7.3. A SIMPLE MODEL OF THE TELEVISION MARKET
As discussed in greater detail in Chapter 2 of this volume, media markets are two-sided,
providing both content to households in return for subscription fees and audiences to
advertisers in return for advertising payments. This two-sided structure and the relative
importance of these two funding sources have important implications for prices, ad levels,
programming choices, quality, and welfare.
In this section, I present a stylized model of television program production and dis-
tribution (broadcasting), which borrows elements from
Armstrong and Vickers (2001),
Anderson and Coate (2005), Armstrong (2005, 2006), and Peitz and Valletti (2008). I use
this model to derive testable implications about outcomes in television markets which are
discussed later in the section. In the next section, I highlight the specific institutional fea-
tures of television markets that have required extending this stylized model in four impor-
tant directions (the Four Bs).
7.3.1 The Baseline Model
7.3.1.1 Baseline Results
A broadcaster potentially makes decisions along a number of basic dimensions, including:
• the price (or more generally the tariff structure) for viewing its programs;
• the advertising intensity within its programs;
10
20
30
40
50
60
Average 24 h rating
1994 2000 2006 2012
Year
Total Cable/sat./IPTV
Broadcast
Figure 7.16 Total ratings by platform type, 1994–2012. Notes: Depicted is the total average 24-h rating
of broadcast and pay-television networks 1994 and 2012. See also
Tables 7.1 and 7.2 for further
information about average 24-h ratings by channel type and channel for broadcast and pay-
television networks in 2012. Source:
SNL Kagan (2014a).
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Handbook of Media Economics
• the quality of its programs; and
• the genre of its programs.
Regulation, competitive conditions, and/or technological constraints may affect these
decisions. For instance, traditional over-the-air broadcast technology does not allow
viewers to be excluded from the signal, and so direct pricing of content may not be fea-
sible. Regulations might constrain advertising intensity, or technology might allow
viewers to skip advertisements. PSBs might face constraints on quality, genre, or the neu-
trality of news programs. We address some of these factors in the presentation to come.
We assume that a monopoly broadcaster has a unit of content (e.g., a single channel,
or a single program) to supply to viewers. A viewer’s gross value for this content is
denoted v, and v is distributed in the population of potential viewers in some manner.
All viewers are homogeneous in terms of their attitude to advertising intensity, and if they
pay p for the content which has advertising intensity a, their “total price” is
P ¼δa + p:
Viewers in most cases dislike intrusive advertising, and so we assume that δ 0. A viewer
with valuation v will then decide to watch this content when v P, and we denote the
number of viewers with v P by x( P), the demand function for viewing.
Suppose that if the broadcaster shows a ads it obtains revenue r(a) per viewer from
advertisers, which we suppose is a concave function. Total revenue per viewer is
therefore
R ¼p + raðÞ:
The relationship between total revenue R and total price P will depend on whether a
subscription charge p can be used. If it can be used, then for any total price P, we have
P ¼δa + p and R ¼p + R(a) so that R ¼P + r(a) δa. The broadcaster will clearly choose
advertising intensity a* to maximize revenue for any given total price
P so that
a* maximizes ra
ðÞ
δa:
Note that a* is the advertising intensity which maximizes the joint surplus of the broad-
caster and the viewer, and it ignores the surplus of advertisers themselves. We often
expect advertiser surplus to increase with a, and in such cases the broadcaster chooses
an inefficiently low level of advertising.
31
In some cases (when r
0
(0) δ) the equilibrium
level of advertising is zero so that a viewer’s disutility from adverting is greater even than
31
Suppose, as assumed by Anderson and Coate (2005) and Peitz and Valletti (2008), that each advertiser is a
separate monopolist, and can extract all consumer surplus when it sells its product. In this case, aggregate
advertiser surplus is captured by the area under their demand curve. This implies that the level of adver-
tising which maximizes total welfare is such that the advertising price, r(a)/a, is equal to the disutility δ.It
follows that advertising is socially excessive (insufficient) if r(a) δa is negative (positive).
