Profit Maximizing Output

A very large part of what we have learned in this class has to deal with the combination of profit maximizing prices and profit maximizing output. These categories are measured quantitatively.  I want to vent for a moment on an output that is measured a bit more qualitatively.  I have pondered for years on the reason production companies release R rated movies.  It makes no economic sense to me.  I looked into the top grossing films of all time and there are only two in the top 100 that are rated R.  The highest on the list was number 66.  The list is primarily PG-13 but there are also quite a few PG titles.  I initially assumed that the top grossing films would also be the top profit producing films because of the incredibly high revenues.  As I looked into this assumption further I found that I was on the right track but not 100% accurate.  Different websites had different information of course, but according to the site the-numbers.com the top profit earning films are also PG-13 or PG.  If you look at the best return on investment the story changes and many more R titles make the list.

From my quick analysis I have found that the income of a film being produced on a low budget favors R and PG-13 ratings, while high budget films are almost always better as PG-13 or PG.  I admit that I have some personal bias on the subject because I choose not to watch R rated films and there are some that I would like to see if the ratings were different.  Even with my bias I see no economic reason for a large production company to produce an R rated film.  I know there are different markets for different products but are there really that many customers that would choose not to see a movie because it was only rated PG-13?  I have heard of companies fighting to receive PG-13 status because they understand the financial benefits so why not just make it PG-13 worthy in the first place?   There are many more arguments to the discussion than I have mentioned but shouldn’t stockholder return play the largest factor in the decision?  


Dave Tufte said...

Captain Jack: 100/100

I really like this post. It's not required that you explore something new to you, but it's pretty cool for me when a student does.

I actually have a former Ph.D. student who published a simulation of how executives green light movies (when I teach FIN 6100 we role play the simulation in class).

Anyway, he's researched the inside details, and he indicated to me once that the director and producer target the rating for the story they want to tell, and then the executives budget accordingly. Movies that are targeted for R usually get smaller budgets because everyone knows they're likely to have lower revenue. So the assertion from the first sentence of Captain Jack's post is kind'of backwards.

So further down in that same paragraph, the issue is not really the gross profits earned for the shareholders. Rather, the projects need to have the same expected ROI. So if a studio makes an R rated movie with a $20M budget, and it makes a $10M profit, this will be viewed as just as good as making a PG movie with a $200M budget that makes a $100M profit.

Of course, there are three problems with all of this. First off, studios are very closely held, they don't release very detailed financials on individual projects, and there hasn't been a lot of shareholder drive to get them to open up about that. Second, just about anything you read about Hollywood emphasizes the opaque accounting surrounding all projects. Third, the routine variability in the ROI of projects is huge; I don't know what range they're willing to accept as routine, but I've got to think it goes from something like -50% to +200% on individual projects. So they diversify their projects quite a bit.

Dave Tufte said...

On a a slightly different note, the choice problem here is not usually covered in ManEc, but is sometimes covered in finance (I can' speak for what Bruce Haslem does with you folks) and quant classes (I scratch the surface a little in ECON 6100 — the spreadsheet course).

Broadly this is called investment under uncertainty. You have multiple projects, that each have their own expected cash flows and risk. In more complex cases, they're not independent of each other. How do you choose which ones to pursue?

The naive approach is to rank them in terms of NPV, and start with the biggest ones. That turns out to be a bad idea. Instead, you should choose all the ones with positive NPV. But then you may not be able to finance them all, so it becomes a liquidity issue rather than an investment issue.

One problem with all of this is that managers tend to never propose projects with negative NPV. But executives know that some projects must have negative NPV, so the proposers are biased.

A second problem is that project proposals are real options, that should be priced with option methods instead of NPV. It's not impossible, but it is harder.

A third problem is that once you start to view projects as options, then you realize that they can proceed in stages, where each step going forward can be viewed as a new option.

And after all this, there's a brand new theoretical result that came out a few months ago. In most decisions we're used to doing some version of cost-benefit analysis. But it turns out that's only correct for decisions that are small relative to the size of the firm. When the decisions are relatively large, it turns out that the costs and benefits of each decision depend delicately on each other in some very surprising ways. That field is all-a-twitter the last few months because this addresses what's been an outstanding problem for decades, and it's yielded results that are very counter to how managers usually think about these things.

Digression: I've publsihed some research on application of economic theory to zombie narratives. I've had some talks with Steve Schlozman about writing up an application of that last paragraph. It turns out this idea is already pretty common in zombie narratives. It goes like this: a character is attacked by 1 strong and 2 weak zombies, fights off the strong one, and gets bitten (usually in the calf) by one of the weaker ones. It turns out that this sort of character is doing the cost-benefit analysis the conventional way: the net benefit to taking out the strongest zombie is the biggest, so you take them on first. But the new theory shows why that's problematic: the threat from the weaker zombies is drastically increased by the presence of the strong one, while the threat from the strong one isn't made too much worse by the presence of the weak ones.

Captain Jack said...
This comment has been removed by the author.
Captain Jack said...

Since this post I have had a few more thoughts come to mind. I like the point that Dr. Tufte made about small projects and large projects ROI matching. The main thought I have had is the risk involved with large budget films. Huge revenues are typically the result of huge production budgets and with the largest expense comes the largest risk. With a little more research I found that the films with the 20 largest budgets were rated PG-13 or PG. I also found that a few of the films on the top budget list were also on the top 20 largest loss list. Many of the movies on the large budget list made the large profits list but there are some real money pits.

