ESSAYS ON COMPETITIVE STRATEGIES IN THE BROADCASTING TELEVISION INDUSTRY YONG LIU. B. Engineering, Tianjin University, P. R.

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1 ESSAYS ON COMPETITIVE STRATEGIES IN THE BROADCASTING TELEVISION INDUSTRY by YONG LIU B. Engineering, Tianjin University, P. R. China, 1993 M. Engineering, Tianjin University, 1996 A THESIS SUBMITTED IN PARTIAL FULFILMENT OF THE REQUIREMENTS FOR THE DEGREE OF DOCTOR OF PHILOSOPHY in THE FACULTY OF GRADUATE STUDIES FACULTY OF COMMERCE AND BUSINESS ADMINISTRATION We accept this thesis as confirming Jo the required standard THE UNIVERSITY OF BRITISH COLUMBIA June 2002 Yong Liu, 2002

2 In presenting this thesis in partial fulfilment of the requirements for an advanced degree at the University of British Columbia, I agree that the Library shall make it freely available for reference and study. I further agree that permission for extensive copying of this thesis for scholarly purposes may be granted by the head of my department or by his or her representatives. It is understood that copying or publication of this thesis for financial gain shall not be allowed without my written permission. Department of The University of British Columbia Vancouver, Canada Date <3*ne- 2- ' DE-6 (2/88)

3 Abstract This thesis presents theoretical models to address market structure and competitive strategy issues in the broadcasting television industry, where technological and regulatory changes have greatly increased the scope of competition. Stating with a static game, the thesis shows that first, the broadcasters choose an intermediate level of differentiation (i.e., they "counter program"). Second, having more channels available does not always make viewers better-off. For certain ranges of the cost of quality provision, viewers are better served in a market with fewer competitors. Third, rather than impeding the number of competitors, the high cost of providing quality programs actually allows a greater number of broadcasters to exist profitably in the industry. The model is extended to incorporate the lead-in effect, an important dynamic factor in television viewing. Interestingly, viewers can be better-off in the dynamic model than in the static model, even though the "switching cost" exists for the broadcasters to lock in viewers. The distribution of customer preferences has a main effect on competitive behavior. The equilibria show strong rigidity when the cost of quality provision varies within certain ranges for uniform and bipolar distributions. However, such rigidity ceases to exist in an unimodal distribution. A monopolist would set a higher quality level than the duopolists for certain ranges of the cost parameter. This, again, leads to the finding that customers can be better-off in the monopoly market. This result disappears if customer distribution is very bipolar. An analytical framework is then set up to address the debate on the retransmission fee ii

4 Ill for broadcasting signals. While the broadcasters do not want to give away for free their valuable television programs, the cable operators simply do not want to pay. The analysis indicates that in certain ranges of the two important parameters, the cost of quality provision and the advertising rate, the cable operator actually receives greater profit in a fee system than in a no-fee system. The fee helps the cable operator stabilize its profit levels as the advertising market changes. It can also work as a coordinating instrument to improve the overall profitability of the distribution channel.

5 Contents Abstract ii List of Tables viii List of Figures ix Acknowledgement xi 1 Introduction Research Problems Methodology and Substantive Findings Literature of Competitive Positioning and Theoretical Contributions Structure of the Thesis 14 2 Institutional Settings of Broadcasting Television The Formative Years: 1939 to The Stable Years: 1955 to The Years of Rapid Change: 1980 to the Present Total Ratings Determines Advertising Rates The Nature of Program Quality and Program Cost Cable Operators as Distributors of TV Programs 22 iv

6 CONTENTS v 3 The Basic Framework Viewer Behavior Revenues and Costs of Broadcasters 26 4 Competitive Positioning of Television Broadcasters Overview Modelling Framework and Monopolistic Behavior Duopoly Competitive Behavior Viewer Welfare Industry Profitability and Number of Competitors Triopoly Competitive Behavior Trends in U.S. Commercial Broadcasting 48 5 Dynamics and the Lead-in Effect Overview The Lead-in Effect Sequential Equilibrium with Lead-in Forward-looking Viewers Summary 69 6 Nonuniform Distribution of Consumer Preferences Overview The General Distribution of Consumer Preferences Summary of the Uniform Distribution The Behavior of a Monopolist Duopoly Equilibrium with Exogenous Quality The Simultaneous Quality-Location Equilibrium in a Duopoly 81

7 CONTENTS vi The bipolar distribution of customer preferences The unimodal distribution of customer preferences Summary of bipolar and unimodal distributions Modifying the Equilibrium with Quality Top-off Bipolar distribution Unimodal distribution Discussion Summary 98 7 Retransmission Fee for Broadcasting Signals Overview Model Framework and Assumptions Revenue, cost, and flow of monetary payment Program viewing and cable subscription Equilibrium Analysis The No-fee System The Fee System Possible Scenarios and Comparisons Retransmission Fee Coordinates the Channel Summary Conclusions and Future Research Summary of the Thesis Future Research on the Television Markets 125 Bibliography 128 Appendix 134

