When the door to a TLA Entertainment video store swings open, the primary question facing most consumers shuffling inside is relatively simple: “What movie will I take home tonight?”

But to Wharton marketing professor Jehoshua Eliashberg and Wharton doctoral candidate George Knox, the key question surrounding the burgeoning $12 billion home-video market goes at least one step further: Which consumers will rent their movie of choice tonight, and which consumers will buy?

In a study entitled, “The Consumer’s Rent vs. Buy Decision: The Case of Home-Video,” Eliashberg and Knox present a new model that they say accurately predicts the consumer’s decision to rent or buy a particular movie at a video store. Using data collected from a home-video store over a six-month period, these marketing experts believe that the results could have a significant impact on how retailers can ultimately influence viewers to buy movies, which, from the retailers’ point of view, is more profitable than renting.

In addition, Eliashberg says, the study’s results could also have implications for marketing to consumers far beyond the parameters of the home-video market. The principles used to analyze the video industry, he notes, could be applied “to any situation where consumers face two options: Option One, whether to pay a flat fee for unlimited consumption or Option Two, whether to pay at each time of consumption.”

Industries where flat-rate and pay-per-use options already exist include health clubs, spas, ski resorts, telephone calling plans, movie theaters, and drama and musical theater subscriptions. Even Weight Watchers, the dieting program, now offers flat-fee or pay-per-use options. “We chose to work on this because it has implications in other areas, not just in the buy-rent decision for home videos. The model we developed here will address these expanded concerns,” Eliashberg says.

More DVD Players, Lower Video Prices

The two researchers began their study by noting that while “there has been a growing interest in research and modeling issues related to the entertainment industry in general and the movie industry in particular,” less attention has been paid to the home-video market and its related consumer decision-making process. And yet the topic is clearly ripe for analysis for one obvious reason: growth.

In 2003, the $12 billion home-video market represented 52% of the revenue of a major motion picture release, compared to just 1% only eight years earlier. Eliashberg credits the growth to two key factors: the expanding use of DVD players and home theaters, and the affordable pricing of videos for sale.  Both, he says, “have made the home video market grow faster than expected in the last few years. While studios understand that aggregate drivers of success in the home video market are different from the box office, how consumers decide whether to buy or rent a particular movie title is relatively unknown both to entertainment executives and academics.”

Eliashberg and Knox developed and tested two models designed to capture how a consumer might choose between buying or renting. The two models reflect a basic premise that “at the heart of any decision to buy or rent is an estimate of how much value the consumer anticipates he or she will derive over subsequent movie viewings.” In short, how do consumers determine value, and how does this affect their buying vs. rent decision?

In the first model, which is based on the real options literature in economics, “the consumer understands that the value of watching a movie diminishes over time and treats the problem of how many times he should watch the movie as an optimal stopping problem.” Part of the value the consumer “attaches to buying is the flexibility” he or she has in “choosing when to stop watching … the movie.” Ultimately, the buyer compares the “expected utility of buying with a one-shot value from renting, and chooses the option that maximizes expected utility.”

In the second model, based primarily on cognitive psychology principles, the consumer is “concerned with the number of times a movie is watched, not value or utility.” Eliashberg notes that in this model, the consumer calculates a threshold level of viewings, based on the costs of renting and buying the title. “If the consumer’s anticipated number of viewings is greater than the so determined threshold level, the consumer;s decision is to buy the home video. Otherwise, he will rent it.”

The main difference between the two models and their subsequent equations, Eliashberg says, “is that in model one, the consumer anticipates decay in enjoyment. He will enjoy it less after watching it the first or second time. With model two, there is no such anticipation. The decision he makes is based on arithmetic — How many times will I watch the movie? — and is the ratio beneficial to buy?”

To collect data used to calibrate both models, Eliashberg and Knox turned to TLA Entertainment Group, a home-video retail chain that operates six stores in Philadelphia and New York City and was ranked 15th in revenue across the country for specialty stores in 2002, according to the report. Eliashberg and Knox chose to collect data from the largest TLA store in Philadelphia during the last six months of 2003; of the 75,000 transactions recorded during this period (covering 9,000 movies and 5,000 members), the study focused exclusively on 24,000 DVD transactions from 4,276 customers for 76 of the most popular movies, available for both renting and buying with the store. These 76 movies included such selections as Anger Management, Bend It Like Beckham, Bowling for Columbine, Bringing Down the House, Die Another Day, Gangs of New York, Holes, Jerry Seinfeld Comedian, Just Married, Lord of the Rings: The Two Towers, Malibu’s Most Wanted, Narc, Punch-Drunk Love, Shanghai Knights and View from the Top.

Why study DVDs and not VHS movies? Two reasons, the study noted. DVDs are priced to sell in the $10 to $25 range compared to VHS tapes, which can cost as much as $100. And “given the scenario we model, both options — renting and buying — have to be available at the same time for the choice to be legitimate. DVDs are most commonly released for rental and purchase simultaneously, whereas VHS tapes are more often released sequentially.”

