Vertical Contracts in the Video Rental Industry

This paper analyzes the implications of contractual innovation in vertically-separated industries, using the example of the video rental industry. Prior to 1998, video stores obtained inventory from movie distributors using simple linear pricing contracts. In 1998, revenue-sharing contracts were widely adopted. I investigate the effect of using revenue-sharing contracts on firms’ profits and consumer welfare, relative to linear pricing contracts. I analyze a new panel dataset of home video retailers that includes information on individual retailers’ contract and inventory choices, as well as rentals and contract terms for 246 movie titles and 6,137 retailers in the U.S during each week of 1998 and 1999 and the first half of 2000. Regression analyses indicate that the contracts had a small positive effect on retailer profits for popular titles, and a small negative effect on retailer profits for less popular titles. However, it is difficult to sufficiently control for the endogeneity of retailers’ contract choices in the regression analyses. A structural econometric model of firms’ behavior is developed that describes the nature of firms’ contract choices. Estimates from this model indicate that both upstream and downstream profits increase by 10 percent under the revenue-sharing contract for popular titles. For less popular titles, the effects can be even larger. I also estimate that consumers benefit when revenue-sharing contracts are adopted. ∗Department of Economics, Harvard University, Cambridge, Massachusetts 02138. E-mail: [email protected]. †A previous version of this paper circulated under the title “The Effects of Revenue-Sharing Contracts on Welfare in Vertically-Separated Markets: Evidence from the Video Rental Industry.” I thank Dan Ackerberg, Ken Corts, Jim Dana, Tom Hubbard, Guido Imbens, Phillip Leslie, Bentley MacLeod, Richard Mortimer, Ariel Pakes, Marc Rysman, and two anonymous referees for many helpful discussions and valuable advice. I also thank seminar participants at Brown University, Florida International University, Harvard University, MIT, Northwestern University, NYU, Stanford University, UC Berkeley, UCLA, UC San Diego, University of Chicago, University of Maryland, Washington University, Yale University and the Society for Economic Dynamics 2002 Conference for many helpful comments. The data for this study were generously provided to me by Rentrak Corporation, and I thank Robert Liuag, Ellen Dannenberg and Amir Yazdani for their help in collecting the data. Financial support from a UCLA Dissertation Year Fellowship and the Social Science Research Council’s Program in Applied Economics with funds provided by the John D. and Catherine T. MacArthur Foundation is gratefully acknowledged. Any remaining errors are my own.