March 4, 2008, 10:12 am

What Are the Lessons of the Blu-Ray/HD-DVD Battle? A Freakonomics Quorum

By Stephen J. Dubner

Even if you don’t care one bit — and this probably describes the vast majority of Americans — you have probably heard by now that a Great Format War has been fought, and apparently won. The HD-DVD format for DVDs, backed by Toshiba, has lost out to Sony’s Blu-ray format. To be sure, there are some caveats. In this Computerworld article, for instance, Lucas Mearian writes that Blu-ray’s victory may not be remotely as meaningful as it seems. Having recently spent a cold, rainy, but thrilling afternoon walking the Freedom Trail in Boston, I would put it this way: the Blu-ray victory may end up being as expensive, and as predictive of ultimate victory, as was the British victory of Bunker Hill. (This is not to say that HD-DVD will come back and win the war; it likely won’t. Still, the Blu-ray victory is hardly unqualified.)

So what are we to make of this format skirmish? We gathered up a group of smart people who think about such things — Shane Greenstein, Andrei Hagiu, Michael Santo, and Pai-Ling Yin — and asked them the following:

Is the battle between HD-DVD and Blu-ray really over? What can we learn from it?

Here are their answers. Thanks much for their participation and insights.

Shane Greenstein, professor of management and strategy at the Kellogg School of Management at Northwestern University:

While the history of format wars teaches analysts not to infer lessons too hastily, it is much more fun to throw such caution to the wind. So here goes. I see three lessons from this recent battle, one for vendors and two for buyers.

The lesson for vendors: a format victory does not guarantee profitability. Neither side in this fight committed a strategic error. Each hardware vendor lined up a large coalition, launched a sophisticated campaign, and fully funded their marketing efforts. Such sophistication led to large sunk expenses. That put both sides in a position to lose money unless the war settled quickly. It did not. HD-DVD had its best chance when it came to market earlier than Blu-ray. HD-DVD did not win because it did not build enough early sales to slow its competitor’s later sales, which went well enough to nearly tip the market.

The HD-DVD coalition responded by offering subsidies for content providers, keeping the fight alive. Reportedly, buyers bought a million units of HD-DVD and a million of Blu-ray, with the latter being more recent. Retailers – especially Wal-Mart and Best Buy – have recently lost patience with splitting precious shelf space between formats, and have settled on Blu-ray, the format that sells more content.

In brief, neither side exits this war with profitability. HD-DVD will soon assume niche status, and the coalition will take a write-down. At best, Sony avoided disaster by not losing completely. Still, that avoidance happened only with a very high initial expense that Sony cannot possibly recover until Blu-ray sells many units for a long time. In brief, neither side has profited, or will do so for some time.

The lesson for an impatient buyer: a format war does not benefit every impatient buyer. An impatient buyer wants the latest functionality at almost any price and wants it soon. Those buyers exist in every market for consumer technology gadgets, benefiting from the usual free-for-all. Things will turn out well for one group of impatient buyers, those who bought Blu-ray, but not necessarily as well for the other group, or HD-DVD buyers. The latter own a system with a good chance of becoming orphaned by hardware vendors and movie title providers. There is no way to buy insurance against such a contingency, nor is there a large tax deduction for donating obsolete equipment to museums stocked with 78 RPM turntables, 8-track tape players, and laser discs.

The lesson for a patient buyer: patient buyers gain certainty by ceding control. Patient buyers usually do not itch to change their situation quickly, waiting for a new gadget to exhibit a clear and pragmatic value proposition. Vendors believe that there are many such buyers in this market, comprising the vast majority of VCR owners. Indeed, it looks as if patient buyers benefited from waiting out this format war, and will soon experience lower prices, larger libraries, more convenience, and reduced uncertainty. Yet, as in prior wars, waiting has its risk. Patient buyers ceded control over the format choice to impatient buyers and sellers. Did earlier market participants make a choice that serves the interests of later market participants? It is difficult to say at this point.

Street Vendors & Externalities

When cities issue permits for street vendors it is often for a fixed fee. The benefit to the vendor can vary, many times simply by the location. The traffic created from visitors whose intention was to visit the building behind the vendor, creates a positive externality for the street vendor.

Take for example a street food vendor. Having a prime location in front of a shopping mall, park or historical monument, the vendor has the added benefit of more visitors and higher visibility than a vendor parked at a corner. The location allows the vendor to offer a meal to visitors without them having to go elsewhere to get it.

Free Riding Sweden Style

In 1991 Sweden slashed their defence budget, trimming 29 army brigades (with 5,000 men per brigade) to 16 and currently down to only 12. As of April 2007, Sweden is preparing to cut krone 900 million (USD 116m) from its Defence Material Administration and reduce research funding by krone 500m as the government looks to offset the drop in defence spending. Since joining the EU early in 1995 they have continued to drastically reduce their defence budget, thus most likely posing the position of “neutrality in war”. While the United States is beefing up military budgets and troops, Sweden can free ride by declaring neutrality to the UN and the rest of the world. Thus all but eliminating their defence budget and spend their money on other governmental projects.