I have recently noticed large production films using less well known cast members. I wonder if the big name expense does not pay off, if production companies are simply looking to the future, or if the risk is just not worth the reward? As a consumer I will not pay for a film that does not interest me just because it has my favorite actor but I will pay for a story line that interests me with a no-name actor.

Dave Tufte said...

Captain Jack: 50/50

I'm glad I motivated you to look more deeply at this :)

If you think about it, it's kind of weird, and a little disturbing, how much I've had to tell people in this blog this semester to focus less on revenue and more on profit. You're all business majors, so you should know this. And you've all got "real world" experience, so you should know this. But still, we're so bombarded by more visible revenue numbers that we forget about what should be our primary focus.

As to less well-known cast members, I think this is a result of TV production moving the movie industry's cheese over the last 35 years. Prior to the premiere of Hill Street Blues in 1981, TV was not known for doing serious drama from the ground up. That's what movies did. That's completely reversed since then. And TV has proved that people will watch non-stars in good story lines. For a while the movies were able to combat that with increased star power (ramping up from Clint Eastwood in the 70's to Julia Roberts in the 90's). But that seems to have been a fad. Having said all that, I'm not sure what the economics is behind those moves.

Jim Craig said...

I have really enjoyed reading this string of posts. Typically I have made comments on posts I know something about and where I have an opinion one way or another on the subject. With this post I am commenting merely because the subject matter has intrigued me and I have learned something new from the post and comments.

Professor Tufte, you mentioned in one of your comments a new theoretical result which emerged a few months ago regarding cost-benefit analysis not being the best approach for large decisions. I wonder, can you elaborate on this? This is the first time I am coming across this idea. In particular I am wondering where the results came from? Were the results published by a PhD student or a professor? Also, is it possible for you to provide a link to some further information about the study and the results? I am curious to learn more about this new idea. Would you consider this as significant as the Nash equilibrium, or is it too early to tell how this idea will affect economics and decision making?

It was also interesting to learn about how the budget for a movie is created and how ROI is more of a focus than gross revenue. As mentioned in other comments all that ever gets reported in the news is the gross revenue a movie has generated and little is mentioned about ROI and profits. This post and comments has been fun to read and has enlightened me a little about the entertainment industry.

Dr. Tufte said...

Jim Craig: 50/50

Yeah! I'm glad you learned something new from this thread.

The article is entitled "Averting Catastrophes: The Strange Economics of Scylla and Charybdia". It is by Ian Martin and Robert Pyndick. Here is a link to a copy of the paper: I'm not sure the linked content is legal, so don't be surprised if the link becomes inactive.

I don't want to discourage anyone, but this paper is probably beyond most Ph.D. students in economics. I would not point MBA students to it ... but you asked, right?

I may have misspoken. It is not that cost-benefit analysis doesn't work for large decisions, but more that we make a really strong assumption in applying basic cost-benefit analysis that fails badly when the decisions are big. You can still do the cost-benefit analysis, but it's significantly more complex, and leads to much more unusual results.

The results are published by two professors. I don't know too much about the lead author. The second author is an old guy at MIT (the best school for economics Ph.D.'s). He wrote the text I used for my first econometrics course in 1984, so he was well-known even then. His Google Scholar page shows 43K cites across well over 100 publications: that's future Nobel Prize territory.

Wow. As significant as Nash equilibrium? I'm not sure there's much out there as significant as that. That would be on any "greatest hits album" of economics (you know the handful of "songs": "supply", "demand", "equilibrium", "marginal cost", "competition", "elasticity" — "Nash equilibrium" would be at that level). Will this one be? I doubt it. It's very big, but not as widely applicable as Nash.

I think the best explanation I can give for these new results is in the thread above. I will add that the usual idea with cost-benefit analysis is that you can compare the costs and benefits and act in a way that benefits yourself. The critical assumption is that acting on that information doesn't change the costs and benefits of other decisions you might have to make. The only time that's really true is when the initial decision isn't large relative to the potential decisions that follow it. This is OK when you're deciding whether to put skim or whole milk in the macaroni and cheese, because that's not big enough to affect which insurance company you go with for your car. But that logic falls apart if you're doing something like choosing which optional coverages to purchase on your auto insurance: you probably can't afford all of them, and if you buy one, it might incline you to be a little more risky, thus increasing the chance of needing the other coverages. What Martin and Pindyck have done is outlined a general approach to how you'd solve that sort of problem. There is no set answer (all conclusions depend on the numbers you've got for your particular problems), but it isn't generally to take care of all your problems, or to take care of just the big ones. In fact, it's often take care of a bunch of small ones and hope you can avoid the big problem.

Dr. Tufte said...

I'm glad you like the ROI thought, but it's kind of different from what's above. I think all smart business people are focused on stuff like ROI. But many of them are not that smart, or don't have the right incentives. And then there's the business press — who really don't have to focus on ROI at all if they don't want to, especially if it's tough to dig out.

Now, I've been sneaky here. Part of getting students to write about random stuff on a blog is that when they start acting like business reporters instead of business students who should know better, I can catch it and point it out.