The Hollywood Economist

Wal-Mart and the Shanghai Pirates

Hollywood’s newest business model?

A street vendor in China selling pirated discs

The video pirates of Shanghai, China, have developed an amazingly successful business model for exploiting the home market. In the back rooms of video stores, shoppers fill their baskets while choosing from an almost endless inventory of DVDs that includes all of the new movies playing in America, Europe, and Japan, as well as a full complement of Oscar screeners. You can also buy current television series—even the latest episodes of Lost, 24, and Desperate Housewives. In addition, these stores stock a huge number of older movies and provide boxed sets of the complete works of noted directors. Finally, in a modified form of video on demand, if a title is not on the shelves, the store gets it from some other location in a matter of minutes.

With these pirated editions, there are no “windows” or artificial delays before a new movie is released on DVD and no zone restrictions that can prevent DVDs from being playable. Most are professionally burned from digital masters, with 5-channel sound, multi-language menus, and high picture quality. The DVDs cost about $1.25, which is less than a movie ticket in Shanghai. As a result of this aggressive pricing, people in China rarely go to movie theaters—ticket sales amounted to only 17 cents per capita in 2005. Instead, they buy shopping baskets full of DVDs.

Retailers—including street hawkers—pay about 50 cents apiece for DVDs from the well-organized pirate manufacturers, whose only expenses are the blank discs (of which China is the world’s largest manufacturer), the cheap boxes in which they are packaged, and the enterprise cost of stealing the digital masters. The success of the video pirates demonstrates the economic principal that the demand for entertainment is exquisitely elastic: DVDs priced at $15—the official, nonpirated retail price—hardly sell in China; DVDs priced at $1.25 a copy (or lower on the street) sell an estimated 1.3 billion copies per year.

This economic lesson has not always played well in Hollywood. Up until the 1990s, the studios placed a wholesale price of $60 or more on most videos because they assumed that they would make more profit selling a few expensive copies to video stores than a lot of inexpensive copies to retail consumers. After the DVD was launched in the late 1990s, most of the studios wanted to price them at over $30 to protect the video rental business. Sumner Redstone, who controlled both Paramount and Blockbuster, famously argued, “The studios can’t live without a video rental business—we [Blockbuster] are your profit.” Warren Lieberfarb, the president of Warner Bros. Home Entertainment, decided to bypass Blockbuster and offered Wal-Mart lower-priced videos as traffic builders. These DVDs were priced as low as $15 a copy. Under relentless pressure from Wal-Mart, which accounted for 40 percent of the studios’ “bin sales,” the price for older DVDs was cut to $6 a copy. These reduced prices turned DVDs into a retail juggernaut and only increased the studios’ video revenue, which reached an all-time high of $21 billion in 2005.

Wal-Mart, which recognizes the same virtue in price elasticity as the Shanghai pirates do, is moving to further reduce the price of DVDs with a plan to burn its own copies of DVDs in kiosks in its stores. Like the Shanghai pirates, the retail giant would buy huge quantities of blanks discs and cheap boxes (probably made in China) at a cost of pennies, but, unlike the pirates, pay a licensing fee to the studios for each copy it burns. The advantage to the customer would be that he could choose a title from among the tens of thousands of movies in the studios’ libraries, and also possibly have it in the language and rated-version (G, PG, R, or NC-17) he prefers, while the studios would save the cost of manufacturing, packaging warehousing, and returns.

When executives from Warner Bros. heard Wal-Mart’s DVD-to-order proposal in Bentonville, Ark., last year, one of its home entertainment executives pointed out that, with present technology, the delay for the customer might be as long as a half hour before he could pick up the DVD. “Great. Could you make it an hour?” the Wal-Mart executive shot back. From the point of view of Wal-Mart, the DVD need not make money itself, as long as it serves to draw—and keep—potential customers in its stores. The remaining issue is the amount of the licensing fee per copy that the studios will charge. The current proposal under discussion of $3 to $4 for older movies is not much below what the studios are now getting (after manufacturing costs) for the DVDs they sell to Wal-Mart. But once the studios agree to the scheme, they would be hard-pressed to resist pressure from Wal-Mart to reduce the licensing fee, since this costless stream of revenue could not be easily replaced. As one savvy Paramount executive points out, “There would be nothing to stop Wal-Mart from playing studios off against each other and drive the license fee down and down on titles until it’s just pocket change.” If Wal-Mart succeeds in this enterprise—and it rarely fails—it will close much of the gap with the Shanghai pirates.