DYNAMIC COMMON AGENCY AND INVESTMENT: THE ECONOMICS OF MOVIE DISTRIBUTION

I. INTRODUCTION The management of vertical relationships is one of the fundamental issues addressed by contract and organization theorists. How do contract choices interact with other strategic choices? What are the consequences of vertical integration? Answers to these questions inform management strategy and public policy. This article analyzes vertical relationships and strategic behavior in the movie distribution market. Vertical relationships in dynamic environments have been neglected, and this article is the first to analyze an infinite-horizon common agency model that considers vertical integration and investment. The model has two distributors (studios or independent distributors) and one exhibitor (theater). Distributors can invest each period before contracting with the exhibitor. A distributor's investment stochastically improves its movies; the probability of having "hits" rises. Dynamic strategic interaction is particularly important in the movie business, and the infinite-horizon model explains several facts that cannot be addressed with a static or two-period model. (1) In the model, distributors avoid simultaneous new hit releases, and hits stay in the theater longer than flops. In reality, release timing and run lengths are critical choices. Distributors often adjust release dates to avoid competing head to head (Chisholm 1999; Krider and Weinberg 1998; Reardon 1992) and run lengths depend on early performance (De Vany and Eckert 1991; De Vany and Walls 1996). Furthermore, in equilibrium, distributors appropriate the lion's share of the marginal value created by their hits. This occurs because hits are rare, and the exhibitor's next best alternative is to show worse movies. This is consistent with real-world exhibition contracts, which use nonlinear revenue-sharing rules that give distributors higher shares of ticket revenue when revenue is high (Filson et al. 2005). Vertical integration (one distributor owning the exhibitor) has implications for strategies and welfare. Although the article emphasizes the impacts on strategies, the welfare analysis is useful because it addresses a historical debate. The Paramount decrees of the late 1940s and early 1950s barred distributors from owning theaters. In the 1980s, the U.S. Department of Justice gave distributors permission to forward integrate again. Several did so, including some of the largest ones. De Vany and Eckert (1991) argue that the courts erred in the original decrees, but to date no formal model supports or refutes their arguments. In the infinite-horizon model, vertical integration is privately profitable but lowers industry value: The combined value of the two firms that merge rises because they appropriate value from the remaining distributor, but suboptimal investment occurs, so the combined value of all three firms falls. Additional results depend on how integration affects bargaining power. If the independent distributor maintains its bargaining power, then the integrated distributor increases its investment and further delays releasing its hits. The integrated distributor uses its hits as threats to appropriate value from the independent distributor. In response, the independent distributor reduces its investment. However, total industry investment never falls, and it rises for a wide range of investment costs. Higher industry investment causes more hits to reach the theater, and consumer surplus rises. As a result, integration may improve welfare. In contrast, if the independent distributor loses all of its bargaining power after integration, then it reduces its investment to zero. The integrated distributor still increases its investment, but industry investment (and welfare) falls. Other strategies also change. For example, the integrated distributor tends to show its own new hits in preference to the independent distributor's because it does not need to delay releasing its hits to appropriate value. …