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The Economics of Television and Online Video Markets
the value to the most valuable advertiser.
32
Otherwise, though, viewers are prepared to
tolerate some advertising in compensation for a lower direct charge, the relationship
between total revenue and total price in the pay-TV regime is
R
pay
PðÞ¼P + ra
ðÞδa
, (7.1)
and an extra dollar extracted from a viewer translates into exactly one extra dollar for the
broadcaster.
By contrast, in the free-to-air world with no direct viewing charge (p 0), there is a
concave relationship between total revenue and total price, given by
R
free
PðÞ¼r
P
δ
: (7.2)
If regulation places a ceiling on advertising intensity, this corresponds to a cap on the total
price P. The function R
free
equals R
pay
at one point (when P ¼δa*, which implies that
p ¼0 in the pay regime), but otherwise lies below R
pay
.
33
The intuition for this is clear: in
the pay-TV regime the broadcaster has two instruments to extract revenue from the
viewer, while in the free-to-air regime it has only one, and so it can more efficiently
extract revenue in the pay-TV regime.
If, as is highly plausible, charging a negative price to viewers (i.e., p < 0) is not feasible,
the analysis of the pay-TV regime sometimes needs modifying. When the chosen total
price P is below δa*, the corresponding direct price p is negative. Thus, when negative
prices are not feasible, the revenue function continues to be given by
(7.1) when P δa*,
while for smaller P the pay-TV regime involves a zero price, and the revenue function
coincides with R
free
in (7.2). When P δa*, the concavity of r() can be shown to imply
that R
pay
(P)/R
free
(P) increases with P, so that the pay-TV regime delivers proportionally
higher revenue than the free-to-air regime, not just in absolute terms.
For simplicity, suppose that the broadcaster already possesses his content, and incurs
no additional costs for distributing this content to viewers. It follows that the broadcaster’s
total profit is
xPðÞRPðÞ, (7.3)
where R is given by R
pay
or R
free
according to whether direct charging of viewers is fea-
sible. Even when charging viewers is feasible, the broadcaster may choose to obtain its
revenue solely from advertisers. (This is the case when the advertising intensity a which
maximizes profits in the free-to-air regime, x(δa)r(a), is below a*, the advertising level
when the firm can charge a positive viewer price.) One can show the total price P is
weakly higher in the pay-TV regime than in the free-to-air regime so that viewers
32
This is presumably the reason why novels and live opera typically contain no ads.
33
This is because R
pay
(P) ¼P + r(a*)δa* P +r(P/δ)δ(P/δ)¼R
free
(P).
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Handbook of Media Economics
are worse off in the pay-TV regime.
34
Likewise, there is weakly less advertising in the
pay-TV regime than in the free-to-air regime so that advertisers typically prefer the free-
to-air regime.
35
While there is too little advertising in the pay-TV regime, in the free-to-
air regime whether equilibrium advertising is excessive or insufficient is ambiguous.
Indeed, total welfare might be higher or lower in the pay-TV regime relative to the free-
to-air regime.
36
Since the broadcaster obtains greater profit when it can charge viewers, it may be that
some content can be profitably supplied only if viewers can be charged. As a result, even if
the use of viewer charges reduces consumer surplus for a given range of content, the fact
that more content might be offered in a pay-TV regime could lead to consumer gains
from the practice.
In a discussion of recent developments in mass media,
Chapter 5 of this volume dis-
cusses the effects of ad-avoidance technology. We also analyze that issue here. In the pay-
TV regime, the widespread introduction of ad-avoidance technology will usually harm
consumers once the broadcaster’s response is considered. Without the ad-avoidance
technology, the broadcaster chooses total price to maximize x(P)(P + r(a*) δa*), while
with the technology it is in effect forced to set a ¼0 and it maximizes x(P)P, which
induces a higher total price whenever a* >0. Since a viewer dislikes advertising, it is
a dominant strategy for her to avoid it when technology is available to permit this.
