Netflix recently announced it would stream movies to it’s customers via the PS3 starting next month. Currently, Xbox360 users have the option. Sounds great but PS3 users can already stream by using the web browser built into the PS3. I use it to watch shows on Hulu (which apparently is going to start charging for their service soon, much to my disappointment. No free lunch indeed.) It is not easy to navigate or type in URLs with the controller but for something simple like watching a video, it works okay.

Apparently this will be a little better quality (the system is supposed to vary the quality of the video based on the speed of your internet connection, and will provide DVD quality if you have a fast internet connection) but the number of titles is still limited to what it is now when streaming online with a computer or the PS3 browser. No major new releases are available to be streamed. Only 1 of the 20 movies in my Netflix queue has the streaming option available.

And for at least a few months, PS3 users will have to insert a disc to enable the streaming function. (This does not count as one of the discs you can have out — it’s a freebie.) Sure, it is probably easier than the built-in web browser but it will be annoying to have to switch out discs when you want to watch a movie. Next year, Netflix plans on having the software built into a PS3 firmware update. If you have a PS3 and Netflix and want to explore the streaming option, go to Netflix, click on the streaming video, then explore the different player options — click the PS3 and you should be able to find the option to put yourself on the list to have a streaming disc shipped to you when they are available in a few weeks.

When I first heard about the option I was excited. But the more I learn about it, the more I think this is just a minor improvent over the status quo — the only real difference is better picture quality and hopefully a more navigable interface. But I guess if it were a really significant improvement, like expanding the list of streamable movies, they would start raising prices. And the last time they did that, for Blu-ray, I had to cut back my purchases.

Apple defended the policy saying that the vast majority of its collection is experiencing a price cut. According to them, this is a way of getting consumers to explore their favorite artists’ older albums. If that works, it might be a win-win for Apple and consumers: our demand for those older songs is likely more elastic (more sensitive to a price change) than for newer songs, so the low price means we finally can afford the product.

Of course, the majority of the songs bought on iTunes are the popular new releases, whose prices are likely to go up. Our demand for these is more inelastic, less sensitive to a price change. (How else can you explain people paying $5 for ringtones?) The 30% price hike here might only dissuade a small percentage of customers from buying, but everyone who still buys pays 30% more, so Apple’s revenues go up. Consumers are worse off in this case, no question about it.

Looking at the 100 most popular downloads, about 75% of them are listed at the $1.29 price, while only 25% are at $.99. While the majority of songs in the catalog see a price decrease, the majority of songs people buy see a price increase.

I haven’t heard about much of a backlash as a result of this, but Apple is rightly concerned that people might think they are being treated unfairly. Consumers love it when firms lower prices for goods that turn out to be not as popular as they hoped. But we get really upset when firms raise prices for goods that are more popular than they expected.

The policy interests me because of my research in the motion picture industry. Movie theaters charge the same price for each movie. Obviously some movies are better than others, so why don’t they charge different prices? A few different studies have been done on this (my favorite is this one by Orbach and Einav).

First, movies are not like songs. With songs, you hear it first and know whether you like it or not, so you know what you’re getting when you buy it, and the point is that you want to listen to it over and over again. Most of us only see a movie in theaters once, so you’re buying a product of uncertain quality. If theaters charged higher prices for good movies and lower prices for bad ones, it might hurt both markets.  The low price is a signal that nobody else wants to see it, from which we infer that it must not be good, and that might be enough to drive people away from those movies altogether. And the higher price of good movies might drive a significant percentage of people away from those movies too — why pay more when you can buy it on DVD in 4.5 months anyway? (That’s the average “release window” between when a movie opens in theaters and when it is available on DVD.)

