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Economics 101: Retail - really?

Wed, 03/31/1999 - 7:00pm
Walter S. Ciciora, Ph.D., Recognized Industry Expert on Cable and Consumer Electronics Issues
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By Walter S. Ciciora, Ph.D., Recognized Industry Expert on Cable and Consumer Electronics Issues

The lesson to be learned is that "compatibility" and "compliance" are very difficult issues.

While listening to a radio talk show in Colorado, I heard something very scary. I'll never forget what one caller asked:

"Why do they keep raising my taxes? Why doesn't the government just pay for it?"

Many Americans are lacking in fundamental economic skills. Consequently, they make a mess of their financial lives. They demand foolish policy from the government. And politicians, eager for votes, act in counterproductive ways. We have an example of economic folly in the way the laws and rules have been created for cable set-top boxes. From an economic perspective, the rules and laws are self-contradictory and self-defeating. In every business, there are only two alternatives for any activity. Either that activity must generate the revenues to pay for itself, or it must be subsidized by some other activity. The preferred approach is for each activity to be separately justifiable. Cross-subsidization of activities can lead to economic inefficiencies and unintended consequences.

The set-top box activity of the cable business includes:

  1. acquisition of the hardware,
  2. maintaining inventory,
  3. installation,
  4. retrieval of unwanted units,
  5. repair, and
  6. upgrading when obsolete.

There are investments and costs associated with this activity. There should be an economic return on these investments which takes into account the costs.

But the government, under pressure from retailers and consumer electronics manufacturers, thought differently. First, the law forces rate regulation on the fees that can be charged for the lease of set-top boxes. The rate is kept artificially low, much lower than ordinary market forces would determine. In fact, the maximum allowable lease rate for set-top terminals is a "steal." This creates a situation where the set-top box activity of a cable business cannot justify its own continued existence. However, set-tops are a necessity if the current methods of conditional access are to be continued. So the set-top box activity cannot be discontinued. Implicitly, it must be subsidized. That is, it must continue even though it does not justify its fully allocated costs. Those costs must be covered by other activities of the business.

Second, the law wants to promote the retail availability of set-tops. This is amazing! First the business foundation for the set-top box activity is destroyed; then others are invited in. Do we expect many foolish takers to this invitation to financial ruin? Of course not. To promote this folly, starting mid next year, cable operators are required to be able to separate security from other functions and make available security modules to consumers who buy set-tops at retail.

Let's compare the two methods of selling set-top boxes:

  1. to cable operators for lease to subscribers, and
  2. directly to consumers through retail outlets.

A cable operator buys a large quantity of set-tops. This means that the manufacturer can set up a production line and run it for an extended period of time. This works out the bugs and results in high yields. Next, these units are packaged in protective boxes and delivered by the truck load to the customer. And of course, the cost of sales is low because the sale was made in huge quantities.

Compare this to the retail sale. If a distributor is involved, the distributor must make a profit. The retailer must make a profit. The salesperson must make a living. The packaging must be more substantial, and it has to be attractive. There must be sales training materials and time allocated for training the salesperson. Because the conditional access must be separable, there must be a connector for the conditional access module, and the internal electronics must have the correct "goes intos" and "comes out ofs" to interface with that conditional access module. Of course, the cost of the conditional access electronics is saved. But in a modern design, that electronics would be part of a larger integrated circuit. The cost of the wires and connector well exceed the cost of the few hundred transistors that are deleted from the other integrated circuits. Clearly, the cost of such a retail unit must be higher than a bulk sale to a cable operator. If a set-top box was sold to cable operators in bulk for $120, one estimate is that the same unit, modified to accept an external conditional access module, would have to retail for at least $200 to cover the additional costs of retail sale.

What about the consumer? In the case of the leased set-top box, the consumer receives as part of the price of the lease:

  1. installation,
  2. service when the electronics misbehave,
  3. upgrades to more modern set-top boxes when the current units become obsolete.

If the subscriber decides to move or to stop taking cable, the set-top box goes back to the cable operator and does not become a wasted asset. All of this comes for a government-mandated, below-market price. When the consumer considers purchasing a set-top, he sees a price tag that is a bit hard to justify in the face of an artificially low monthly lease from the cable operator. He knows that if the technology in the purchased set-top becomes obsolete, he will have to absorb the loss. He knows that if it breaks, he will have a hard time finding someone to fix it, and the repair will likely be expensive. There will not be the simple exchange at no cost for a properly functioning unit. And if there is a problem with the cable service and it turns out to be the consumer's own set-top box, there will be a service call fee from the cable operator. It doesn't take too much thought to realize that this is a poor value proposition.

Some argue that the vast efficiencies of the consumer electronics industry will drive prices down. These arguments forget that most of the set-top boxes sold to cable operators come from consumer electronics manufacturers, either directly or as contract manufacturers to more familiar brands. Consumer electronics and set-tops are made of the same basic stuff.

There is still one other factor to consider. The cable operator is allowed to charge a rate-regulated fee for the conditional access module based on its cost. Because the demand for these modules is expected to be very low, there will be poor manufacturing efficiencies. They may have to be hand-made in small quantities. It is not inconceivable that the conditional access modules will cost the cable operator more than a complete set-top. In that case, the lease of a conditional access module may exceed the cost of the lease of a set-top box! That would make the whole thing a non-starter. This is just Economics 101.

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