8 CONTENTS A Advertising Rates for Syndicated Programs B Heterogeneity in Quality Evaluation C Sample R and S-Plus Programs

9 List of Tables 4.1 Equilibrium Results of the Static Duopoly Quality Top-off Decisions in the Triopoly Market Numerical Solutions of c* as a Function of the Lead-in Parameter a Quality and Viewer Welfare with Lead-in (a^o.ol) Viewing Choices of Forward-looking Viewers Values of c and Optimal Quality for a Monopolist in Bipolar Distribution Critical Values of c for Selected Distribution Shapes (/5) Equilibrium Configuration When Customer Preferences Are Nonuniform Ranges of c in Which the Consumer Welfare Result Obtains Possible Scenarios of Competition in the No-fee and Fee Systems 112 A. 1 Average Ratings and Spot Rates for 30 Syndicated Programs 136 viii

10 List of Figures 4.1 An Illustration of Market Competition and the Demand Functions Equilibrium Quality in the Monopoly and Duopoly Markets Comparison of Viewer Welfare between Monopoly and Duopoly Markets Equilibrium Quality in the Duopoly and Triopoly Markets Comparison of Viewer Welfare between Duopoly and Triopoly Markets Probability Density Functions of the Symmetric Beta Distribution Marginal Revenue Is Discontinuous for Some Customer Distributions Optimal Monopoly Quality Levels as a Function of c When /3 = Optimal Monopoly Profits as a Function of c When /5 = Location Equilibria of Firm A in Duopoly Competition with Exogenous Quality Structure and Participants of the Television Market Cable's Profit Difference Between the Fee and No-fee Systems (Scenario 1-1) Equilibrium Levels of Program Quality (Scenario 2-3, c = 0.06) Subscription Price and Cable's Profit Margin (Scenario 2-3, c = 0.06) Cable Operator's Profit at Equilibrium (Scenario 2-3, c = 0.06) Pass-through Rate of the Retransmission Fee (Scenario 2-3, c = 0.06) A.l Plot of Average Ratings and Spot Rates for Syndicated Programs ix

11 LIST OF FIGURES x C. 1 R Code Used in Chapter 6 for the Monopoly 140 C.2 R Code Used in Chapter 6 for the Duopoly 141 C.3 S-Plus Code Used in Chapter 6 for Consumer Welfare 142

12 Acknowledgement It is my great pleasure to acknowledge the valuable contribution to this work by the members of my dissertation committee: Professors Daniel S. Putler, Charles B. Weinberg (Research Co-Supervisors) and Thomas W. Ross (Committee Member). Dan is the first faculty member I worked with in the pursuit of a research career in marketing. He introduced me to the University of British Columbia and has supported me at every step of the Ph.D. progress. His many smart ideas and keen insights made working with him very productive and fun. I consider myself very lucky to have known Chuck at UBC and have him as a mentor. To me Chuck is the example of perfect combination of great personality and intelligence. I always have a lot to learn from him in research and in everyday life. It will be very satisfying if I can achieve in my future career a part of what he has achieved. I want to give special thanks to Tom who serves as a valuable member of my committee. His many insightful suggestions greatly improved this thesis. I deeply thank my family - my wife, Wei Lu, who has accompanied me going through all the up-and-downs in this research career, and my parents and parents-in-law - without their care and support, this thesis and much of my research work could not have been possible. xi

13 Chapter 1 Introduction 1.1 Research Problems The television broadcasting industry has undergone significant technological changes over the past twenty years. Partially as a result of advances in technology, and a worldwide trend toward deregulation, the regulatory environment for television broadcasters in many countries has also drastically changed over this time frame. In addition, state owned broadcasters (e.g., the BBC in the United Kingdom and the CBC in Canada) are increasingly relying on advertising revenues to fund program production. The impact of both these technological and regulatory changes has been to greatly increase the scope of competition in terms of the number of potential program alternatives that a television viewer can choose from at any given time. From the immediate post World War II period until the early 1980s most viewers in the U.S. were able to receive only a handful of channels (three to six in most local television markets), and in most other countries the number of channels available was even more limited. The limited choice in this period was due to a combination of the limitations of terrestrial over-the-air broadcasting technology and 1

14 CHAPTER 1. INTRODUCTION 2 how television broadcasters were regulated. 1 Television viewers in many places now have nearly 100 channels to choose from, and advances in digital cable and digital direct broadcast satellite technology offer the possibility of giving viewers 600 channels to choose from in the not so distant future. Commercial television broadcasting, along with other advertising supported media industries, differs from most other major industries in the way the market functions. The industry is made up of two distinct, but closely related, markets, one for viewers and the other for advertisers (Barwise and Ehrenberg 1988; Vogel 1998). While viewers may pay a fixed fee to watch television at all (e.g., for a cable subscription or a television license), they pay essentially nothing to watch any particular program. Instead of charging viewers directly, commercial television broadcasters receive their revenues from selling time to advertisers. Advertisers are willing to spend more for air time (say a 30-second spot) in programs that have a greater number of viewers than in programs with fewer viewers. As a result, the number of "eyeballs" watching a program drives a broadcaster's revenues. Another important aspect of the television industry is that providing watchable (i.e., high quality) television programs is extremely expensive. In the late 1990s the average cost of producing a one-hour prime time U.S. network program was $1.5 million (Vogel 1998, p. 122). Moreover, lowering production values in an effort to reduce costs tends to greatly reduce the appeal of a program to viewers (Barwise and Ehrenberg 1988; Jankowski and Fuchs 1995). Commercial television broadcasting is an important industry both in terms of its sheer size (the U.S. industry alone had $80 billion in revenues in 1998) and its social and cultural significance. At the same time, this is an industry where questions about market failure frequently arise. It is generally believed that without government regulation, the broadcasters will provide program varieties at a less than socially-optimal level. However, the appropriate 'Chapter 2 provides description in greater detail on why this was the case.

