August 23, 2001 ECONOMIC SCENE Good Monitors Make for Better Contracts
By HAL R. VARIAN
BEFORE 1998, video rental stores bought tapes from distributors for about $70 each. Because the tapes were so expensive, the stores bought relatively few of them, with the result that customers had to wait to see their favorite films. To paraphrase a noted amateur economist, the hits were so popular that no one was able to rent them.
In 1998, the industry began to move to a different plan: distributors provided tapes to the stores for a small upfront fee of $3 to $8 and then took 40 to 60 percent of every rental. This "revenue sharing" model is the norm today, at least for hit movies in large rental chains.
This policy has been a big success. According to the Harvard economist Julie Holland Mortimer, revenue sharing raised the combined profits of the distributor and retail outlet over 7 percent and increased access to popular tapes, making consumers significantly better off.
Video stores have been in existence since the early 1980's. Revenue sharing contracts were available in the video industry for about 10 years but were not widely used until after 1998. Why did it take the industry so long to adopt this superior form of contract?
There is a big difference between the traditional fixed-fee sale of tapes to stores and revenue sharing: the distributor has to be able to track sales to ensure appropriate payment. Just as good fences make for good neighbors, good monitoring makes for good contracts.
Monitoring costs are sharply lower these days because of the availability of low-cost computer networking. It used to be that only large chains could afford smart cash registers and proprietary networks to monitor sales. Now virtually any retail outlet can buy PC software that does sophisticated sales tracking and sends reports over the Internet to central accounting offices.
Dedicated cash registers have virtually disappeared the last 10 years, replaced by generic PC's with special software. The latest trend is to eliminate proprietary file transfer protocols and send sales reports as standard e-mail attachments. Smart cash registers have become a commodity, and that makes them very cost-effective tools for monitoring revenue.
A similar revolution has occurred in the trucking industry. Most of those semis you see on the highway have a PC inside. The economist Thomas Hubbard of the University of Chicago has studied this industry extensively and reports that nearly 50 percent of trucks built in the early 1990's had some form of electronic monitoring system installed.
Some of these computers are "trip recorders" that monitor various aspects of the truck's operation, like when the engine is running, the speed of operation and when sudden acceleration or deceleration takes place.
Others systems, known as electronic vehicle monitoring systems, use wireless data technology to communicate location and to transmit instructions from central dispatchers to drivers.
The romantic view of the truck driver as a lone cowboy, beholden to no one but himself, is seriously out of date. Today, most long- haul truck drivers are as carefully monitored as the office stenography pool used to be.
Vehicle monitoring systems allow for more efficient employment contracts since they have lowered the cost of observing departures from agreements. A trucker might say he will take the optimal route rather than making a side trip to visit his girlfriend, but how could his behavior be verified without a monitoring device?
Additionally, when dispatchers know the current location of every truck, it is much easier to optimize routing.
Some rental car companies have installed a form of trip monitors to detect speeding and other forms of unsafe operation. Such systems should eventually lead to lower insurance costs and, therefore, lower rates for automobile rental. Individuals can decide whether they want to go fast and pay more, or obey the speed limit and pay less.
Computer-mediated contracts are an important development because they help make economic relationships more efficient. By reducing monitoring costs, they allow for forms of contracting that were previously unavailable.
But there's a cost to all this monitoring: privacy. Truck drivers may not like being watched, and video renters may not be happy about their transactions being stored on a centralized server. Rental car safety is desirable, but the customers may prefer autonomy to lower rates. A group of judges from the United States Court of Appeals for the Ninth Circuit in San Francisco protested monitoring technology installed on their computers.
These are real concerns. On the other hand, people generally enter into contracts voluntarily and can choose how much monitoring they will tolerate in exchange for lower prices or higher wages. Abuse of private information is bad - there are laws about who can see your video rental records - but voluntarily agreed-on contracts are generally a good thing.
The critical issue is informed consent. Truck drivers know they are being monitored. Video renters who sign up for loyalty programs should be aware that part of the cost of those free videos involves tracking cumulative rentals. A panel of federal judges investigating the San Francisco complaint has recommended posting a prominent message about the monitoring technology every time users log on.
When trip monitors were first introduced, truck drivers had misgivings about them. But enough of the benefits from better monitoring, routing and improved capacity utilization have flowed to their paychecks to make them quite popular among drivers today.
Want to work at home? Would you be willing to have your work-related activities monitored to do so? Want to sell a product? Would you be willing to wait till it was sold to be paid? These questions and more like them will face us all as computer-mediated contracts become more widespread.