Coming Soon To A Theater Near You: Flexible Pricing

by: Robert Wagner

Coming SoonEvery once in a while you discover an idea that is so obvious that you hit yourself in the forehead and shout "Ugh...why didn't I think of that!!!?" The idea is so simple it should have been obvious to everyone, but it is just now coming to the market. That concept is flexible pricing for movie theaters. The same "name-your-price" solution that has revolutionized the hotel, airline, insurance and yard sale industry is coming to your local theater. This video titled, "Dealflicks: Priceline For Movie Tickets" explains the concept.

What I love about the concept Deal Flicks is based upon is that it is right out of an microeconomics 101 text book. If you ever wondered what your professor was talking about when discussing marginal revenue and marginal costs, this is the perfect example. Certain industries like the airlines, hotels and theaters have a cost structure that is ideal for auction/name-your-price applications. The reason for this is that the majority of their costs are fixed or sunk and relatively substantial, whereas the marginal cost of the service they provide is almost negligible. If a jet is scheduled to fly from New York to San Francisco, the majority of the costs involved are in flying the jet from coast to coast. The cost to the airline is basically the same if the jet is full or if the jet is empty, which is why auction-type pricing applications are so successful when applied to the airlines industry.

"A little of something is better than all of nothing," the cost to the airline of letting an additional passenger on board is basically a small bag of peanuts, a can of coke and a slight, most likely immeasurable decrease in mileage per gallon due to the extra weight. As long as the airline covers those almost negligible marginal costs with the price of the ticket, their profits will increase. It is a win-win situation. A similar situation for hotels exists. A hotel can let a room sit vacant, or rent it out for a nominal fee, and as long as that fee is greater than the cost of maid service (and maybe some stolen towels and soap) its profits will increase. Firms maximize profits when they increase supply until margin revenue equals marginal costs, and firms like Priceline (PCLN), Hotwire, Expedia (NASDAQ:EXPE), eBay (NASDAQ:EBAY), Amazon (NASDAQ:AMZN), Deal Flicks and others all help firms and individuals to do just that; maximize profits.

In the video the interviewer states "the model makes perfect sense," and it does. The Deal Flicks CEO points out that 88% of theater seats sit empty. 88% of seats sit empty and the industry still makes $40 billion dollars per year. If the theaters can fill those seats with ticket and concession sales at a level that covers their marginal costs, their profits are sure to increase; it is basic microeconomics 101.

Why then do theaters let 88% of their seats sit idle? The reason is simple, they have a price floor set for tickets that is above the market's equilibrium price, thus creating a surplus. This surplus is necessary however because of the blockbuster nature of the business. When a movie is released, people rush to the theater to be the first to see it. Theaters only have a limited time to capture ticket sales before the demand is gone, therefore they over-build their theaters to accommodate the spike in demand associated with blockbusters. People are willing to pay the high ticket price initially, and the seats will be packed, but after the Friday and Saturday night rush is over, the theaters sit empty until the next weekend or blockbuster comes to town. That creates a huge deadweight loss that can be captured with the right pricing strategy. People will only pay the peak price for so long, and then the price has to drop or the theater will sit empty. In this way, theaters are much like electric utilities. They have to build enough capacity to meet peak demand, which occurs during the day when factories and businesses are running, and then a lot of capacity goes unused at night when all the lights are turned off. The "smart-grid" concept is an example of how the electric industry is trying to apply this flexible pricing mechanism, at least in part, to the electric consumer.

To reduce demand during the high cost peak usage periods, communications and metering technologies inform smart devices in the home and business when energy demand is high and track how much electricity is used and when it is used. It also gives utility companies the ability to reduce consumption by communicating to devices directly in order to prevent system overloads. Examples would be a utility reducing the usage of a group of electric vehicle charging stations or shifting temperature set points of air conditioners in a city. To motivate them to cut back use and perform what is called peak curtailment or peak leveling, prices of electricity are increased during high demand periods, and decreased during low demand periods

Bugs will surely need to be worked out, but this concept truly has the potential to revolutionize the entertainment industry, much like it has other industries. The main obstacle is to get the theaters and studios to agree on a system, or to get the studios to agree at all. The current system of revenue sharing between the studios and theaters is too diverse and complex to cover in this article, but the important point is that it exists. Right now, unless a studio agrees to participate, the only part of the movie ticket that is "flexible" is the part the theater keeps; the studio's portion acts like a "reserve" price or price floor for the ticket. The economic solution therefore is relatively simple, the studios and theaters simply need to define what their marginal costs are, combine the two, and that becomes the agreed to "reserve" price. Both the studio and theater would be ensured a pricing level that would cover their costs and reach a profit maximizing level of supply for a given demand.

With flexible pricing however you get two benefits for the price of one. Flexible pricing doesn't only work to eliminate the deadweight of a surplus, it also works to eliminate the deadweight loss of a shortage created by a price ceiling. This is what should be real attractive to the studios. Whereas the flexible price to address the price floor tends to shift producer surplus to the consumer, flexible pricing for a price ceiling shifts the consumer surplus to the producer. What this means in practical terms is that it kills the black market for tickets. Right now a blockbuster movie ticket may be priced at $7.00 opening night, way below the level the free market would support. You quickly call your girlfriend and rush to the theater only to be greeted by a big "sold out" sign and a huge line of unhappy customers. You think that your hot date has just been ruined until you see the guy offering two tickets for $50. You quickly buy the tickets and prevent your hot date from going cold. In this scenario, the scalper is walking away with the producer surplus that should have gone to the theater, studio or both, and he did so by taking $50-$14=$36 in consumer surplus from you, but you don't care because you were willing to pay the $50. Flexible pricing is a win-win situation, and allows the studios and theaters to cut out the middle man and send the scalper home empty-handed.