15 CHAPTER 1. INTRODUCTION 3 degree of regulation cannot be ascertained without sufficient understanding of broadcasters' competitive behavior. Moreover, there might be factors other than program variety (such as the quality of television programs) that a social planner should be concerned with. Given its importance, its distinctive "two market" structure, and its rapidly changing technological and competitive environment, four critical questions concerning commercial television broadcasting arise. First, what is the basic nature of competition in a "two market" industry in terms of the products (programs in this instance) competitors offer and the extent to which they differentiate themselves from one another? Second, how do the optimal strategies of broadcasters differ in markets with more competitors versus markets with fewer competitors? Of particular concern is what are the implications of having markets with a greater number of competitors on the quality of television programming offered by broadcasters? Industry participants and observers have offered contradictory opinions on this topic. According to Barwise and Ehrenberg (1988, p. 112) "As viewers we mostly watch the programs that have higher production values - bigger budgets, better performers, more rehearsal, better scripts and locations - especially when we have otherwise comparable choices on other channels. This will lead to increased spending on program quality as more channels become available to compete for more viewers' attention." In contrast, Don Hewitt (the executive producer of 60 Minutes, and reported in Jankowski and Fuchs 1995) responding to a question about the effect on quality of the projected increase in the number of television channels that will be available to viewers in the future indicated that "If viewers ten years hence are still trying to find eight hours a day of worthwhile television fare, they're not going to find it then any more than they can find it now."

16 CHAPTER 1. INTRODUCTION 4 Consequently, it appears that the implications of greater competition on programming quality is not well understood. The third question to be addressed is how the high cost of producing quality television programming influences the number of broadcasters that can be supported in the industry? In other words, does the high cost of quality provision limit the number of broadcasters that can successfully compete in the industry? Finally, what are the implications of having more viewing options (the primary impact of the technological and regulatory changes witnessed over the past twenty years) in terms of the viewing public's well-being? Generally having more options to choose from is considered to be unambiguously beneficial for consumers. However, whether or not this holds true for "two market" industries has not been explored. Besides television broadcasters, cable operators exist as a significant member in commercial television markets. As described in more detail in Chapter 2, the relationship between broadcasters and cable operators has been all but stable. Conflicts have been frequent in the distribution system of TV programs. One of the current debate focuses on whether the cable operators should pay the broadcasters a retransmission fee to carry the broadcasting signal. Through what is known as the "must carry" rule, the FCC requires cable operators to carry all the broadcasting signals already available over the air in a given area. 2 In return, the cable operators do not have to pay the broadcasters, the major networks among them, to carry these signals. While it is true that television audience can now receive the broadcasting signals with better picture and sound, which is a benefit to the broadcasters, the broadcasters have long complained about this situation. Two primary reasons exist. First, the broadcasters, especially the major networks, spend billions of dollars on programming each year. It certainly sounds ridiculous 2 These signals are included in most cases in the basic cable package. In Chapter 2, we discussed how the "must carry" rule relates to the creation of broadcasting networks like Fox.

17 CHAPTER 1. INTRODUCTION 5 that anybody other than the audience should get these valuable products free. Second, most of the viewing in cable homes is still on commercial broadcasting channels. 3 It appears that the cable systems get double marks - receive the products free, and then charge subscribers mainly because of these products. As some industry experts put it, "From the cable point of view, this proved to be one of the most benign pieces of legislation in communications history, since cable providers thereby acquired $6 or $7 billion worth of product at no cost, for which they could in turn charge their customers... thanks to the 'must carry' rule, the cable companies pay nothing for the programming that provides the bulk of their appeal" (Jankowski and Fuchs, 1995, p.73). As a result of these complaints, the FCC in 1993 modified its regulation and started to allow retransmission fees. This left the charge/pay decision as a pure economic problem to the broadcasters and cable operators - regulatory obstacle does not exist any more. Unable to prevent such fees through FCC regulation, the cable operators threatened that if the retransmission fees are charged, they would pass all the fees to cable subscribers and put the blame of price hike on the broadcasters. Despite this confrontation, no clear answer exists as to to what extent the cable systems will be worse-off and the broadcasters be better-off with such a fee charged, or they will be worse-off/better-off at all? A rigorous analysis is clearly needed to shed light on this potentially critical problem. 3 A number of surveys and studies show that the most important reason for subscribing to cable were improved television reception, and most subscribers spent most of their viewing time on the commercial channels which they can receive without any cable service (see, e.g., Heeter and Greenberg 1988; CableA^ideo Research Center, 1983; Jankowski and Fuchs, 1995; Braise and Enrobers, 1988).

