Verizon Strikes A Blow For Competition And Consumer Choice.

Probably not a headline anyone thought to see here at Tales of the Sausage Factory, but the fact is that Verizon’s decision to offer “skinny bundles,” and to (at least so far) defend that decision against the inevitable programmer lawsuits, confronts one of the biggest problems in pay TV. For many years now, I’ve talked about the interrelation between large cable operators exercising control over programmers and programmers responding by consolidating so they can exercise market power over cable operators. The result, as laid out in this 2013 paper by S.Derek Turner at Free Press, big cable and big content have become locked in a death spiral driven by ever-increasing prices to the point where even Americans in love with television increasingly look at “cutting the cord” and dropping their pay TV subscriptions altogether.


Now before anyone jumps on me, I am fully aware that Verizon is a profit maximizing firm that is doing this for the best of all possible reasons — to keep existing customers and hopefully attract new ones. I’m also aware of the limitations of the offer — they sell it with the lower speed FIOS package because they are going after the cost sensitive cord cutter not the higher end customer who either is not cost sensitive or has already cut the cord and now wants super broadband speed. So what? Public policy is not about getting companies (or anyone else) to do the right thing for the “right reason,” it is about getting companies to do the right thing for their own reason. Verizon sees that good policy (giving consumers more choices) is also potentially good business. Hoorah!


Mind you, as with all market dynamics, there is always an interplay between the invisible hand of the market and the very visible hand of government. It is, I would maintain, no coincidence that we are seeing a ferment in pay-tv and online video at a time when the DoJ antitrust division, the FCC and even folks in Congress signal that they will not take kindly to companies exercising market power to get in the way of innovation online. Also, as with the “false dawn” of online video in 2009-10, we can expect the dominant players (including Comcast, now no longer constrained to play nice to try to get its acquisition of Time Warner Cable approved) to fight back. We should by no means declare “mission accomplished” when it comes to breaking up the existing business model/incipient market failure/death spiral. We have a lot of work to do, and companies like Verizon might well settle in court the way DISH and Disney did on the Hopper.


Nevertheless, credit where credit is due. Likewise, huge applause to Cablevision for offering an even more revolutionary “cord cutting package” consisting of a digital antenna for free over-the-air-TV and the option to add HBO Go to the package (pay us a small fee and we’ll authenticate the ap for you). While Cablevision is more revolutionary, it does not require it to withstand lawsuits from ESPN and other disgruntled programmers, and maintains the dichotomy of the industry between all or nothing on cable channels which is why I give Verizon a bit more shout out cred here.


Now if I can only get Verizon to follow the suggestion I made back in 2008 that they sell high-speed FIOS broadband at dirt cheap prices to get people addicted to speed.


I unpack a bit what’s going on and why, and what additional policy steps need to happen to support pro-consumer changes in the industry, below . . .


Harold, Could You Please Put This In Context By Boring Me With A Lecture on Cable Programming Economics?


As I wrote back in 2006 in my white paper “The Switching Equation And Its Impact On The Video Programing Market and MVPD Pricing,” aka “Market Power For Dummies” (which is sadly hard to find now since Media Access Project closed its doors and shuttered its website), sports programming is a unique good for which there is no substitute. Enough people are major sports fans that no MVPD (“multi-channel video programming distributor” which is reg speak for pay-TV provider) can hope to build a viable business without sports programming (and certain types of other “marquis” or “must have” programming, but sports seems to be the biggie). Sports programmers know this, and therefore can charge a huge pile of money for their programming. MVPDs pass this on to customers — include the “very large but not large enough to support an entire MVPD” segment of the market which does not want to pay this much for sports programming.


Understanding that last statement requires an understanding of how cable companies sell their product. Cable sells “bundles” of channels, so that consumers have to take lots of channels they never heard of in order to get the channels they want. In the old days, this worked out very well for the cable operators, since they could charge lots more for subscription prices based on offering lots of cheap junk channels. But then programmers – particularly those affiliated with broadcast affiliates, responded by consolidating and bundling their programming. Cable responded by consolidating to give themselves more bargaining power over programmers, who responded by consolidating, etc.


Ultimately, after about a dozen years of this market-driven march to merger, we have a universe dominated by two VERY LARGE MVPDs (Comcast and Direct TV), and a handful of VERY LARGE programmers (Disney, CBS, News Corp. – and Comcast NBCU, which creates its own set of problems). In this dynamic, the two largest MVPDs and the largest programmers generally set the contract terms and pattern for the industry, and everyone else has to follow it because they lack enough negotiating leverage to set their own terms (unless you do something like DISH did, invent a device called “the hopper” which lets you skip commercials, and then bargain with the giant programmers to get online streaming rights in exchange for limiting the ability of consumers to skip commercials.)


