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13.4 Information Economy

Learning Objectives

  1. Determine how switching costs influence the information economy.
  2. Summarize the tenets of the three major founding pieces of antitrust legislation.
  3. Determine how a company might use vertical integration.

The modern theory of the information economyAn economic model based on selling intangible information rather than products. was expressed in the 1998 publication of Information Rules: A Strategic Guide to the Network Economy, written by Cal Shapiro, an economics professor at University of California, Berkeley, and Hal Varian, now chief economist at Google. Their fundamental argument was simple: “Technology changes. Economic laws do not.”Carl Shapiro and Hal R. Varian, Information Rules: A Strategic Guide to the Network Economy (Cambridge, MA: Harvard Business School Press, 1998).

While economic laws may not change, the fundamentals of the business of information are far different from the fundamentals of most traditional businesses. For example, the cost of producing a single sandwich is relatively consistent, per sandwich, with the cost of producing multiple sandwiches. As discussed in Section 13.1 "Characteristics of Media Industries", information works differently. With a newspaper, the first copy costs are far higher than the marginal costs of secondary copies. The high first costs and low marginal costs of the information economy contribute very heavily to the potential for large corporations gaining dominance. The confluence of these two costs creates a potential economy of scaleAn economic model with high first costs and low marginal costs that heavily rewards expansion., favoring the larger of the competitors.

In addition, information is what economists refer to as an experience goodA good that requires the customer to experience it in order to judge its value., meaning that consumers must actually experience the good to judge its value. The problem with information is that the experience is the good; how do you know, for example, that a movie has high-quality acting and an interesting plot before you’ve watched it? The solution to this is branding, which was discussed in Chapter 12 "Advertising and Public Relations". Although it may be difficult to judge a movie before watching, knowing that a given film was made by a certain director or stars an actor you like increases its value. Marketers use movie trailers, press coverage, and other marketing tools to communicate this branding message in the hopes of convincing you to watch the films they are promoting.

Another important facet of information technology is the associated switching costsThe cost that a user must pay to switch from one technological format to another.. When economists consider switching costs, they take into account the difference between the cost of one technology and the cost of another. If this difference is less than the cost it would take to switch—for information, the cost of moving all of the relevant data to the new technology—then it is deemed possible to switch. A classic example is moving a music collection from vinyl LPs to CDs. For a consumer to switch systems—that is, to buy a CD player and stereo—that person would also have to rebuild his or her entire music collection with the new format. Luckily for the CD player, the increase in convenience and quality was great enough that most consumers were inclined to switch technologies; however, as is apparent to anyone going to a thrift store or garage sale, old technologies are still being used because the information on the records was important enough for some people to keep them around.

Regulation of the Information Economy

Although Chapter 15 "Media and Government" will discuss government regulation in greater depth, a basic understanding of the interaction between government and media over time is essential to understanding the modern information economy. Public policy and governmental intervention exacerbate an already complicated system of information economics, but for good reason—unlike typical goods and services, the information economy has many significant side effects. The consequences of one hamburger chain outcompeting or buying up all other hamburger chains would surely be fairly drastic for the hamburger-loving world, but not altogether disastrous; there would be only one type of hamburger, but there would still be many other types of fast food remaining. On the contrary, the consequences of monopolization by one media company could be alarming. Because distributed information can influence public policy and public opinion, those in charge of the government have an interest in ensuring fair distribution of that information. The bias toward free markets has been mitigated—even in the United States—when it comes to the information economy.

The Federal Communications Commission (FCC) is largely responsible for this regulation. Established by the Communications Act of 1934, the FCC is charged with “regulating interstate and international communications” for nearly every medium except for print.Federal Communications Commission, “About the Federal Communications Commission,” http://www.fcc.gov/aboutus.html. The FCC also attempts to maintain a nonpartisan, or at least bipartisan, outlook, with a maximum of three of its five commissioners belonging to the same political party. Although the FCC controls many important things—making sure that electronic devices don’t emit radio waves that interfere with other important tools, for example—some of its most important and most contentious responsibilities relate to the media.