Second, it puts theaters in a difficult situation when dealing with movie studios. When I was working with a theater in St. Louis for my graduate thesis, it was at the time when Star Wars Episode I: The Phantom Menace was released. Everyone knew the movie was going to be huge, and the contract terms that 20th Century Fox got on the movie were insane — the studio got more of the profits (in percentage terms) than on any movie contract I’ve ever seen. As a result, movie theaters understandably considered increasing ticket prices. Expecting this astronomical demand and people waiting in line for days to see the movie, the theater chain increased the price on Phantom Menace tickets by $.25. Not much at all, right? Probably not, but it was enough to have news stations do live coverage outside theaters, talking to customers who were mad at being taken advantage of. All because of twenty-five cents.

The unexpected consequence? There was just as much backlash from other studios as there was from the public at large. The vice president of the theater chain told me that he got calls from other studio representatives asking: “Why aren’t our movies good enough to warrant higher prices?” (Remember: movie studios get a percentage of the revenues, so if theaters can increase prices and still sell tickets, that helps the studios too.) The other studios were jealous! So to avoid irritating everybody else involved, the theater stopped the practice after the first week or two.

As an economist, I love what Apple is doing. While we have statistical techniques we can use when we do not observe price variation, they rely on sometimes unrealistic assumptions. The best way to determine what the demand curve in a market looks like is for firms to change prices and see what happens to the quantity sold. One of the most frustrating things about working on motion pictures is that a) every movie is the same price at the theater, and b) theaters change their prices usually just once a year to adjust for inflation. If we observed more price variation, and saw how consumers responded to it, it would inform our analysis of consumer behavior so much more. But any time a theater has tried dropping prices, movie studios get upset because they think it might hurt their profits, so theaters don’t do it.

How will this pricing change affect you in the future? If Apple determines that there’s a huge response to the dropping of prices on less popular songs, that might end up transferring over into their movie or TV downloads too, benefitting consumers even more. The downside? If they see that the price increase boosts profits, expect more of that in other areas too…

I’m currently working on two papers on motion picture revenues: one on box office revenue determinants and another on DVD revenue determinants. Previous research on VHS rentals showed those to be inferior and that made a lot of sense to me — when your income is lower, you rent more movies. The presumption made here (which I make as well) is that you substitute away from going to the theater or buying a DVD and instead just rent it. But it’s not so clear that’s what’s happening.

The data on DVD revenues suggests that new DVDs are also an inferior good. The data on box office revenue, looking at the last 16 years in theaters (and over 2,000 movies) suggests those are inferior also. Those conclusions didn’t make sense to me at first. I thought: if people are renting more DVDs when income goes down, aren’t they spending less money at theaters and on new DVDs?

Apparently not. The National Association of Theater Owners (NATO) project this year to be a pretty decent one for theaters. They cite the fact that in 5 of the last 7 recessions, box office revenue went up. It appears that people cut back on more expensive things like sporting events, vacations and amusement parks, and take the family to the movie theaters a little more. The effect is not large, but it’s there.

Take, for example, the big Memorial Day weekend at the box office. Last year, total box office for Memorial Day weekend (4 days) was $219 million. This year, it’s $221 million. Ticket prices may be a bit higher, but I think theaters have raised their prices less this year than the standard 4% of the last decade. If ticket prices are up 3% while revenues are only up 1%, that means quantity has fallen by 2%. But that fits the general pattern of the last decade of flat or so of flat if not declining attendance (about since the time DVD players started becoming more affordable). One might reasonably argue that any decrease in tickets sold this year vs. last year are not due to the recession, but rather due to a continuation of a trend toward more home viewing on DVD, Blu-ray, and VOD.

I’m not sure why this inferiority result surprised me, but it did. NATO’s explanation seems to make sense, but it runs counter to what I had thought before running the regressions. I guess that’s why we do the research…

UPDATE: My co-author and I have decided that “counter-cyclical” is a better term for the motion picture industry rather than the standard “inferior.” The word inferior, in an economics context, generally implies that when income increases, the demand for the good falls because consumers are substituting something better instead. McDonald’s sales have done well in the recession, as people substitute cheaper goods (McD’s) instead of more expensive meals out. But that’s not quite what we think is happening with movies. We think it’s more that when the economy goes bad, people have an increased desire to escape their troubles with movies. So when the economy goes bad, box office sales, rentals and even DVD sales go up. It’s not necessarily that when times are good they substitute to a higher quality of entertainment (perhaps they do, live sports maybe…), but they don’t need to escape their life quite so much.