To obtain useful implications from the models, Eliashberg and Knox introduce what they call “relevant parameters” — namely, factors that, once estimated, can be employed to make inferences about the “rent/buy behavior of individuals and the rentability/purchasability of movies.” For instance, they consider whether the consumer balances the cost of watching the same movie again with the future possibility of positive value — which could be seeing some favorite scenes again. And while price explains part of the process used to determine renting vs. buying, niche appeal accounts for many customer purchases.

R-rated Action Films

Several clear patterns eventually emerged. Confirming what the authors call “industry intuition,” the study documents that the TLA store’s customers are more likely to buy action movies that did well at the box office and have an R-rating. And when it comes to predicting who will buy and who will rent, a movie’s value, represented most clearly by the authors’ first model, had a clear advantage. “We find that accounting for diminishing value of the video adds significant predictive power … to the model,” the authors write.

The results also indicated that basing the prediction solely on the box office gross could not explain why a movie like How to Lose a Guy in 10 Days (with receipts of $106.1 million) inspired one buy out of 41 transactions, whereas a cult favorite like About Schmidt ($65 million) saw seven buys out of 54 transactions. “Conventional wisdom holds that a movie can correct for a bad showing at the box office by subsequent DVD sales, because DVD releases provide more of a ‘level’ playing field to all movies being released than at the theater, where only a handful of movies at any given time are seen as being successful.”

The purpose of the study, Eliashberg cautions, is not to determine which variable “can strongly predict rental and purchase sales across the entire home video market.” Rather, the marketing experts propose that retailers such as TLA can use the equations related to price, rental options and different purchasing patterns to predict which consumers will buy a movie — and then generate customized purchase prices for consumers that take these histories into account. The goal? To create an option that is so attractive that a customer will buy rather than rent a movie, a more profitable transaction for the retailer. Noted Eliashberg and Knox: “We are interested in a particular retailer’s prediction problem, given its own customer base, in order to customize its prices or manage its inventory.”

Which means, in the future, that the home video consumer who walks into a TLA store could soon be subject to the same price-discrimination practices that many consumers already face when buying airline tickets or browsing online product stores. For instance, say a prospective renter of one “purchasable” movie title — i.e., a movie whose value does not diminish rapidly over time — has a previous pattern of buying or renting similar movies, data which TLA has collected. When he goes to rent, TLA punches the consumer data into the Eliashberg-Knox equation or model, and comes up with a tempting movie purchase price offer of $12.50. But when renter No. 2 enters and picks up the same “purchasable” movie but doesn’t exhibit a previous pattern of buying, the result from the rent vs. buy model might force the retailer to sweeten the offer a bit. Based on the variables, she is offered the movie for $10.50.

By collecting information about consumer spending habits and purchase predictability, retailers already offer various consumers the same product at different prices. Eliashberg thinks the home video market — and any market that offers flat fee vs. pay-per-use options — is ready for the same scenario.

“How many times have I found myself sitting next to someone else, and he or she has made me feel like a sucker, or I made him feel like a sucker, for going to the same destination on an airline but paying more for the ticket?” Eliashberg noted. “Price discrimination has become acceptable. It is very micro marketing.”

And, he added, “our model is also very applicable to websites. In fact, in the introduction to the paper, we talk about different types of home video business models on the web. There are those like Columbia House that allow you only to buy, and those like Netflix that allow you only to rent, and then those like Wal-Mart that allow you to either buy or rent. Our model will tell you in advance which movies are particularly rentable and which ones are buyable. And the customized pricing options are definitely applicable and able to be used by those websites offering both options for their customers.”

The paper cautions that “these results represent the clientele of TLA and may not be representative of the home video market as a whole.” And Eliashberg did admit that choosing to base his study on a particular video store in downtown Philadelphia could result “in a very idiosyncratic preference for movies, one that should be taken into account. I have seen that also in movie theaters. If you [compare] what movies people like in downtown Philadelphia as opposed to the suburbs, that could have an affect on the study.”

The paper also notes that the dataset does not allow the authors to observe day-to-day availability of a movie title. “To the extent that consumers substitute across titles given unavailability, we would not expect this to bias our results. However, if consumers substitute renting for buying the same movie or vice versa because the movie is unavailable in one format, we would expect our results to be biased … We can only partially control this by choosing movies that TLA stocks heavily.”

As far as the study’s ability to predict trends, Eliashberg suggests that “stores such as TLA will continue to make business mainly from the rental activity unless they take seriously our customized pricing accommodations. And then they can generate, through price discrimination, more profit for themselves by offering the clientele the opportunity to buy.”

The Consumer’s Rent vs. Buy Decision: The Case of Home-Video