As the guardian of the public interest, the FCC has called for more competition among media companies; for example, the ongoing litigation of the merger between Comcast and NBC is not concerned with whether consumers will like streaming Hulu over the Internet, but rather whether one company should own both the content and the mode of distribution. The public good is not served if consumers’ ability to choose is taken away when a service provider like Comcast restricts access to only the content that the provider owns, especially if that service provider is the consumers’ only choice. In other words, the idea of public good is concerned not with the end result of competition, but with its process. The FCC protects consumers’ ability to choose from a wide variety of media products, and the competition among media producers hopefully results in better products for consumers. If the end result is that all customers choose Hulu anyway, either because it has the shows they like or because it offers the best video-streaming capability, then the process has worked to create the best possible model; there was a winner, and it was a fair fight.

A Brief History of Antitrust Legislation

The main tool that the government employs to keep healthy competition in the information marketplace is antitrust legislation. The seminal Sherman Antitrust Act of 1890 helped establish modern U.S. antitrust legislation. Although originally intended to dissolve the monopolistic enterprises of late-19th-century industrialists such as Andrew Carnegie and John D. Rockefeller, the law’s basic principles have applied to media companies as well. The antitrust office has also grown since the original Sherman Act; although the office of the attorney general originally brought antitrust lawsuits after the act’s passage, this responsbility shifted to its own Antitrust Division in 1933 under President Franklin D. Roosevelt.

The Sherman Antitrust Act of 1890 outlined many propositions and goals that legislators deemed necessary to foster a competitive marketplace. For example, Chapter 1, Section 2, of the act states that “Every person who shall monopolize, or attempt to monopolize, or combine or conspire with any other person or persons, to monopolize any part of the trade or commerce among the several States … shall be deemed guilty of a felony.”Legal Information Institute, “Monopolizing trade a felony; penalty,” Cornell University Law School, January 5, 2009, http://www.law.cornell.edu/uscode/html/uscode15/usc_sec_15_00000002----000-.html. This establishment of monopolization as a felony was remarkable; before, free-market capitalism was the rule regardless of the public good, making the Sherman Antitrust Act an early proponent of the welfare of people at large.

Two additional pieces of legislation, the Clayton Antitrust Act of 1911 and the Celler-Kefauver Act of 1950, refined the Sherman Antitrust Act in order to make the system of antitrust suits work more effectively. For instance, the Clayton Act makes it unlawful for one company to “acquire … the whole or any part of the stock” of another company when the result would encourage the development of a monopoly.Legal Information Institute, “Acquisition by one corporation of stock of another,” Cornell University Law School, January 5, 2009, http://www.law.cornell.edu/uscode/html/uscode15/usc_sec_15_00000018----000-.html. More than just busting trusts, the Clayton Act thus seeks to stop anticompetitive practices before they take hold. The Celler-Kefauver Act made it more difficult for corporations to get around antitrust legislation; while the Clayton Act allowed the government to regulate the purchase of a competitor’s stock, the Celler-Kefauver Act extended this to include the competitor’s assets.

Deregulation and the Telecommunications Act of 1996

Although the early part of the 20th century seemed to be devoted to breaking up trusts and keeping monopolies in check, the media—particularly in the latter part of the century—was still able to move steadily toward conglomeration (companies joining together to form a larger, more diversified corporations). Widespread deregulation (the removal of legal regulations on an industry) took place during the 1980s, in large part through the efforts of free-market economists who argued that deregulation would foster more competition in the information marketplace. However, possibly due in large part to the media economy’s focus on economies of scale, this was not the case in practice. Companies became increasingly conglomerated, and corporations such as Comcast and Time Warner came to dominate the marketplace. The Telecommunications Act of 1996 helped solidify this trend. Although touted as a way to let “any communications business compete in any market against any other” and to foster competition, this act in practice sped up the conglomeration of media.Federal Communications Commission, “FCC — Telecommunications Act of 1996,” November 15, 2008, http://www.fcc.gov/telecom.html.