18 CHAPTER 1. INTRODUCTION Methodology and Substantive Findings This thesis endeavors to provide answers to these questions from a theoretical perspective. A spatial model of competitive positioning is constructed and used throughout the thesis. In the model broadcasters compete through their selection of program type (modelled as a horizontal dimension) and quality level (a vertical dimension). A broadcaster's costs increase as the quality (probably best viewed as the production values) of the offered program increase. A viewer determines which program to watch and whether to watch at all based on selecting the alternative that maximizes that viewer's utility. In turn, the potential utility a viewer receives from a particular program depends on both the quality of that program, and the extent to which the program's type matches the tastes of the viewer. If the utility level provided by a viewer's relatively most preferred program does not exceed some reservation level, then the viewer will choose not to watch television at all. Consistent with the "two market" structure of commercial television, a viewer does not directly pay for the program she watches, instead each broadcaster receives revenue from advertisers based on the number of viewers that watch their program offering. A market composed of the broadcasters, advertisers, and TV audience is analyzed in answering the first four questions. Analytical results are derived for monopoly, duopoly, and triopoly markets to provide a number of interesting, and in some cases surprising, answers. It is found that broadcasters strive to minimize competition when the costs of producing high quality programs is relatively high, and when the distribution of viewer tastes is not concentrated in a limited range of program types (i.e., when the distribution of viewer tastes is not unimodal). They accomplish this through both the choice of the type of program they offer (i.e., the usual optimal strategy is for broadcasters to "counter program") and the quality of those programs. Using the terminology of the spatial competition literature, broadcasters usually choose an intermediate level of differentiation, neither minimally nor

19 CHAPTER 1. INTRODUCTION 7 maximally differentiating themselves on the horizontal dimension. When the distribution of viewer tastes over program type is not unimodal, we show that there is a range of the cost of quality provision over which the equilibrium location and quality choices of broadcasters is "sticky" (i.e., the equilibrium choices do not change over this range). The analysis indicates that a range of the cost of quality provision exists in which the broadcasters in markets with fewer competitors provide higher quality programs than broadcasters in markets with a greater number of competitors do. The reason is that when there is one more competitor in the market, an individual broadcaster receives a lower return on the investment in quality as a result of more quickly becoming involved in direct competition with one or more other broadcasters, resulting in a lower optimal level of quality provision. In turn, the lower optimal quality level causes the broadcaster to have a smaller total audience, and one that is more limited in its range of preferred program types. Thus, the optimal strategy of broadcasters moves toward relative "narrowcasting" as the number of competitors in the market increases. Surprisingly, rather than impeding the number of firms that can successfully compete in the market, it is found that a high cost of providing quality programs actually allows a greater number of firms to exist profitably in a stable market than is the case when the cost of quality provision is lower. The reason for this has to do with the broadcasters' incentive to avoid direct competition (which at the extreme becomes ruinous) as the cost of quality provision increases. In what may be the most unexpected, and in many ways counter-intuitive, result of the analysis, it is shown that increasing the number of viewing options (the number of broadcasters in the market) does not necessarily make the average viewer better-off. Under a set of very plausible circumstances viewers are, on average, better-off when they have fewer viewing options to choose from. Our findings in this area are due to the interplay between having a larger number of broadcasters in the market (which results in viewers, on average, having

20 CHAPTER 1. INTRODUCTION 8 the choice of an alternative that more closely matches their tastes) and the effect this larger number of broadcasters has in reducing the average quality of programs provided. Over some ranges of the cost of quality provision, the quality reduction effect dominates the increased average match of program types to viewer tastes, resulting in a reduction in average utility levels. These results are proved robust when some extensions of the model are analyzed. For instance, the consumer welfare results still obtain when the broadcasters compete in a dynamic game. When the distribution of consumer preferences (i.e., the tastes of television viewers) is explicitly modeled and examined, it is found that the equilibrium results in a homogeneous market differs qualitatively from those in the heterogeneous markets. Unless the distribution of customer preferences is unimodal, elastic demand induces a "buffer" zone between firms so that they may not directly compete. Firms' marginal revenue curve of quality provision is thus discontinuous between the direct competition case and the local monopoly case. As a result, the quality-variety equilibria show strong rigidity. That is, they remain unchanged for a certain wide range of the cost parameter of quality provision. 4 However, the discontinuity in the marginal revenue curve is completely smoothed away if customer preferences are very homogeneous. The result that consumes are actually better-off when served by a monopolist than by the duopolists still holds for a large range of non-uniformly distributed consumer preferences. It disappears only when the distribution is extremely bipolar. The retransmission fee problem is addressed by combining competitive positioning with the distribution channel models, which have achieved much success in the marketing and 4 Some of our results relate to a kinked demand curve which was first noted by Lerner and Singer (1937) in a spatial competition setting. Based on the kinked demand curve, Salop (1979) found a perverse effect of parameter changes on price equilibria. A number of important differences exist between Salop's model and ours. First, we focus on quality-variety equilibrium, while his is concerned with price competition. Moreover, Salop models a circular city under monopolistic competition. Thus after free entry, all firms earn zero profit and automatically locate at an equal-distance from one another on the circle. Therefore in his model variety is not an issue and maximum differentiation is exogenously imposed. We do not restrict ourselves to this situation and analyze a bounded linear city. Finally, the bounded linear city setup allows us to examine nonuniform distributions in addition to the uniform.

