42 billion dollars. That is the amount of money the global box office was worth in 2019 (before the pandemic). Impressive, isn’t it? In 2018 when box office and home entertainment revenues were added together, the global film industry was valued at $136 billion. Hollywood is (de facto) the world’s oldest national film industry. American movies are not only popular in the United States, but also around the world. Furthermore, American film companies hold the majority of the global film industry’s market share. Hollywood’s success globally is quite evident today. However, the business strategies used by the filmmakers in the past to ensure their success are not known to many.

Film companies transformed films into branded products to ensure that film revenues exceeded cinema fixed costs. With the advent of feature films, the companies began to pay large sums to actors, actresses, and directors and for the rights to well-known plays and novels which continue to be a major feature of the film industry. To attract an audience, film producers borrowed branding techniques from other consumer goods industries. However, the short product life-cycle forced them to extend the brand beyond one product – using trademarks or stars – to purchase existing ‘brands,’ such as famous plays or novels, and to deepen the product-life-cycle by licensing their brands.

Thus, the main value of stars and stories did not lie in their ability to predict success, but in their services as massive “publicity machines” that maximized advertising effectiveness by rapidly accumulating high levels of brand awareness. Following the release of a film, information through word-of-mouth and reviews have an impact on its success. The young age at which stars reach their peak, as well as the skewed income distribution among superstars, confirm that stars were compensated for their ability to generate publicity. Similarly, because ‘stories’ were paid several times as much as original screenplays, they were purchased in part for their popular appeal. To some extent, stars and stories marked a film’s qualities, confirming that they at least contained themselves. Consumer preferences confirm that the main reasons for seeing a movie were the stars and the stories.

Another interesting aspect to explore is ‘Film Financing’ in Hollywood. Products from well-known brands abound in today’s films. What is the back-end economics of these transactions? Hundreds of brands — cars, computers, clothing, to name a few — appear on the big screen each year. Aside from a guaranteed amount of screen time, the big-money deals include a slew of other perks, such as verbal cues written into the script and the rights to run cross-promotional advertisements with the film’s leading actor. In the vast majority of cases, however, no money is exchanged between the brand and Hollywood. Producers require props, and brands are happy to lend them out for free in exchange for exposure. The reason behind these arrangements is straightforward: movies are quite pricey. A major studio film typically costs around $65 million to produce, excluding marketing and distribution. A majority of that is made up of general production costs, which includes set designs, props, and wardrobe. The prop budget alone for an action film can run into millions of dollars. Property masters (those in charge of props) are always looking for ways to cut costs, and product placement can be a lifesaver. According to some industry insiders, getting free stuff — hotel rooms, cars, fancy clothes, etc — can cut a big production’s budget by $250k to $5m+. That may not seem like a significant sum in the context of a $65 million film, but this amount can be used for better music, special effects, or other details that improve the final cut’s quality. Most of the time, these are mutually beneficial trades: films save money on their budgets, and companies gain exposure and brand recognition.

While there are a variety of financial structures tailored for film production, the one gaining traction in Hollywood right now is ‘slate financing’, where financial investors collaborate with a studio to back a slate of films. This structure is based on the assumption that a portfolio of movies, like a portfolio of companies, is more likely to produce the desired returns and protect against capital losses. In other words, the hits can compensate for the bombs. The good news about slate deals for larger private investment funds is that, given the time and expense of producing multiple films, their ostensible benefits are only available to parties with a large amount of capital to put to work. According to an industry source, “It can be riskier to invest a smaller amount in a single film than it is to invest a larger amount in a slate of films.”

Lobbyists for Hollywood argue that the film industry is difficult and that it requires a tax break. Hearing this as a state legislator should be enough to cause at least a pause because, except in the year 2020, Hollywood has never performed better. Global box office revenues have not fallen in more than 15 years. So, the notion that a thriving film industry requires a tax break seems a little absurd. These tax breaks are known as MPIs, which stand for “Movie Production Incentives.” They are exactly what their name implies: tax breaks for the film industry to encourage film production. The state of Louisiana in the United States first proposed the idea in 1992 to bring film production jobs to the state. To their credit, they have created some jobs – albeit almost always at the expense of taxpayers. These incentives are provided on a state-by-state basis, with the majority of states receiving them. However, when it comes to states, here’s the most perplexing fact: states with the highest income tax rates, such as New York, Connecticut, Massachusetts, and Hawaii, typically provide the most generous MPIs. States with lower income taxes, on the other hand, tend to offer fewer and less generous MPI subsidies. Four of the nine states in the United States that do not have state income taxes do not have any MPI subsidy programmes. By delving into the data behind this paradox, one can begin to understand the criticism that Hollywood studios are subsidised by taxpayer funds. To be more specific, that is not even criticism; it is simply a fact. As any rational economist would point out, taxpayers are always on the hook for ineffective government subsidies. One study in Massachusetts found that each film job created by the state’s MPI programme cost taxpayers a whopping $324,000.