Media Conglomerates and Vertical Integration

The extension of the Telecommunications Act of 1996 of corporate abilities to vertically integrate was a primary driving factor behind this increased conglomeraton. Vertical integration has proven particulary useful for media companies due to their high first costs and low marginal costs. For example, a television company that both produces and distributes content can run the same program on two different channels for nearly the same cost as only broadcasting it on one. Because of the localized nature of broadcast media, two broadcast television channels will likely reach different geographical areas. This results in cost savings for the company, but also somewhat decreases local diversity in media broadcasting.

In fact, the Telecommunications Act made some changes in authority for these local markets. The concept of Section 253 is that no state may prohibit “the ability of any entity to provide any interstate or intrastate telecommunications service.”Federal Communications Commission, “Telecommunications Act of 1996, Section 253 (a),” January 3, 1996, http://www.fcc.gov/Reports/tcom1996.pdf. Thus, since state and local governments cannot prohibit any company from entering into a marketplace, there are checks on the amount of a local market that any one company can reach. In addition, the Telecommunications Act capped the share of U.S. television audience for any one company at 35 percent. However, the passage of additional legislation in 1999 allowing any one company to own two television stations in a single market greatly diluted the effect of this initial ruling. Although CBS, NBC, and ABC may be declining in popularity, they “still offer the only means of reaching a genuinely mass television audience” in the country.Gillian Doyle, Understanding Media Economics (Thousand Oaks, CA: Sage, 2002).

Corporate Advantages of Vertical Integration

Almost all of the major media players in today’s market practice extensive vertical integration through either administrative managementThe potential for divisions of a single company to share the same higher-level management structure. or content integrationThe ability of a company to use the same content across platforms.. Administrative management refers to the potential for divisions of a single company to share the same higher-level management structure, which presents opportunities for increased operational efficiency. For example, Disney manages theme parks and movie studios. Although these two industries are not very closely connected through content, both are large, multinational ventures. Placing both of these divisions under a single corporation allows them to share certain structural similarities, accounting practices, and any other administrative resources that may be helpful across multiple industries.

Content integration—an important practice for media industries—is the ability of these companies to use the same content across multiple platforms. Disney’s theme parks would lose much of their charm and meaning without Mickey Mouse and Cinderella’s castle; the integration of these two industries—Disney’s theme parks and Disney’s animated characters—proves profitable for both. Behind the scenes, Disney is also able to reap some excellent benefits from their consolidation. For example, Disney could release a movie through its studio, and then immediately book the stars on news programs that air on Disney-owned broadcast television network ABC. Beyond just the ABC broadcast network, Disney also has many cable channels that it can use to directly market its movies and products to the targeted demographics. Unlike a competitor that might be wary of promoting a Disney movie, Disney’s ownership of many different media outlets allows it to single-handedly reach a large audience.

Ethical Issues of Vertical Integration

However, this high level of vertical integration raises several ethical concerns. In the above situation, for example, Disney could entice reviewers on its television outlets to give positive reviews to a Disney studio movie. Therefore, this potential for misused trust and erroneous information could be harmful.

In many ways, the conglomeration of media companies takes place behind the scenes, with only a minority of consumers aware of vertically intergrated holdings. Media companies often try to foster a sense of independence from a larger corporation. Of course, there are exceptions to this rule; the NBC sitcom 30 Rock often delves into the troubles of running a satirical sketch-comedy show (a parody of NBC’s Saturday Night Live) under the ownership of GE, NBC’s real-life owner.

The Issues of the Internet

Although media companies are steadily turning into larger businesses than ever before, many of them have nevertheless fallen on hard times. The instant, free content of the Internet is largely blamed for this decline. From the shift of classified advertising from newspapers to free online services to the decline in physical music sales in favor of digital downloads, the Internet has transformed traditional media economics.