21 CHAPTER 1. INTRODUCTION 9 supply chain management literature. While the broadcasters receive revenue from advertising, they also receive retransmission fees in a fee system (as opposed to a non-fee system, which is the current state). They make decisions on what programs to produce and broadcast to the market. The cable providers pay for any retransmission fee the broadcasters would charge, and set optimal subscription rates for subscribers. The audience, who can view the broadcasting signal over the air for free, decide whether to subscribe to the cable service. The results of the model indicate that in most cases, the cable operators are indeed worseoff if the retransmission fee is charged. Their profit will be lower than that in the no-fee system. However, this is not always the case. Two factors are critical in this market: the advertising rate per ratings point paid by the advertisers (to broadcasters), and the cost factor of providing quality programs (by broadcasters) that are valued by audiences. For certain ranges of these factors, the cable operators can be better-off when the retransmission fee is charged. The fundamental reason for thisfindingis that the retransmission fee may help broadcasters improve their program quality. This increases audiences' willingness to pay for a better signal through cable subscription, which then leads to greater profitability for the cable operators. The broadcasters are always better-off with the fee charged. These results indicate that the retransmission fee can work as a channel coordination tool to improve overall channel profits. 1.3 Literature of Competitive Positioning and Theoretical Contributions Product positioning is one of the most important aspects of afirm'smarketing strategy (Wind, 1990). A well designed and implemented positioning strategy not only serves consumers' need better, but also distinguishes afirmfrom its competitors. In thefieldof marketing, stud-

22 CHAPTER 1. INTRODUCTION 10 ies of strategic positioning are closely linked to the research tradition of spatial competition (e.g., Ansari et al. 1994; Carpenter 1989; Desai 2001; Hauser 1988; Moorthy 1988; Vandenbosch and Weinberg 1995). Since the seminal work of Hotelling (1929), a rich stream of literature has contributed to the development of product/price competition models. 5 Most extant studies of competitive positioning assume thatfirmscompete both in product strategies and on price. While locating close to competition is clearly logical if one wants to "steal" demand from competitors, it is now well-accepted that the existence of price competition reducesfirms'tendency to do so. As a result, where the equilibrium obtains depends on the interplay of this pair of strategic forces. In the literature, these are known as the market share effect (of demand) and the market power effect (of price competition). In a number of settings it has been found that the market power effect dominates the market share effect, resulting infirmsseeking maximum differentiation (e.g., D'Aspremont et al., 1979; Shaked and Sutton, 1981). Two additional assumptions are common in this literature. One is that the demand is inelastic. That is, a customer always buys one and only one unit of product. In a spatial setting, this assumption allows afirmto retain all the customers in its hinterland, no matter how far it is from them. The other is uniformly distributed customer preferences. Both assumptions are frequently made to make the analysis tractable, but usually come at the expenses of deviating from reality and losing generalizability. Questions then arise as to how product positioning changes when (the usually dominant) price competition is absent? Does the Principle of Minimum Differentiation a la Hotelling hold? How elastic demand and distribution patterns of customer preferences work together to influencefirms'competitive behavior? 5 In terms of product characteristics, two parallel research traditions prevail, namely horizontal differentiation and vertical differentiation. The former refers to product positioning in a space where buyers have heterogeneous ideal points (e.g., Hotelling, 1929) while the latter refers to that in a space where "the more, the better" holds true for everyone (e.g., Shaked and Sutton, 1983). Models have also been constructed for firms competing on both dimensions (e.g., Neven and Thisse, 1990).

