Revenue‐Sharing in Movie Exhibition and the Arrival of Sound

I. INTRODUCTION At least since Adam Smith, economists have been intrigued by share contracts. There has been a proliferation of models, most of which tend to explain the share contract as resulting from some mix of optimal risk-bearing and optimal effort motivation. (1) A large number of researchers have attempted to test these models empirically. Sharecropping contracts, not surprisingly, are the most intensively examined (the bibliography in Knoeber [2000]), but similar studies have been conducted in many other areas. For example, Martin (1988) and Lafontaine (1992) examine franchise arrangements, Hallagan (1978) investigates contracts used to lease gold claims, Leffler and Rucker (1991) analyze a sample of private timber sale contracts, Goldberg and Erickson (1987) study long-term contracts for the sale of petroleum coke, Aggarwal and Samwick (1999) investigate incentive contracts between firms and their executives, and Chisholm (1997), Goldberg (1997), and Weinstein (1998) all examine profit-sharing contracts between fi lm companies and the "talent." This article differs in an important respect from most previous studies, which analyze a cross-section of contracts in an attempt to determine how (or whether) they vary according to the attributes of the contracting parties or the products being contracted for. Instead, it investigates an area where a sudden technology shock led to the rapid and widespread replacement of one form of contracting by another. The industry is the motion picture business, and the shock was the arrival of sound. During the silent film era, the vast majority of first-run feature films were rented to cinemas for flat daily or weekly payments. Within two years of the release of the first sound picture, revenue-sharing contracts were the norm, and they remain the norm to this day. (2) My goal is to investigate the degree to which the standard economic concerns--moral hazard, risk sharing, and measurement problems--can explain this change. Because the contracting parties remained the same, the question becomes, what was altered in the nature of the product, or in its provision, so as to have altered correspondingly the incentives faced? I conclude the following. First, the advent of sound fundamentally changed the inputs-- live music and other acts, supplied by the exhibitor and central to the show, were replaced by a soundtrack and short sound films, supplied by the film company. The benefit of deterring exhibitor shirking through the use of flat rental fees (which made the exhibitor full residual claimant) declined accordingly. The party whose effort makes the largest contribution to marginal product generally receives the largest proportion of the residual claims, and in the decades following the arrival of sound, the proportion of residual claims collected by film companies rose steadily. In addition, average revenue per film increased with sound, whereas the cost of ensuring that exhibitors reported attendance revenue honestly--done by locating a film company's representative in the theater--remained the same. The ex post division of revenue (necessary for revenue sharing) thus became cheaper on a per film basis. Finally, uncertainty ab out the value (in terms of expected attendance revenue) of the early sound films appears to have raised the cost of negotiating lump-sum rental fees, and thus promoted experiments with revenue sharing. However, although this may have contributed initially, it cannot explain the practice's persistence--uncertainty about film values declined as talking films became better known. II. THE NATURE OF THE PROBLEM A film company contracts with an exhibitor so that they may jointly produce the final good: a movie presentation. (3) To that end, each supplies essential inputs. The film company provides the movie (itself assembled from a variety of inputs) and some sort of national advertising support. The exhibitor provides the theater (which consists of seating, projection equipment, a refreshment stand, and other support activities) and some form of local advertising. …