While the profit centers fight, wasting time and energy, the management of separate companies might bargain more efficiently, since they don't have 'internal rents' to collect. The problem of uncertainty in which company gets the lion's share can be dealt with by diversification.

Posted by: Barry on October 29, 2002 05:32 AM

Coase's theorem seems to presuppose a powerful and efficient state which can enforce property rights (after creating efficient ones) and can prevent force and fraud. The idea that this is, or can be laissez faire is nonsense. Someone has to create the market and enforce the rules. At the same time there is an immediate problem. Someone or many someones will try to use the state to extract rents. The state has to be neutural, but at the same time the state becomes property to be bargained for.
This, of course, is above and beyond the problem of information and risk, which are mentioned in the other posts.

Posted by: Daniel Klenbort on October 29, 2002 05:36 AM

The battles over how internal costs (overhead, etc.) are attributed to the various operating units and over who gets credit for revenue generation can lead people to behave in ways that are counterproductive to the overall company's interests.

I have seen this at every level on Wall Street, from fights between trading desks, to dust-ups in the investment banking suites. The classic surviving and prospering firm, Goldman Sachs, has always been characterized as having better internal conflict resolution than the late Salomon Brothers, for instance.

Coase's theorem seems to presuppose a powerful and efficient state which can enforce property rights (after creating efficient ones) and can prevent force and fraud. The idea that this is, or can be laissez faire is nonsense. Someone has to create the market and enforce the rules. At the same time there is an immediate problem. Someone or many someones will try to use the state to extract rents. The state has to be neutural, but at the same time the state becomes property to be bargained for.

Pre-Communist absorption Hong Kong is the clearest example of this I can think of.

Posted by: George Zachar on October 29, 2002 05:59 AM

From DeLong to Drudge:

Case Muses About Spinning Off AOL Unit From Time Warner

Regards,

Posted by: Tom Maguire on October 29, 2002 06:06 AM

There's an interesting point here, in the idea that the company hurts itself by infighting. But it seems to me that in discussing this, we are pre-supposing that the hurt is less than it would be if the two companies were separate. And in order to do this, we have to posit one of two things: the absence of a regulatory state, or a near-perfectly efficient regulatory state.

In economic theory, the two companies should be separate, bargaining for goods in a market place in order to ensure optimal allocation of assets that can be decidedly sub-optimal when allocated through internal corporate mechanisms. However, this assumes that the only way companies can jockey for position is within the marketplace, which isn't true. The other way they can jockey for position is through lobbying. I think all of us can agree that lobbying is generally a more wealth-destroying activity than trading/competing, even though it has a higher payoff for the winner, because it tends to be extremely destructive for loser. On net, it destroys, rather than creates, wealth.

So while the AOL/Time Warner merger may be suboptimal in perfect competition, it could still be decidedly optimal in the beggar-thy-competitor regulatory competition of an advanced regulatory state such as ours. Replacing pricing with infighting is efficient. But replacing infighting with lawsuits and campaign contributions is not.

Posted by: Jane Galt on November 4, 2002 11:28 AM
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