23 CHAPTER 1. INTRODUCTION 11 Although it has received very limited attention in marketing, nonprice competition has attracted lots of attention in the economics literature. 6 In his American Economic Review article, Abbott (1953) calls for studies focusing on "pure quality competition" while the majority of existing studies focus on "pure price competition," 7 "Yet the limiting case of 'pure quality competition' is surely of great importance. Markets which approximate it - characterized by price rigidity or stickiness and by products which are not fixed in quality - form a substantial fraction of today's economy. Analysis of "pure quality competition" is also important because it provides an analytical device of great usefulness in the study of free markets in general. By stilling the movements of price, we are enabled to observe with greater clarity the kinds of behavior and adjustment other than price and output changes which are found in markets where both products and price are free to vary. These kinds of behavior are especially significant in the many markets in which prices, although not completely rigid, move sluggishly." (p. 827) Similar views are echoed by, for instance, Stigler (1968) and Schemalensee (1976). The reality that price competition is limited in many industries also points to the need for examining competitive behavior in a nonprice context. Industries in which firms compete mainly on product but not on price include, but not exclusive to, commercial radio broadcasting (Steiner, 1952), television (Fournier and Martin 1983), motion pictures, most banking services, and of course, any price-regulated industries. While the research on relaxing inelastic demand is limited, there are primarily two ways of modelling elastic demand. One is to use a linear demand curve q = a, + bp where p 6 This is not entirely surprising since price is one, if not the most important one, of the 4Ps marketers are primarily concerned with - it is directly related to profits. However, as suggested later, markets without price competition are many and thus deserve the effort to model them. 7 Abbott (1953) define "quality" as a mixture of vertical, horizontal, and innovational qualities. It is now more of a tradition to use "quality" when referring to the vertical quality, and "variety" when referring to the horizontal quality.

24 CHAPTER 1. INTRODUCTION 12 is the delivered cost (i.e., mill cost plus travel/transportation cost). Following this method, Smithies (1941) found that decreasing demand in the hinterlands prevents rivalsfromcoming too close to the center, therefore inducing product differentiation. The other way to model elastic demand, which we follow in this paper, is to use a rectangular demand curve. That is, customers either do not buy or buy exactly one unit. Studies in this tradition include Economides (1984), Moorthy (1988), and Lerner and Singer (1937). The majorfindingof these studies is that firms try to move away from each other. However, since price competition exists in the above mentioned studies, it's arguable that it forms a confounding factor for product differentiation due to the market power effect. Furthermore, existing studies focus exclusively on the lost demand in the hinterlands. The fact that lost demand can also occur in the market center has been largely overlooked. Contrary to that in the hinterlands, lost demand in the center may indeed mitigatefirms'tendency to differentiate. These effects can be seen more clearly when the distribution of customer preferences is nonuniform. There are only a few published studies that relax the assumption of a uniform distribution, and they mostly support PMD (for a detailed review see Brown, 1989). Two recent exceptions are the studies by Neven (1986) and Ansari et al. (1994) who found that PMD does not hold for certain nonuniform distributions. However, price competition and inelastic demand are assumed in both studies. 8 In this thesis, competitive positioning with nonprice competition, nonuniform distribution and elastic demand is examined in detail. An importantfindingis that the absence of price competition does not automatically induce minimum differentiation. Instead, firms use other "marketing mix" instruments (product quality in this thesis) to control demand. An effect mimicking the market power effect of price competition is found. At equilibrium firms differentiate by focusing on different segments of the market. Two important factors 8 Neven (1986) uses a quadratic travel cost function, which has been shown to induce differentiation in and of itself (D'Aspremontet al., 1979).

25 CHAPTER 1. INTRODUCTION 13 interact to influence market equilibria. One is the cost of quality provision; it primarily influencesfirms'quality levels and thus their market coverage. The other is the distribution of customer preferences; the homogeneity/heterogeneity of customer preferences influences firms' variety choices. With the setup in the thesis, local monopolization can be advantageous to oligopolists for certain range of the parameters. This confirms the speculation of D'Aspremont, Gabszewicz, and Thisse (1979) that it may be possible that "oligopolists should gain an advantage by dividing the market into submarkets in each of which some degree of monopoly would reappear" (p. 1149). A dynamic, two-period model is analyzed as one part of the thesis. It illustrates how competitive strategies are impacted by firm's interaction overtime, and serves as another distinguishing aspect of this thesis - most of the existing positioning studies present static analyses. In terms of the existing studies on television programs, most of them focus on the issue of scheduling. That is, given a set of television programs, how would a broadcaster schedule them over the night and over the week to attract viewers (e.g., Gensch and Shaman 1980; Danaher and Mawhinney 2001; Rust and Eechambadi 1989; Shachar and Emerson 2000). While scheduling is an important issue for the industry, it is not the only one. As opposed to scheduling, programming focuses on the decision of what programs to produce (see, e.g., Rust and Eechambadi 1989). Since programming involves many factors that are critically important to the industry (such as production cost, program quality, syndication, and program distribution), it is surprising that little published research exists in this area. We intend to fill this research gap by explicitly modelling product positioning.

26 CHAPTER 1. INTRODUCTION Structure of the Thesis The remainder of the thesis is structured as follows. Chapter 2 presents a brief description of the history and economics of the U.S. television broadcasting industry in order to provide background on both the institutional setting of the industry, and on some of the assumptions made in the theoretical models. Chapter 3 sets up the basic assumptions about the viewing choice of television audience and the behavior of television broadcasters. The next three chapters focus on issues related to broadcasters' competitive positioning. In a static game, Chapter 4 analyzes competitive positioning of the television market for monopoly, duopoly, and triopoly markets. Chapter 5 then incorporates the dynamic lead-in effect into the model, and examines the implication of viewers being myopic or forwardlooking decision makers. Nonuniformly distributed consumer preferences (as represented by a symmetric beta distribution) is studies in Chapter 6 for its impact on positioning strategies when there is no price competition and when consumer demand is elastic. Chapter 7 adds the cable operators to the model and addresses the retransmission fee debate. Finally, Chapter 8 concludes the thesis and suggest a number of potentially fruitful directions for future research.