The other benefit, especially to the studios, is that it allows them to recapture more revenues in a shorter period of time. The biggest threat to a blockbuster is another blockbuster, so the sooner the studios get their money back the better. Flexible pricing would allow greater ticket sales in a shorter period of time, some of which would be sold at a premium price. The more seats that can be filled on opening weekend, the better. Flexible pricing combined with flexible scheduling of the available theaters would do just that. That is the incentive for the studios to work with the theaters to make this work. Online ticket sales would allow the movie to sell out weeks in advance giving the theater time to adjust their schedule and expand the number of theaters to accommodate the advanced ticket sales.

Even if the studios don't adopt flexible pricing the Theaters could go it alone without the studio, and keep all the producer surplus to themselves (if their contract with the studio would allow it). A theater could take the middle-ground where it would maintain one theater for the traditional fixed price tickets, where people risk not being able to get a ticket, and maintain another theater with the same movie that offers flexible pricing with a reserve price equal to the contracted Studio's take. That way consumers get the best of both worlds, the studio gets its contracted cut, and the theater wouldn't risk alienating any loyal moviegoers that like the traditional system. That would also benefit theater supply and servicing companies like Ballantyne Strong (NYSEMKT:BTN), Cinedigm (NASDAQ:CIDM) and specialty theaters like IMAX (NYSE:IMAX) and RealD (NYSE:RLD), that would benefit from the expansion of the number of theaters.

The theater business already incorporates flexible pricing in a way with matinee pricing, student, children and elderly pricing, so the auction system isn't all that different from the current system, it just adds more flexibility. While the above description makes it sound simple, the nature of the entertainment industry does present some challenges, and those challenges may explain why some tech-savvy movie fan created Deal Flicks and not a major studio or theater network. As mentioned above, the movie industry creates both price-floors and price-ceilings for the same product, a situation created by wildly different demand depending upon night or day, weekend or weekday, holiday or not, winter or summer. It will take some work to design a system that doesn't cannibalize the profitable periods at the expense of the less profitable periods. Studios also have the ability to act like a monopoly in the short run, and are sure to want to protect that pricing power. A possible solution would be to maintain the current pricing structure for opening weekend and then go to flexible pricing in the off-peak periods, or a similar mixed-approach that attempts to maintain the best aspects of both systems. The point being is that the studios haven't embraced the system yet, and they most likely have reasons not to that will need to be overcome. This wouldn't be the first time Hollywood resisted changing their system. Back in 1948 it took a supreme court decision to force the studios to change their ways.

This concept would not only be applicable to theaters like AMC Entertainment, Carmike Theaters (NASDAQ:CKEC), Cinemark (NYSE:CNK), Regal Entertainment (NYSE:RGC), Marcus Theaters (NYSE:MCS) and studios like Disney (NYSE:DIS), Universal/COMCAST (NASDAQ:CMCSA), DreamWorks (NASDAQ:DWA), News Corp. (NASDAQ:NWSA), Sony (NYSE:SNE) and others, it would also be applicable to sports, concerts, and other arena and stadium entertainment. Madison Square Garden (NASDAQ:MSG) and Ticketmaster/Live Nation Entertainment (NYSE:LYV) could also apply this concept to capture more producer surplus and eliminate the scalpers from the streets. It would also help in maximizing the size of the audience and scheduling the events. If an event sells out in minutes like a Beyoncé tour, the tour schedules an event, shows up for their one-time only event, and then is gone the next day leaving many people unable to attend the event that would have if there had been another event. Auction/flexible pricing would allow the event to set a minimum reserve price, auction off as many tickets as possible, and schedule as many events at the same location as the market will bear or the facility would allow. Once a certain location has sold a profit maximizing level of tickets, the auction site would open up another location and repeat the process. Not only would the ticket revenues be maximized, the cost of setting up and tearing down and moving would be minimized and spread over multiple instead of a single event. Once again, it is a win, win, win situation where the entertainer, arena and fans all benefit.

The above discussion covered some of the winners of this system. Who would be the potential losers? Because one would expect the first run theater attendance to increase under this system, the value of second run movies would be expected to decrease. Pay-per-view cable providers like Time-Warner Cable (TWC) would be expected to lose revenue as would DVD rentals like Coinstar/Redbox (NASDAQ:CSTR). Premium channels like HBO/Time Warner (NYSE:TWX) and Starz (NASDAQ:STRZA) would also be impacted by the tougher competition. Netflix (NASDAQ:NFLX) and other similar services would also likely lose some revenues. $1.00 theaters would likely become a thing of the past, but would simply transform into a flexible pricing theater and get the movie sooner than in the past.

In conclusion, if flexible pricing does catch on in the movie, sporting and arena entertainment industries, it could have a monumental impact in the way business is done in those markets, much like the impact flexible pricing has already had on travel and leisure companies. There are sure to be winners and losers, some of which I attempted to identify in this article, and most likely many more to be discovered as this trend develops. While this concept is only in its infancy, it most likely is worth keeping an eye on because the impact could be so revolutionary. Revolutions lead to change, and change often leads to profits and losses, as the winners and losers battle it out for survival and market share. The good thing for investors is that it is early in the fight, and this article is an effort at designing a financial battle plan for fighting the coming war of flexible prices.

Disclaimer: Opinions expressed herein by the author are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment advisor capacity. This is not an investment research report. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings, and consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.

Disclosure: I am long BTN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.