Intermediate Microeconomics and Its Application 12th Edition by Walter Nicholson,Christopher Snyder

Exercise 22

For many years, Blockbuster was the largest video rental company in the world, operating retail outlets in nearly 2,000 locations in the United States and in many foreign countries. The rapid growth of the company in the 1980s and early 1990s can be attributed both to the increased availability of VCRs and DVD players and to the related changes in the ways people watched movies. By the late 1990s, however, the company began to face increasingly complex challenges as the technology for delivering entertainment content to households evolved. Ultimately the company filed for bankruptcy in 2010 and was completely absorbed by Dish Network in 2011. In this application, we look at how the microeconomics of households' demands for entertainment (in combination with changing technology) made it impossible for Blockbuster to continue in the business model it had chosen.
Challenge 1: Content Availability
The first challenge Blockbuster faced arose directly out of the nature of consumer demand for movies and related entertainment products. The advent of VCRs and DVDs significantly increased the possibilities for home viewing. But consumers were obviously sensitive to the costs of doing so. At first content providers (that is, movie studios and television networks) were reluctant to provide very much of their copyright material to Blockbuster, fearing that such a move would substantially reduce what they could make from consumers directly. As a consequence, providers charged large fees for tapes and DVDs and offered relatively few copies to Blockbuster. This resulted in a high cost to consumers both because of direct rental charges and because of the frustration experienced by finding little content available. To meet these problems, in the mid- 1990s Blockbuster negotiated "revenue-sharing" contracts with major providers. These encouraged the providers to offer more copies of popular offerings at much reduced prices. Demand for rentals grew rapidly as consumers discovered that the costs to them of renting had fallen dramatically.
Revenue-sharing contracts did pose a major danger to Blockbuster, however. With such contracts, content providers had every incentive to offer similar deals to other rental firms. The company had helped to establish a licensing contract that was indeed preferable for the ultimate consumer, but also established the route to increased competition.
Challenge 2: The Netflix Innovation
Perhaps the firm that initially derived the most benefit from Blockbuster-type revenue-sharing contracts was the fledgling rent-by-mail firm, Netflix. Renting by mail again reduced costs to consumers by two ways. First, time costs were significantly reduced because DVDs arrived at the doorstep. The need to go to the video rental "store" was eliminated. A second advantage Netflix had was that it provided DVDs from a few central locations. That meant that it could have a much larger inventory than was possible in any one Blockbuster store. Consumers could easily search this inventory with their home computers, so the costs of such search were dramatically lower. Blockbuster tried to compete with Netflix by establishing a rent-by-mail option, but this option was never very successful, in part because the firm itself feared that the mail option would undercut the positions of its own stores.
Challenge 3: Streaming
The widespread availability of high-speed internet service provided a third, and final, challenge to the Blockbuster rental model. Once movies or TV shows could be streamed directly into homes, the time costs for consumers acquiring films or TV shows essentially fell to zero. On-screen search options further reduced the costs of finding what one wanted. In addition, new competitors such as Amazon and Hulu threatened the established video outlets. For example, Netflix tried to split its rent-by-mail from its streaming operations in 2011, presumably with the ultimate goal of ending the mail option. But consumer opposition led the company to an embarrassing reversal after only a few weeks. Blockbuster was even slower to respond to the new streaming technology and ultimately filed for bankruptcy in September 2010. But that did not end the evolving saga of the company. Dish Network must have had some reason for buying the company, so it is likely that Blockbuster may reemerge in some form that combines retail outlets, streaming, and delivery of content by satellite.
Many of the changes discussed in this example arose because the time costs involved to acquiring rentals were reduced for consumers. How would you put a value on such costs? How would consideration of time costs affect the overall relative prices of rentals? If time costs differ among consumers, how should this affect the ways in which consumers would spread themselves among the various rental alternatives?