27 Chapter 2 Institutional Settings of Broadcasting Television The U.S. was the birthplace of commercial television broadcasting, and has always had an enormous influence on the television programming seen in much of the rest of the world. Historically the U.S. industry differed from nearly all other countries in the extent to which it was paid for by advertising revenues. However, as indicated earlier, the trend in many other countries is toward U.S.-style commercial television broadcasting. Many of the assumptions used to develop the theoretical model were made in an effort to reflect the institutional setting of the U.S. industry. Consequently, a brief description of the history and several important aspects of the economics of the industry will help set the stage for the conceptual model. 2.1 The Formative Years: 1939 to 1955 Although the first experimental broadcast of television occurred in 1922, and CBS had a regular daily broadcast in the New York City market for 18 months in the early 1930s, the true start of television broadcasting in the U.S. is closely linked to the 1939 New York World's 15

28 CHAPTER 2. INSTITUTIONAL SETTINGS OF BROADCASTING TELEVISION 16 Fair. In a classic example of event marketing, both RCA and DuMont Laboratories used exhibits at the World's Fair as an important promotional event for their launch of consumer television sets into the New York market (Polkinghorn 1973). The FCC authorized commercial television broadcasting to begin on July 1 of However, rapid development of commercial television broadcasting only began to develop after World War II. During this period NBC, CBS, and DuMont began their networks as new stations were built in a number of cities, ABC launched the fourth commercial television network in early 1948, and the number of households with television sets greatly increased. In the early post-war period only the 12 channels (channel 2 to 13) in the VHF (very high frequency) spectrum were allocated to television broadcasting. However, it quickly became apparent that too few channels had been allocated to television since problems of interference began to emerge between stations in nearby cities that were assigned to the same channel. In response, the FCC in what came to be known as "The Great Television Freeze" halted the approval of all new station licenses on September 30, 1948 in order to devise a plan for allocating new stations (Miller 2000; Hinds 1995). The FCC's Sixth Report and Order of July 1, 1952 required some existing VHF stations to move to different VHF channels, existing VHF stations in a few selected cities (e.g., Peoria, Illinois; Fresno and Bakersfield, California) to switch to newly approved "ultra-high" frequency (UHF) channels (14 to 83) so as to create markets that were UHF "islands," and established guidelines for allocating a potential 617 VHF and 1436 UHF stations (Miller 2000; Ingram 1999). The part of the order that had the greatest effect on competition was the decision that most markets would be limited to two or three stations with VHF channel assignments, with any additional stations being assigned to UHF channels (Polkinghorn 1973). At the time of the order there were 108 VHF stations, and only New York City and Los Angeles had more than three stations (Schoenherr 2001). As a result, in most markets only two or three of the four competing networks had affiliates on VHF channels. NBC and CBS typically were the first

29 CHAPTER 2. INSTITUTIONAL SETTINGS OF BROADCASTING TELEVISION 17 stations with affiliates since they were in a position to persuade their existing radio affiliates to quickly apply for television station licenses, while ABC and DuMont were forced to either fight for the one remaining VHF station, or make a UHF station an affiliate. 1 Having UHF affiliates in markets that also had VHF stations turned out to be simply not viable. There were two reasons for this. First, none of the existing television sets in 1952 contained a UHF tuner, nor did the vast majority of sets built after the end of the freeze. Only in 1964 (12 years after the establishment of the UHF television band) did the U.S. Congress pass "all channel" legislation that required television sets made in the U.S. to receive UHF channels. In order to obtain a UHF signal most viewers had to purchase a converter box that, unfortunately, did not produce a crisp picture (Hinds 1995). The second problem was that the UHF transmitters of the that time had considerably less power than available VHF transmitters, thus UHF stations had much weaker (and more limited) signals than their VHF competitors. Given these unfavorable conditions, only 75 of the original set of 160 UHF stations were still on the air by 1960 (Hinds 1995). 2.2 The Stable Years: 1955 to 1979 For a 25 year time period the competitive environment for commercial television was stagnant with three entrenched competitors developing extremely high quality (i.e., high production value) programming in an effort to compete for viewers and advertising revenues. In 1967 there was an attempt to launch a fourth network (the United Network), with a set of affiliates that was largely composed of UHF stations, however the network was only on the air for 11 days before it folded (Ingram 1999). 'ABC with its own radio network and the financial advantages obtained when it was purchased by United Paramount Theaters in 1953 survived, while the DuMont network went off the air in 1955.