As a result, the industry ends up locked in a business model that requires cable operators to offer huge bundles of programming at a fairly high price. Because any one consumer can only get the service he or she wants by paying for the entire bundle, the individual programmers have no incentive to lower the price for their specific programming bundle. If the price is too high, they want the cable provider to eat the loss. Cable providers occasionally refuse to pay the high fees for “retransmission consent” (as the fees paid by cable operators to programmers are called – particularly when it involves retransmitting the programming on a broadcast signal). This results in blackouts. While the programmer loses some money during this period, the programmer still has access to at least 60% of the market if they don’t black out on Comcast and DIRECTV, so the short term dip in revenue is a bearable cost for long term profit. Meanwhile, the cable operator risks losing customers (which are very hard to get back once they have switched to another MVPD, or cut the cord altogether).


This also works out well for those programmers with “must have” programming because the cable subscriber generally blames the cable operator for the high price of the bundle, for the programming blackout, and for forcing the subscriber to take a bundle in the first place. (See this documentary from South Park, Colorado for an illustration.)


So How Did Sports Get Into This? Why Does Everyone Make This About ESPN?


This trick only works for programmers with “must have” programming. If a cable operator will not lose subscribers when the programmer denies retransmission, then it is the cable operator that controls the price, since the cable programmer needs to reach the audience but the cable operator does not need the programming network to attract and hold customers. Even a very popular channel with good ratings may get paid diddlysquat by cable operators for the excellent market reason that the cable operator does not have to pay but the programmer needs to reach an audience.

To be in the position of driving the programmer content train, you need both a lot of aggregated programming networks, so that when you pull your programming you really impact the cable operator big time, and you need “must have” programming that will prompt lots of fanatic viewers to leave your pay-tv service if they can’t get the programming.


The most powerful kind of programming, with the most fanatical fan base, is sports programming. Sports programming also has the advantage that, unlike other forms of programming, you need to watch it live. I might wait a year for the DVD of this season’s Game of Thrones and not worry. But no one who wants to watch their favorite team is going to wait for the highlights DVD at the end of the year. So sports programmers can demand a super-high premium because it is both popular and has no substitute for the real time viewing.


Chief among the sports programmers on this is ESPN. ESPN is so popular it is actually able to impose a pay for subscriber access model for its website. That is to say, you can’t buy access to ESPN’s web content directly. Your broadband access provider must pay on a per subscriber basis, just like they do for ESPN’s video programming. Which means that, again, every single subscriber is paying ESPN for access to the ESPN website, even if you never visit ESPN online and don’t care about their stupid programming or web content.


Any MVPD that doesn’t offer ESPN has a problem. It will not attract and retain a sufficient number of subscribers to remain profitable. So MVPDs pay an outrageous sum, about $6.04/sub, for ESPN. As this graph from the Wall St. Journal shows, that comes out to an almost $5 premium over the next most expensive channel, TNT (which charges $1.34/sub, and can do so because of its “March Madness” sports programming). What is even more striking is that the median cost for cable channels (i.e., half the channels charge more, half charge less) is $0.14/sub. Or, in other words, you have a very few channels that can charge a lot of money and drive the cost of the programming bundle, with the single largest contributor to this cost being ESPN.


Sports programmers like ESPN could, of course, go the HBO route and charge their viewers directly. But they would make less money. Right now ESPN gets $6.04 for every subscriber to a pay-TV service. While many sports fans would probably pay that much for ESPN, a lot of cable subscribers are likely to drop ESPN at that price. So to make the same amount of money as they do now, ESPN would need to raise its premium by a lot. But even sports fans have limits on how much they can pay, so raising the rate will force even more viewers to drop ESPN.


This is, of course, how the market is supposed to work. As we all learn in Econ 101, demand for a service will vary with price. You supposedly hit the maximum trade off of profit for the producer when the supply and demand curve cross each other, assuming a bunch of things that are not all true with cable programming but which is true enough for this already waaaay too long econ explanation. Disney forcing cable operators to sell ESPN (and other must have programming) as part of a bundle, it maximizes its revenue because the cable operator needs to treat the high premium for sports as part of its overall cost and pass that on to all customers, rather than passing on the premium only to those customers willing to pay the premium for sports.


Doesn’t ESPN Blame the Greedy Sports Teams?

Yes they do. And, as with cable operators blaming ESPN, there is some truth to that. Leagues and team owners are well aware of the popularity of their product, as evidenced by the ridiculously high prices they charge for tickets, their ability to extort insane concessions from cities for new stadiums to the 100s of millions of dollars they charge in naming rights to these stadiums.


So, no surprise, the sports leagues and team owners want a taste of all that money. So they charge ESPN, TNT and everyone else big bucks for broadcasting rights. Naturally, ESPN and the other sport programmers pass these along to the pay-TV providers, since Lord knows ESPN is not gonna drop its profits, and he pay-TV guys, who also don’t want to eat that additional cost, pass it on to you.


OK, But Why Is Verizon (and the Rest of the Industry) Finally Doing Something About This Now? This Has Been Going On For Years.

Since pay-TV has very limited competition, and the programming costs are passed on to everyone, we can treat this as a problem of monopoly pricing. For a general explanation of monopoly v. market pricing, see this blog post by James Heany.


Critically, a monopolist cannot charge an infinite amount of money for something. Eventually, no matter how much a person wants or needs a good, the price goes high enough so that the person won’t or can’t pay. However, the monopolist might still make more profit from fewer customers. We call this the “monopoly efficient price,” the price a monopolist can charge that maximizes the total profit, even with fewer customers buying the good.


