Vertical Integration and Market Foreclosure in the Korean Movie Industry Yusun Hwang∗ November, 2013 Abstract I examine the exhibition behavior of movie theaters in the Korean movie industry in order to investigate the influence of vertical integration on competition. I focus specifically on the choice of films, screen allocation, and movie run stopping over different vertical structures. Because, in the Korean movie industry, not only can we observe the same movie being shown in both integrated theaters and unintegrated theaters but also observe the same theater showing movies from distributors of different vertical structures, I use movie and theater fixed effects to control for the unobserved quality of movies and theaters. The empirical results suggest that vertically integrated theaters are more likely to choose their affiliated movies than other competing movies, and they choose them more often than other competing theaters do. In addition, integrated theaters give their own movies a greater number of screenings over longer time periods. This effect is mostly restricted to company operated theaters, and it is greater when movies are expected to get positive word-of-mouth as well as when underlying demand is high such as holidays. I argue that these results are not driven by the matching between movie and theater based on anything other than integration status, and that vertical integration leads to the foreclosure, denial of access, of independent distributors to integrated theaters, to the detriment of consumers. JEL-Classification: L14, L22, L42, L82 Keywords: Vertical Integration, Vertical Foreclosure, Movie Industry ∗Department of Economics, University of Southern California, Los Angeles, CA 90089. Email: [email protected] 1 1. Introduction The possibility of vertical foreclosure in vertical mergers has been a major concern of antitrust authority investigations. Theories suggest that for the purpose of gaining monopoly power, verti- cally integrated firms may deny an access of competing downstream (upstream) firms to interme- diate goods (downstream outlets). They also suggest that vertical foreclosure can survive as an equilibrium in an oligopoly setting, indicating that vertical integration can harm consumer welfare by raising price of final goods.(Ordover et al. (1990), Salinger (1988), Hart et al. (1990), Choi and Yi (2000), Chen (2001)) Empirical studies have provided evidence that vertical integration gives rise to foreclosure. For example, Ford and Jackson (1997), Waterman and Weiss (1996), and Chipty (2001) found that vertically integrated cable operators in the cable television industry were more likely to carry their affiliated networks. In particular, Chipty (2001) demonstrated that Time Warner, which owns the premium movie service, HBO, tends to exclude AMC, the basic movie service, from its basic package offer. In addition, Goolsbee (2007) found that broadcast networks are more likely to carry their own shows than independent programming. Regarding to movie industry, Gil (2008) and Fu (2009) examined the effect of vertical integration between distributors and exhibitors in the Spanish and in the Singapore movie industry respectively. Both studies found that vertically integrated theaters showed their affiliated movies longer than unintegrated theaters did. However, the existence of vertical foreclosure is, by itself, not sufficient to allow for the con- clusion that vertical integration harms consumers. In fact, in economics, the effects of vertical integration on consumer welfare have long been a source of debate. Theories predict (Ordover et al. (1990), Salinger (1988)) that vertical integration may have efficiency-enhancing effects by reducing transaction costs or eliminating successive monopoly mark-ups, and as a result, vertical integration can improve consumer welfare by lowering prices. Hence, the welfare effect of vertical integration depends on the relative importance of anti-competitive effect of vertical foreclosure and efficiency gains. A few studies have attempted to assess the consequences of a vertical merger, providing mixed results.1 Goolsbee (2007) found that broadcast networks apply lower standards to carrying their 1For a survey of empirical studies, refer to Lafontaine and Slade (2007) and Rey and Tirole (2007) 2 own shows than to carrying independent programming. Specifically, independent programs need to generate over 15 percent higher revenues from advertising than comparable in-house programs in order to get on the air, suggesting that the foreclosure effect outweighs efficiency gains. On the other hands, Chipty (2001), in her paper on the cable TV industry, concluded that vertical integration does not harm but rather benefits consumers. By comparing consumer welfare across integrated and unintegrated markets, she argued that efficiency gains dominate losses from foreclosure. Corts (2001) studied how vertical integration in the movie industry between producers and distributors affected competition of movie release-date scheduling. He demonstrated that integrated firms inter- nalize the negative externality of close release dates, indicating that vertical integration improves the efficiency. Gil (2008), also, interpreted his findings as efficiency gains in his investigation of vertical integration between movie distributors and exhibitors. He argued that integrated theaters run their own movies longer than other movies, and longer than unintegrated theaters do, and concluded that vertical integration solves the distortion of movie run length created by the revenue sharing contracts in the movie industry. However, this kind of interpretation should be made with caution because theaters face capacity constraints caused by having a limited number of screens. To retain their own movies for a longer period of time, integrated theaters should sacrifice revenues generated by other movies that otherwise would have been shown, which could be interpreted as a reduction in total box-office revenues as well as consumer welfare. A major obstacle in assessing the effects of vertical integration is that we hardly notice that com- panies with different organizational forms handle the same set of products from both integrated firms and independent firms in the same market. When each product is a differentiated good, which holds in many industries, controlling product quality is crucial to demand estimation, but observables often explain little about product quality. If we can observe that downstream firms do business with the same set of products, we might attribute observed difference between integrated downstream and unintegrated downstream to the effects of vertical integration by controlling prod- uct quality. This is the case in the cable TV industry in which cable TV providers offer different sets of channels chosen from the same set of channels available. However, the cable TV industry is virtually monopolized in many markets. Several cable TV providers operate nationwide, but it is common that a specific provider is the only option that consumers can choose in their residential area. In that case, the comparison of integrated markets to unintegrated markets could suffer from 3 differences in underlying demand over markets in the assessment of the consequences of vertical integration. In this spirit, the Korean movie industry provides several advantages for the analysis of vertical integration. First, because two major domestic distributors own multiplex chains, it is possible to observe how integrated theaters give preferential treatment to their own movies against other movies supplied by rival distributors compared to unintegrated theaters. That is, we can observe four different combinations between movies and theaters: (1) integrated movies shown in integrated theaters, (2) integrated movies shown in unintegrated theaters, (3) unintegrated movies shown in integrated theaters, and (4) unintegrated movies shown in unintegrated theaters. This circumstance enables us to control unobserved movie quality2 as well as theater quality by using movie-theater fixed effects. Theater fixed effects also control the difference in underlying demand for movies over geographical markets. With these fixed effect, the effects of vertical integration are determined by difference in differences approach in the level of movie by theater. Second, it is distributors and not movie theaters that promote movies nationwide, suggesting that theaters in the same geographical market face the homogeneous demand for each movie. Al- though each theater might enjoy some degree of market power because of its membership programs, it is difficult to conclude that potential consumers at an integrated theater have strong preference for movies from its affiliated distributor. Moviegoers are usually concerned about the contents they can see such as trailers, casting, and directors, but not about what is happening behind the film like which company distributes the film. In addition, movie theaters are located close to each other in many markets, especially in urban areas in Korea. In the extreme case, two different theaters are operating within 100-meter distance. It is hard to believe that integrated theaters draw different sets of consumers based on their preference. Hence, the observed differences in exhibition behavior between integrated and unintegrated theaters can be attributed to the practice of discrimination by means of vertical integration under the assumption that in-house promotion by theaters has little impact on movie demand.3 Third, contracts between distributors and exhibitors are fairly