The table below shows the top 20 DVDs purchased for 2008 as well as the top 20 DVDs rented in 2008. Movies in bold on the rental list also appear on the purchases list. The value in the “Rent vs. Buy” column for those movies shows the difference in rank between the rental list and the purchase list.

I think it’s interesting to note that only 7 of the movies are on both lists. For every movie but Iron Man, the movie ranks higher on the rental list than on the sales list. Apparently most people who wanted to watch Iron Man bought the DVD, but the rental market was still strong. For the rest of those movies, they weren’t good enough to buy, but people still wanted to see them.

Here’s what I see when I look at these two lists. I see that there are two kinds of movies that people rent: Academy Award Nominees and crap. People wanted to watch Michael Clayton (good movie, btw) and No Country For Old Men (boring, IMO) so they could have some idea of which should win the Oscar. And people wanted to watch Good Luck Chuck (for some unknown reason) but knew based on its horrible box office performance and reviews that they would probably only want to watch it once — and even then probably only for $1 at Redbox. Baby Mama and Fool’s Gold are in this same league too.

I think it’s noteworthy that The Dark Knight was the best-selling movie of the year at the box office, as well as the best-selling DVD, but it is nowhere on the rental list. I guess when everybody has already seen the movie and everybody knows someone who owns the DVD, there’s no reason to rent it.

Of the top 20 movies sold, 9 of them can legitimately be called kid’s movies. (And yes, it can be a kid’s movie if it has The Rock in it. He’s the new Ice Cube — Ice Cube after he sold out, that is, and did Are We There Yet? and Are We Done Yet? Now The Rock does Race to Witch Mountain and Game Plan. I smell what the Rock is cookin’ and it doesn’t smell so good.) Only one of these 9 movies, Game Plan, is also on the rental list. Parents buy their kids the DVD, plain and simple.

Part of what we’re looking at in the DVD paper is how different aspects of movies affect DVD sales and how that differs from box office revenues. We have already found, for example, that a movie’s sexual content does not have a positive impact on box office revenues for R-rated movies. However, it does have a positive impact on DVD sales for R-rated movies. Conclusion: people want to watch those movies in the privacy of their own homes.

Some facts on the DVD/VHS market in case you’re interested: The DVD sales market is by far the most profitable distribution vehicle for movie studios. The revenues from DVD sales are more than the worldwide box office of movies, and the studios get a larger chunk of the revenues on DVDs (about half of box office revenue goes to your theater, the other half goes to the studios who made the movie; with DVDs, studios get more like 80% of the revenue). The DVD rental market shrunk last year, and only makes up about 1/5 of the revenue of the DVD sales market. That market shrunk last year too, as the economy took a turn for the worse. Blu-ray sales picked up, but not enough to offset the DVD sales decrease. VHS is practically dead: VHS rentals make up less than 4% of all rentals.

Netflix sent me an e-mail this week saying that if I wanted to stay on my same plan (3 discs at a time, including Blu-ray), I would have to pay an extra $3 per month. Until now, they were charging me an extra $1 for Blu-ray, and they are increasing that charge to $4. I promptly changed my plan to 2 discs at a time and am saving $4/month. One might think that people who can afford a Blu-ray player wouldn’t have a problem with an extra $3 a month, and I think that’s what Netflix is counting on. But I’m cheaper than most people, so my demand for everything is more elastic. And rumor has it that Redbox is carrying Blu-ray in other places around the country for the same price of $1/day, and as long as that hits St. Cloud soon, I should be just fine.