Eventually, however, even a monopolist can charge too much and lose customers by going over the monopoly efficient price. In the pay-TV world, we call this “cord cutting.” Increasingly, even though online video is not a true substitute for cable programming (especially sports programming), customers decide that cable just ain’t worth it and Netflix and YouTube and everything else online or on DVD can cover their entertainment needs. Once people make the decision to drop their pay TV service, it is incredibly difficult to get them to resubscribe.


So pay-TV now finds itself in something of a death spiral. Everyone agrees it would be a bad idea for their business if so many people stopped watching pay-TV that the industry died. But because of the way the market works, no entity in the supply chain has incentive to fix the problem. They want to pass on the cost of lowering prices to the other entities in the supply chain. Aggravating things further, as the subscriber base which pays for this erodes away, the incentive in the short term is to raise the price on the captive customers.


This death spiral is particularly painful for small and mid-size pay-TV providers (even Verizon is only “mid-sized” in pay-TV terms, and even “mid-sized” like Cox, FIOS, etc. are tiny when compared to Comcast and DIRECTV). Companies like Verizon are steadily losing customers to cord cutting, and the trend seems likely to continue. But because they have fewer customers, ESPN is able to force them to pay a higher premium, since Verizon will lose much more from dropping ESPN than ESPN loses by not having access to Verizon’s subscribers. Verizon cannot drop ESPN because (a) it would lose all its ESPN watchers, which would be too many to lose all at once; and, (b) ESPN is part of the Disney bundle, even if it is priced separately, so Verizon would also lose a whole bunch of “must have” programming and lose pretty much all its subscribers.


Additionally, Verizon wants to offer an online streaming video service to its mobile subscribers and the world generally. There is no way Verizon can do that affordably using the existing cable model of a bundle that includes high-priced sports programming.


So Verizon has lots of incentive to shake things up and break the current bundles. OTOH, it doesn’t want to just encourage people to switch to its broadband service like Cablevision. Verizon likes being in the real-time Pay-TV service. It just wants to sell the product in a way potential customers would actually like them to sell the product. That way Verizon can properly price the various realtime programming and maximize its profit.


Or, in other words, the magic of the market aligns Verizon’s incentive to profit maximize with the consumer desire to get lower prices by only paying for the programming the consumer actually watches (or, at least eliminate big chunks of programming you pay for but never actually watch). This would also make it harder for ESPN and others to raise their prices without feeling the impact directly. Yaaaay!!! The market actually produces the right result for a change – kinda sorta mostly but enough to declare “mission accomplished” for the invisible hand. Woo hoo!!! Verizon and all you other providers can compete for my consumer love!


So Mission Accomplished, Death Spiral Averted, Nothing To See Here?

Not so fast my deregulatory narrative construct. First, you’ll notice this isn’t happening because of actual competition among pay-TV providers. It is happening because the market structure caused the pricing to overshoot the monopoly efficient price. We still have a major problem in the video and broadband competition market to deal with here.


But even setting that aside, we have no guarantee Verizon will be successful. ESPN has a contract, and it is suing Verizon for breaching it. Without reading the programming contract, I have no way of assessing whether Verizon has a good chance of winning or not. From Verizon’s perspective, however, there are several advantages to pushing this. First, they may win. Second, if they lose, they will have demonstrated to regulators (who keep talking about doing something on this and never actually do) that there is absolutely no way out of this dysfunctional pay-TV death spiral unless Congress passes a new law or the FCC does something to address program unbundling. (I’ll discussion of regulatory options for another time, we’re up to about 3000 words already!)


But even if Verizon wins, it may only provide temporary relief. As noted above, DISH came up with a great technology for skipping commercials called “The Hopper.” Programmers sued that this violated both the copyright on the programming and the terms of their retransmission contracts with DISH. Won just about every round in the litigation. So the programmers simply made immunity to commercial skipping a term in their next round of retransmission negotiations. While DISH picked up some concessions on its future video streaming service, consumers don’t get to skip commercials on a lot of the programming anymore.


Verizon may have something similar in mind here. Even if it wins its law suit, it may face some tough choices the next time it has to negotiate retransmission consent. So any victory in the short term might be undone going forward.


Finally, Verizon is in a unique position to challenge this model. It has lots of other lines of business in case this video stuff doesn’t work out, and it has a huge amount of revenue and free cash flow to fight an expensive legal battle. Smaller pay-TV operators are not so lucky. Furthermore, based on history, the smaller, weaker cable guys are likely to get even more screwed over if Verizon wins, since the programmers will use their market power over the smaller providers to try to make up for any lost profit.


None of this means Verizon’s efforts here are in vain, and Lord knows I am certainly hopeful that we may at last be seeing some real changes in the pay-TV market that could help bring prices down, enable innovative new business models, and overall benefit consumers. But it does not mean the problems in the video marketplace are solved, or that “the market” will invariably work it out.


For now, though, applause to Verizon for taking on the bundles and going to court on this.


Now about my idea for giving away FIOS . . .


Stay tuned . . . .


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