One of the main issues with an unregulated Internet is that it allows digital files to be replicated and sent anywhere else in the world. Large music companies, which traditionally made almost all of their money from selling physical music formats such as vinyl records or compact discs, find themselves at a disadvantage. Consumers can share and distribute music files to anyone, and Internet service providers are exempted from liability under the DMCA. With providers freed of liability and media consumption a driving factor in the rise of high-speed Internet services, ISPs have no incentive to deter illegal sharing along with legal downloads.

Digital Downloads and DRM

Although music companies have had some success selling music through digital outlets, they have not been pioneers in online music sales. Rather, technology companies such as Apple and Amazon.com, sensing a large market for digital downloads coupled with a sleek delivery system, have led the way. Already accustomed to downloading MP3s, consumers readily adopted the model. However, record companies believed that the lack of digital rights management (DRM) protection offered by MP3s represnted a major downside.

Apple provided a way to strike a compromise between accessibility and rights control. Having already captured much of the personal digital audio player market with the iPodthat uses other Apple products, Apple has also long prided itself on creating highly integrated systems of both software and hardware. Because so many people were already using the iPod, Apple had a huge potential market for a music store even if it offered DRM-locked tracks that would only play on Apple devices. This inflexibility even offered a small benefit for consumers; Apple succeeded in convincing companies to price their digital downloads lower than CDs.

This compromise may have sold a lot of iPods and MP3s, but it did not satisfy the record companies. When consumers started to download one hit single for 99 cents—rather than buying the whole album for $15 on CD—the music industry felt the pain. Still, huge monetary advances in digital music have taken place. Between 2004 and 2008, digital music sales increased from $187 million to $1.8 billion.

Piracy

The music industry has wasted no amount of firepower to blame piracy for the decline in album sales: “There’s no minimizing the impact of illegal file-sharing. It robs songwriters and recording artists of their livelihoods, and it ultimately undermines the future of music itself,” said Cary Sherman, president of the Recording Industry Association of America.Cary Sherman, “File-Sharing Is Illegal. Period,” USA Today, September 18, 2003. However, economists see the truth of the matter as significantly more ambiguous. Analyzing over 10,000 weeks of data distributed over many albums, a pair of economists at the Harvard Business School and University of North Carolina found that “Downloads have an effect on sales which is statistically indistinguishable from zero.”Felix Oberholzer-Gee and Koleman Strumpf, “The Effect of File Sharing on Record Sales: An Empirical Analysis,” Journal of Political Economy 115, no. 1 (February 2007): 1–42. Either way, two things are clear: Consumers are willing to pay for digital music, and digital downloads are on the market to stay for the foreseeable future.

Key Takeaways

  • Switching costs and economies of scale play major roles in the information economy. The former helps determine whether a new technological format will take hold, and the latter encourages the growth of large media conglomerates.
  • The three founding pieces of antitrust legislation were the Sherman Antitrust Act (1890), which laid the foundation of antitrust legislation; the Clayton Antitrust Act (1911), which allowed the government to regulate purchase of a company’s stock; and the Celler-Kefauver Act (1950), which allowed the government to regulate the purchase of another company’s assets.
  • Vertical integration occurs when a company controls all aspects of an industry: procuring raw materials, manufacturing, and delivering. Media companies benefit from vertical integration, but the practice raises numerous ethical issues.

Exercises

Visit the Columbia Journalism Review’s “Who Owns What?” web page at http://www.cjr.org/resources/index.php. Choose a company from the drop-down menu. Make a chart of all the company’s different media outlets and complete the following activities:

  1. Choose two subsidiaries of the parent company and discuss how they might be able to use vertical integration to their advantage.
  2. How might the larger corporation be using an economy of scale?
  3. How might the company be attempting to lessen switching costs? For example, does the company offer the same content on multiple platforms in order to reach customers who may have only one of these platforms? Give an example.
  4. How might the three founding pieces of antitrust legislation affect the company’s decisions?