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Will Hollywood Be Unraveled by Unbundling?

Megan McArdle is a Bloomberg View columnist. She wrote for the Daily Beast, Newsweek, the Atlantic and the Economist and founded the blog Asymmetrical Information. She is the author of "“The Up Side of Down: Why Failing Well Is the Key to Success.”
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Whither Hollywood?

It seems that the digital revolution is finally reaching cable television. Multiple companies, including Dish Network, have announced new streaming services that you might call "narrow cable": a stripped-down array of channels at a stripped-down price. An excellent article by my colleague Alex Sherman argues that "The largest U.S. cable companies may be approaching a cliff they’ve long tried to avoid -- competition with each other." Whether we like it or not, whether it even saves us money or not, it seems that the future is going to be less bundled.

A few days ago, I idly mentioned to some friends that I thought this might well portend major cash flow problems in Hollywood. They seemed very surprised to hear it, so I thought it was worth laying out my reasons. Keep in mind that this is not a firm prediction, but an outline of what I think is a plausible path for big trouble in big entertainment. But here are a couple of important facts about Hollywood.

The first thing to point out about movies -- and pardon me for stating the obvious -- is that they're incredibly expensive to make. The low-budget horror film "Insidious Chapter 2" cost $5 million to make; indie movie "Boyhood" was in the same range. "Selma," a prestige drama without elaborate special effects, was about $20 million. Slick thriller "Gone Girl," again without a massive cast, exotic foreign shooting locations or blockbuster special effects, ran to about $60 million. That doesn't include marketing budgets or the overhead of running a studio, just the production cost of the movie. And, obviously, if you like big-budget, special-effects-driven Hollywood spectaculars, things start north of $100 million and just keep heading up from there.

This is also true of television; "Breaking Bad" ran about $3 million per episode, on the high end of the range for a basic cable drama but not outrageously so -- that's also the reported budget for "Homeland" and less than that of "Game of Thrones" or a hit network show such as "CSI."

Technology can drive down costs somewhat, but unlike the recording industry, it also drives up costs -- by, for example, enabling directors to spend vast fortunes on special effects. This also has potentially disastrous effects on the demand side.

The second thing we need to point out about the film industry is that on average, it no longer makes a profit on the box office for blockbuster films. The box office covers some of the costs, but movies break even on the "ancillary revenue": pay per view, cable, streaming services, syndication, merchandising. The merchandising is one reason that we've seen such a drive towards "tentpole" films, especially comic book films that have crossover appeal from kids to adults; I doubt "Selma" or "Boyhood" drove much in the way of T-shirt and action figure sales, though we could argue that it would be a better world if they did.

By one analysis, cable now contributes more than half of all operating profits generated by movies. What this means is that cable and network television and the movie business are not as distinct as they seem; they are actually an ecosystem that is tightly bound together. A change to one niche may have big reverberations.

So television shows and movies cost a lot to make, and both of them depend heavily on a distribution system that seems poised for rapid change. Why do I think this might cause money to start draining out of Hollywood? Because both the first- and second-order effects of unbundling are going to put pressure on budgets.

The first-order effect of unbundling is pretty obvious: It makes it easier for people to pay less by consuming a restricted bundle of content, rather than the current model, which is basically "all you can eat." Now, I'm not arguing that people are going to pay less; I think it's also possible that the cord cutters will eventually find that they are devoting more of their budget to content than ever. We're currently examining cord cutting for the McSuderman household, and at first glance, stringing together narrow bundles to replicate what we watch now will not cost much less than what we have now -- and, of course, as cable companies make less money on cable service, they're going to have to jack up the price of Internet service in order to cover the fixed costs of maintaining the cable infrastructure, a cost that used to be shared across the content and broadband services.

But let's say they're going to pay less, because that's what cord cutters seem to believe will happen, and that's certainly one plausible outcome. Maybe all that money comes out of ESPN. But maybe it turns out that price-insensitive sports watchers were subsidizing AMC and F/X and all the rest. Cable is such a tangle of cross-subsidies -- between broadband subscribers and cable watchers, between various sorts of consumers with different demand functions -- that it's very difficult to predict what will be gone, or diminished, when everything shakes out.

Meanwhile, the other major source of revenue for TV shows and movies is also threatened: advertising. The television ad market is inexplicably soft when it should be strong. Except that when I talked to an actual expert, it turned out not to be inexplicable; as consumers have switched to on-demand and DVRs, advertisers are refusing to pay for folks who may not actually watch their ads. Over the long term, I expect this trend to continue and worsen, both because it will be harder to get people to watch paid advertising and because companies have more ways to serve their own marketing content over the Web.

And then there's piracy.