30 CHAPTER 2. INSTITUTIONAL SETTINGS OF BROADCASTING TELEVISION The Years of Rapid Change: 1980 to the Present The rise of cable television, propelled largely by the creation of specialty cable networks, is primarily responsible for ending the long period of competitive stability in the commercial broadcast industry. Cable television (known as Community Antenna Television, or CATV, at the time) was invented in 1948 as a means of providing subscriber households in remote and mountainous areas with access to the signals of nearby over-the-air broadcast stations through coaxial cable. In the late 1950s some cable systems began to import the signals of more distant independent television stations, but the FCC quickly restricted these activities, and did so until 1972 (National Cable Television Association 2000). Home Box Office (HBO), thefirstcable network, debuted in Wilkes-Bare Pennsylvania in Moving beyond limited local markets, HBO leased a transponder in 1975 on RCA's Satcom 1 communications satellite, which enabled cable systems throughout the country to carry HBO (Schoenherr 2001). In 1976 Ted Turner uplinked the signal from his Atlanta UHF station WTBS for satellite retransmission to cable systems across the U.S., and the "Super Station" was born. Growth in the number of satellite delivered specialty cable networks accelerated with the launch of ESPN and Pinwheel (soon to be Nickelodeon) in 1979, followed in short order by CNN in 1980, and MTV in 1981 (Schoenherr 2001). By the spring of 1998 the number of specialty cable networks had grown to 171 (National Cable Television Association 2000). In 1979 fewer than 20% of U.S. households subscribed to cable, but by 2000 thatfigurehad risen to nearly 70% (National Cable Television Association 2000). Through what is known as the "must carry" rule, the FCC requires local cable systems to include the signals of all over-the-air broadcast stations from the designated market area as part of the cable system's basic package. One important implication of the must carry rule is to greatly expand the audience size (and picture clarity) of low power UHF stations. Largely because of the "cable enhanced" power of formerly unattractive UHF stations, Ru-

31 CHAPTER 2. INSTITUTIONAL SETTINGS OF BROADCASTING TELEVISION 19 pert Murdoch's News Corporation was able to successfully launch the Fox Network in The same strategy of using the must carry rule to create a network using low powered UHF stations as affiliates has also been used by WB, UPN, and PAX Net. 2.4 Total Ratings Determines Advertising Rates As indicated earlier, commercial television broadcasting functions using a "two market" structure of viewers and advertisers. Perhaps surprisingly, program ratings play a dominant role in setting advertising rates. In Appendix A we provide an empirical analysis of the relationship between ratings and advertising rates for 30 syndicated programs in the television season. This analysis reveals there are two broad classes of syndicated programs, thefirstconsists of dramatic programs (i.e., situation comedies, crime dramas, science fiction and fantasy programs, and other programs of a theatrical nature) and news magazines, while the second class of programs includes talk shows, game shows, and mock court shows (e.g., Judge Judy). Within each broad class of program, ratings alone explain an overwhelming majority of the variance in advertising rates for 30 second spots. Specifically, for the first broad class of syndicated programs (all dramatic programs and news magazines) average ratings alone explain over 91% of the variance in average advertising rates, while average ratings explain 72% of the variance in average advertising rates for the second broad class of syndicated programs (talk shows, game shows, and court shows). Confirming these empirical findings, our conversations with media buyers in one mid-size North American media market revealed that a ratings point is worth $900 per 30-second spot in that market regardless of the demographic composition of the program's audience. 2 In addition to the must carry rule, another important factor that enabled News Corporation to successfully create the Fox Network was its purchase of Metromedia's chain of television stations, several of which are on VHF channels. In an important bit of historical irony, Metromedia was initially formed when the network owned stations of DuMont were spun out of DuMont Laboratories when the DuMont network ceased operations (Ingram 1999).

32 CHAPTER 2. INSTITUTIONAL SETTINGS OF BROADCASTING TELEVISION 20 Barwise and Ehrenberg (1988, pp ) provide an explanation as to why only ratings really matter in determining advertising rates: "In brief, an advertiser places commercials in a few time-slots each week and generally wants the largest possible audiences for each of these. This is because the composition of the audiences, by factors such as income, age, or usage of the product in question, is, to a first order approximation, much the same (i.e., television audiences are largely unsegmented)...hence the sheer number of viewers (the ratings) has to be the advertiser's main criterion." Another explanation for the almost constant advertising rate per ratings point is the existence of advertisers whose target consumers (thus the target television audience) differ dramatically. For instance, the target audience of ads for P&G's Bounce paper towel differ from those of J. P. Morgan's investment services, while both can be different from those targeted by AllState for its life insurance policies. As a result, the willingness to pay for different audience segments by a diversified group of advertisers drives up the importance of audience size. 3 While some researchers suggest that advertising rate is primarily a function of ratings (e.g., Wright 1994; Goettler and Shachar 2000), the lack of price competition in broadcasting television markets was noted and applied in several past studies as well (e.g., Fournier and Martin 1983; Fournier 1985; Litman 1979). 2.5 The Nature of Program Quality and Program Cost There are both relatively controllable and uncontrollable elements of television program quality. The relatively uncontrollable elements include such things as the likability of the under- 3 1 appreciate the comments along this line by seminar participates at Northwestern University, UCLA, and the Wharton School.