But this behavior involves a negative spillover onto other viewers, since the broadcaster
can then obtain less revenue from advertisers, and this induces it to raise its direct price.
Thus, in this simple framework, a prisoner’s dilemma occurs with ad avoidance, and all
viewers would be better off if ad avoidance were not feasible. Of course, in a purely
advertising-funded regime, the adoption of ad-avoidance technology would be cata-
strophic for the market.
We next consider a number of natural extensions to this basic model.
7.3.1.2 Oligopoly
The basic model above considered a single broadcaster in isolation, taking rival offerings
as exogenous. Additional issues arise when the impact of one broadcaster’s choices on a
rival is considered. To illustrate, suppose there are just two broadcasters, A and B, and
for the relevant time-slot suppose a viewer must watch the content of one or the other
34
Recall that if a negative price is not feasible, that R
free
¼R
pay
for all P δa*. If the best price in the free-to-
air regime satisfies P δa*, it is clear that the best price in the pay-TV regime could not be lower than this.
If the best price in the free-to-air regime is greater than δa*, the fact that R
pay
/R
free
increases with P for
P δa* implies that the broadcaster is better off choosing a higher total price in the pay-TV regime.
35
Either the total price is below δa* in both regimes or the total price above δa* in both regimes. In the
former case, advertising levels are the same. In the latter case, advertising intensity is a* in the pay-TV
regime and strictly higher in the free-to-air regime.
36
See Anderson and Coate (2005) for further details.
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The Economics of Television and Online Video Markets
(or neither). If P
A
and P
B
are the total prices chosen by the respective broadcasters, sup-
pose that A gains X
A
(P
A
,P
B
) viewers, while B attracts x
B
(P
B
,P
A
). Then, as in (7.3), given
the rival total price P
j
, broadcaster i¼A, B chooses its total price to maximize
x
i
P
i
, P
j
RP
i
ðÞ
,
where R is given by R
pay
or R
free
according to whether direct charging of viewers is
feasible.
37
In theoretical models of broadcasting, a popular specification for x
i
is the
symmetric Hotelling demand system, with
x
i
P
i
, P
j
¼
1
2
P
i
P
j
2t
,
where t is the “transport cost” parameter, which reflects how substitutable are the two
firms’ offerings. In this framework, note that total prices are strategic complements, and a
broadcaster’s best response to its rival’s total price is an increasing function of that price. In
particular, if there is asymmetric regulation applied to just one broadcaster in the form of a
price cap (in the pay-TV regime) or a ceiling on advertising (in the free-to-air regime),
this will cause a corresponding reduction in the unregulated rival’s choice of price or
advertising.
In this particular case, the symmetric equilibrium choice of price P satisfies
R
0
PðÞ
RPðÞ
¼
1
t
: (7.4)
In the pay-TV regime where R is given by
(7.1), it follows that the equilibrium charge to
viewers is
p ¼t ra
ðÞ (7.5)
and this charge is positive provided that t > r(a*). In the free-to-air regime the equilib-
rium advertising intensity satisfies
r
0
aðÞ
raðÞ
¼
δ
t
: (7.6)
Since we know that R
pay
/R
free
increases with P, it follows that R
0
pay
=R
pay
R
0
free
=R
free
,
and so
(7.4) implies that the total price paid by viewers is higher in the pay-TV regime
than in the free-to-air regime so that viewers in this model are better off in the ad-funded
regime.
38
In addition, the concavity of r() implies that equilibrium advertising intensity is
greater in the free-to-air regime than in the pay-TV regime.
37
This presentation assumes that the competitive interaction is such that each broadcaster commits to pro-
vide a given quantity of advertising. If instead the competition is in terms of prices on the advertising side, a
complicated feedback can occur in the market, as discussed in
Armstrong (2006).
38
From (7.5),ifr(a*) t then firms in equilibrium do not charge viewers directly, and the outcome is the
same as in the free-to-air regime.
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Handbook of Media Economics
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