Review of The Hollywood Economist: The Hidden Financial Reality Behind the Movies by Edward Jay Epstein

The Hollywood Economist: The Hidden Financial Reality Behind the Movies by Edward Jay Epstein is a book about one of the world's most cutthroat businesses. You may know Epstein as the author of the classic, absolutely must-read article Have You Ever Tried to Sell a Diamond?, about how the diamond cartel maintains high profit margins on perfectly ordinary lumps of carbon.

Epstein is fascinated by both industries, and there are certainly similarities between them. The movie studios have their own methods of keeping profit margins higher than under perfect competition, like oligopoly signaling:

"Major studios avoid simultaneously competing in the same demographic categories by using a service that reports the relative potential draw of various new movies appealing to the same category of viewers if offered at the same time."

Very clever! No uncomfortable meetings, which would be an antitrust gray area. It reminds me of the famous paper Collusive Bidding in the FCC Spectrum Auctions[pdf], which argued that a poorly designed auction mechanism had allowed telecom companies to coordinate a division of the licenses and enforce the proposed division by directing punishments at rivals.

Any industry that is cohesive enough to practice oligopoly signaling can probably make trouble for upstarts, and so Epstein has also written about the problems with the Netflix (NFLX) business model,

"Netflix can buy 10,000 copies of a major title for $150,000 to mail out, [but] it will need to spend about $16 million to license it for streaming. Such a 100 fold increase in price can obviously be deleterious to profits especially since Netflix still has to maintain its mailing centers, and buy DVDs, for the subscribers who elect to continuing using the mail-in service..."

The way that Hollywood is going to crush Netflix parallels the way that Hollywood crushed the Edison Trust. Thomas Edison owned most of the major American patents relating to motion picture cameras. His monopoly lasted for less than a decade before a federal court mysteriously ruled [pdf] that his exercise of his patent rights violated antitrust law.

The Hollywood Economist is a book about complexity. Movie studio lawyers create these incredibly intricate - really, needlessly complicated - contracts for allocating revenue from movies. It reminds me of something David Merkel said recently: "complexity is the enemy of the one receives it". The corollary would be that complexity is good for the party that creates it. Hollywood uses complexity to snare sophisticated investors who should know better, even hedge funds!

"Take JP Morgan Chase, which sent out a 'teaser' to hedge funds, reading, 'Despite compelling economic returns, major film studios are capital constrained and often must seek co-financing arrangements with other studios and other outside sources.'"

Yet we know from Epstein's analysis that the studios have mid-double-digit IRRs on their movies. So, why would they need outside capital? Because, they can get it on great terms from credulous investors!

Anyway, the book would have been a 3/5 except it was short enough to read in under two hours, so I'm raising to 4/5 for brevity.

By the way, Wal-Mart is Hollywood's biggest customer! Thus, Wal-Mart gets to censor, on behalf of its customers, the movies produced in the United States.