Source: A free-rider problem. Economist, 00130613, 9/9/95, Vol. 336, Issue 7931

Anchorage's SoNo

Anchorage is not well known for historic neighborhoods since it is a relatively young city and has had a pattern of boom and bust economic and urban development (as in the pipeline days and the frontier days). But within the last 4 years a number of small independent stores have popped up just a little ways outside of the traditional "downtown" area. THEY CALL IT SoNo -- as in just south of Norstroms. There are no sources I can reference but I believe Bernies Bungalow, a local martini bar, was the first of the young (21-30) hipster business to really plan itself. From there a storefront, which had served as a cheap space for numerous business and political campaigns, is now a high price beauty salon. Currently, there are at least 5 high end clothing boutiques in the area.

What is this an example of? A positive externality. The area is now HIP so new stores that are based here gain a boost of hipness from their location. It also demonstrates some "free rider" action because only 2 of the stores have done any paid advertising promoting the "shop in SoNo" message but they all benefit from the branding.

The Online Dating Network Effect

Given the world wide web is truly global, dating online and match making was an inevitable byproduct. With sites such as Match.com and eHarmony.com, users are tempting fate in order to find the love of their life. Established dating sites can be categorized as a true network effect. According to eHarmony, "for every one match on eHarmony.com that resulted in marriage, there were 999 'compatible' matches that did not." Regardless, social networking and online dating sites alike have become very successful. In 2005, for example, eHarmony boasted over 6 million members.

The network effect of communicating via the internet can be explained by Metcalfe's law - stating the value of a telecommunications network is proportional to the square of the number of users of the system. Whereas only one computer connected to the internet is useless as a communications tool. The value of every additional computer increases with the total number in the network because the total number of connected users increases. However, the capability of this network depends on the number of users actually connecting. Hence in the online dating world, 6 million subscribers is only as successful as those who actually find a connection.

One major threat to the online dating industry is unsubstantiated growth and the need for critical mass. While in the early years of social networking, increased network size paved a way for its ultimate acceptance. Competitive pressures fueled the promotion of larger and larger membership bases but subscribers don't really benefit fromthe absolute size of these networks.

The relevancy of the network is based on the number of possible matches that meeting the user's criteria. Even with Metcalfe's law there will be a point where the shear size reduces the value of the network unless members can realy find ways to navigate through an effective search for a match. Otherwise, the bigger the pool of members, the harder it may be to find your soul mate. Wading through possibilities would be endless.

In this case, critical mass for the user would be the point when a relevant network has a sufficient number of members who could fit a search criteria. Creating a better experience for the membership and ultimately increasing the total number of subscribers or the network itself.

Source: Consumers are having second thoughts about online dating (2005). Retrieved March 28, 2008 from, http://weattract.com

Pecuniary Externalities

Monday, January 22, 2007

ANDREW SAMWICK

For what it's worth, I think Paul Krugman makes some good points about the problems inherent in using the tax code to encourage or discourage the purchase of health insurance in his column today (original here, reposted here). I obviously don't sign on to his characterizations of "Bush and his advisers," and he stops short of his usual call for a single-payer system, so there's no reason to get into that today.

Were it up to me, I'd completely eliminate the exclusion of health insurance premiums from taxable income. That levels the playing field between premiums and other expenses (as the Bush plan tries to do), but it does so without forcing the tax code to be the arbiter of whether something was a legitimate health expenditure or not. It also raises tens of billions of dollars in additional tax revenue that can then be directed to all the other things the government needs to pay for.

However, I found this statement (highlighted in bold) in Krugman's column to be odd:

While proposing this high-end tax break, Mr. Bush is also proposing a tax increase — not on the wealthy, but on workers who, he thinks, have too much health insurance. The tax code, he said, “unwisely encourages workers to choose overly expensive, gold-plated plans. The result is that insurance premiums rise, and many Americans cannot afford the coverage they need.”

Again, wow. No economic analysis I’m aware of says that when Peter chooses a good health plan, he raises Paul’s premiums. And look at the condescension. Will all those who think they have “gold plated” health coverage please raise their hands?

Is he kidding me? That is almost the definition of a pecuniary externality. Wikipedia describes it as follows:

A pecuniary externality is an externality which operates through prices rather than through real resource effects. For example, an influx of city-dwellers buying second homes in a rural area can drive up house prices, making it difficult for young people in the area to get onto the property ladder.

This is in contrast with real externalities which have a direct resource effect on a third party. For example, pollution from a factory directly harms the environment.

Both pecuniary and real externalities can be either positive or negative.

So in the President's defense, there's a very simple argument to be made here. When one person feels inclined, for whatever reason, to purchase more health care services, that puts upward pressure on the price of health care services (if the supply curve is not flat) and thus the cost to everyone else in the market. Normally, we don't pay any attention to this, because that is precisely the mechanism by which a competitive market achieves economic efficiency.

The President is referring to the pecuniary externality generated by a tax distortion in the treatment of health insurance, which interferes with a market achieiving economic efficiency and thus should concern us. It goes as follows. Premiums are fully excludable from income tax, but out-of-pocket expenses are not tax advantaged. That favors health insurance arrangements in which there are low deductibles and high premiums. Such arrangements can lead to higher utilization of health services, since the insured faces no financial cost at the margin once the low deductible has been met. (This is just a standard moral hazard argument.) Krugman may not believe that the relevant behavioral effects are large here, but he's on shaky ground with his "Wow ... no economic analysis ..." comment.