Many states even provide cash rebates on qualified MPI purchases. To be more specific, these are production cost rebates, not tax breaks. In other words, costs incurred by the studio are submitted to the state for reimbursement, costs that are considered “qualified” in particular, and a portion of this is returned to the studio – typically between 20% and 25%. It is similar to cashback rewards in some ways, except that you do not need good credit to be eligible for these cashback perks. You only need a big studio. The taxpayers are the ones who provide this free money. Furthermore, the production costs submitted to the state for reimbursement are occasionally artificially inflated. It is called the “honour system”. Several film directors have been charged with tax evasion after telling state governments one inflated figure while paying their production staff a significantly lower figure.

However, if movies can be such a good investment, why do so many Hollywood films fail to make a profit for their investors despite having tax breaks, hundreds of millions in funding, tens of millions in paid product placement, and, to top it all off, box office sales that exceed their budgets?

Here is where the concept of Hollywood accounting comes into play. Hollywood’s accounting methodology is quite notoriously enigmatic. To reduce profit, the scheme employs dubious legal, and sometimes illegal, expense systems. Consider a film studio that also owns a subsidiary costume company. On the surface, it appears to be a perfect match. Films are produced by studios. Actors are employed in films. Costumes are required for actors. So, if one owns a studio, why not also own a costume company? Isn’t it textbook vertical integration? Not so fast. These structures do not work in practice because there is an obvious conflict of interest. Specifically, the studio can mark up the cost of their costumes, purposefully over-billing their film. The studio artificially raises its expenses to transfer earnings away from the investor and toward the costume firm – which the investor does not own. Profit-shifting based on a conflict of interest is common in Hollywood. Screenwriter Ed Solomon claims that his Sony-owned blockbuster Men in Black is still not ‘in the black.’ This is nearly a quarter-century after its release and grossing over $600 million on a $90 million budget, not to mention the three sequels.

But this prompts the question, are movie studios the villains here?

The in-person moviegoing industry has been severely impacted by online streaming. However, contrary to popular belief, movie theatres continue to be a multibillion-dollar revenue source for Hollywood. To comprehend the economics of movie theatres, one must first understand how they generate revenue. Movie theatres are not in the film industry. Movie theatres serve food and beverages. Since AMC has the largest theatre market share in the United States, let us consider them a proxy for the industry. According to the company’s 2019 annual report, food and beverage sales accounted for nearly a third of total revenue, totalling 1.7 billion dollars. Even more impressive are the net margins on that revenue, which are 84 per cent. This prompts the question: if theatre companies like AMC profit over a billion dollars a year from food and beverages, why does the industry as a whole lose so much money? According to the company’s 2019 annual report, it “lost” 149 million dollars in revenue of nearly $5 billion. However, if depreciation is excluded, the picture changes. After depreciation, AMC had a net profit of slightly more than $300 million. Even $300 million in quote-on-quote “real net profit” on $5.5 billion in revenue is not a good business. In other words, their real net margins are only 5%. So, why is this the case? Food and beverages are not the issues. This sector of the industry is a cash cow. The answer to this question has to do with how studios are charged to show their films in theatres.

During the first week of a film’s release, theatres may only receive 20 to 25% of the ticket price, with the remaining 75 to 80% going to the studios. The revenue split shifts in the second week, with a higher percentage of revenue going to the theatre and a lower percentage going to the studio. By week six, the theatre usually receives the majority of the film’s ticket revenue. This will continue week after week until the film is no longer shown in theatres. This adaptive revenue share is precisely why popcorn is so expensive.

It is not wrong to believe that studios are squeezing movie theatres. Disney faced a massive backlash after informing theatres that they would receive a 0% revenue share on all ticket sales during the opening week of their new Star Wars film. This may not appear to be a fair trade but they do not have a choice. Assume a theatre decides not to show the new Star Wars film because it will not generate any revenue from ticket sales. It may risk losing potential customers who will go to a different theatre showing the new Star Wars film. In the eyes of Disney’s detractors, they are a monopolising death star, crushing theatres one galaxy at a time. However, for the capitalist Jedi on the outside looking in, such an argument is difficult to win. Disney does not have a monopoly. They are not using Darth Vadar’s invisible force choke to compel theatres to show their film. Disney has the pricing power that has been criticised because they simply make great movies. That is the brilliance of the intergalactic system known as ‘free-market economics.’

By Khushi Yadav