Compared to the recording industry, Hollywood has been relatively resilient to piracy. There are a lot of theories floating around about why, but here are the factors I find most plausible:

  1. Piracy tends to be driven by teenagers and young adults, because they have lots of time, little disposable income and peer norms that support piracy. They're also the ones who find it easiest to learn new technical tricks. Obviously, other groups pirate, but piracy networks, like other sorts of networks, are better when they are denser, so teenagers are the most important part of the ecosystem.
  2. Teenagers still go to the movies because they still live at home, and they're too young to go to bars, so this is one of the few places they can hang out without adult supervision.
  3. Homes tend to have cable, which you can think of as a sort of very expensive Spotify subscription that is paid for by parents. So the marginal cost of consuming extra video content is pretty low, though it may involve browbeating Mom into coughing up extra money to add HBO to the cable package. The marginal cost of consuming additional non-pirated music, on the other hand, was high -- $15 for an album, or a tedious hour spent dubbing a cassette from a friend's copy. It therefore made sense to invest time into file-sharing networks that could drop your marginal cost of consuming virtually any music to zero.
  4. People have more time to consume music than video, because you can do something else while listening, so the demand for piracy, and thus the thickness of the networks, was higher.

The fourth is a minor point, but may matter. The first three matter a lot.

One thing that narrow bundles do is raise the marginal cost of consuming more content. Note that they do this even if the average spend remains about the same. Getting access to extra content means persuading your parents to shell out for another subscription service, or spending your own money on same -- and the more that cable unbundles, the higher the marginal cost of each additional piece of content. Which, in turn, means that for many people, especially teenagers, the cost-benefit analysis will start to weigh more heavily in favor of piracy.

And here we return to the problem of cost. There was a time when file-sharing advocates used to earnestly explain that it would actually be good for artists, because they could give the recordings away as loss leaders and make up the money with live performances and merchandise. But there is a limit to how many shows people can attend, and there is little evidence that people have increased the number of shows they attend because they can download the music for free. 

But music still continues, and it can on a quasi-amateur basis. Most of the cost of making music is the time of the performers, and even a large band only has a few people in it. Add in techs and road help, and you've still got something that can be produced for very little money -- and has been for thousands of years. Hard on the artists, of course, but consumers will still have music, even if they might not get as much of it from their favorite artists as they did before.

Movies and television, however, simply don't work that way, and they won't until computing power and software are so sophisticated that we can make an entire feature film on a desktop. Even small productions require large staff and lots of equipment, an amount of human capital that cannot be assembled by effectively asking everyone involved to volunteer their time in the hopes of having some fun and possibly making it big later. Unlike band rehearsals, a movie shoot cannot be scheduled around everyone's day job; people have to show up at a particular time and place and stay there until you're done shooting, which means that you are going to have to pay them. Which in turn means that unless you expect to sell gazillions of dollars worth of merchandise, there is no way to give a movie away for free and make up your costs in ancillary sales.

This means widespread piracy would likely have much greater effects on supply than it did in music, where it was easier to shift toward a lower-cost product. And as the brilliant Gabriel Rossman has pointed out, there are second-order effects as well as the primary effect of simply displacing sales. Piracy shifts industries toward a different mix of products -- music singles instead of albums, for example, or wide releases rather than rotating prints through theaters -- which alters revenue and cost structures, and may mean less stuff gets made. Arguably, we are already seeing this in Hollywood, which is making fewer movies, and the ones that are made are heavily weighted toward tentpole franchises that offer a lot of merchandising opportunities.

Perhaps more important, Rossman notes that the music industry had a lot more room for revenue declines, because so much of a budget was spent on promotion, both in the form of ads and, um, alternative marketing like payola. The ratio of promotion to production costs was about 10:1, meaning $10 got spent on promotion for every $1 spent on actually making the album. "This means that over the long-run," he writes, "a drop in music revenues will in large part be felt by radio stations and others who specialize in promoting music."

Hollywood, on the other hand, spends more money on production than distribution -- about twice as much. So a decline in revenue will not be cushioned by taking it out of the hides of promoters; it will hit production itself.

I'm not predicting that Hollywood is going to go out of business. But I do think it may be on the cusp of what my own industry has gone through: a radical disruption in which people are more avid than ever to consume what we produce but there are fewer and fewer ways to monetize it. And given just how much money it takes to make the basic product, that will mean a lot less money for the folks who work in Hollywood and, quite possibly, less content, of lower quality, for the rest of us.

That doesn't mean that we should get the heavy hand of government in there to prop everything up -- I doubt that's possible, and I'm quite sure it's unwise. But it does mean that we should be prepared for the earthquakes that have hit journalism and music recording to start rippling into previously safe territory.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Megan McArdle at mmcardle3@bloomberg.net

To contact the editor on this story:
Brooke Sample at bsample1@bloomberg.net