A Look Back At How The Content Industry Almost Killed Blockbuster And Netflix (And The VCR)

Editor’s note: Derek Khanna is a leading technology policy consultant and columnist. He previously worked for the House Republican Study Committee where he authored their report on copyright reform and is a former fellow with Yale Law School’s Information Society Project. Derek regularly writes for The Atlantic, National Review and Forbes. Follow him on Twitter @DerekKhanna.

The once iconic video-rental giant Blockbuster is shutting down its remaining stores across the country. Netflix, meanwhile, is emerging as the leader in video rental, now primarily through online streaming. But Blockbuster, Netflix and home media consumption (VCR/DVD/Blu-ray) may never have existed at all in their current form if the content industry had been successful in banning or regulating them.

The first video-rental store opened in 1977. It was 600 square feet and located on Wilshire Boulevard in Los Angeles. George Atkinson, the entrepreneur who decided to launch this idea, charged $50 for an “annual membership” and $100 for a “lifetime membership” but the memberships only allowed people to rent videos for $10 a day. Despite an unusual business model, Atkinson’s store was an enormous success, growing to 42 affiliated stores in fewer than 20 months — and resulting in numerous competitors.

In retrospect, Atkinson’s success represented the emergence of an entirely new market: home consumption of paid content. It would become an $18 billion dollar domestic market, and, rather than cannibalize from the existing movie theater market, it would eclipse it and thereby become a massive revenue source for the industry.

Atkinson’s success in 1977 is particularly remarkable as the Sony Betamax (the first VCR) had only gone on sale domestically in 1975 at a cost of $1,400 (which in 2013 dollars is $6,093). As a comparison, the first DVD player in 1997 cost $1,458 in 2013 dollars and the first Blu-ray player in 2006 cost $1,161 in 2013 dollars. And unlike the DVD and Blu-ray player, it would take eight years, until 1983, for the VCR to reach 10 percent of U.S. television households. Atkinson’s success, and that of his early competitors, was in catering to a market of well under 10 percent of U.S. households.

While many content companies realized this as a massive new revenue stream — e.g. 20th Century Fox buying one video rental company for $7.5 million in 1979 — the content industry lawyers and lobbyists tried to stop the home content market through litigation and regulation.

The content industry sued to ban the sale of the Betamax. This legal strategy was coupled by leveraging the overwhelming firepower of the content industry in Washington. If they lost in court to ban the technology and rental business model, then they would ban the technology and rental business model in Congress.

Litigation Attack

In 1976, the content industry filed suit against Sony, seeking an injunction to prevent the company from “manufacturing, distributing, selling or offering for sale Betamax or Betamax tapes.” Essentially granting this remedy would have banned the VCR for all Americans. The content industry’s motivation behind this suit was largely to deal with individuals recording live television, but the emergence of the rental industry was likely a contributing factor.

While Sony won at the district court level in 1979, in 1981 it lost at the Court of Appeals for the Ninth Circuit where the court found that Sony was liable for copyright infringement by their users — recording broadcast television. The Appellate court ordered the lower court to impose an appropriate remedy, advising in favor of an injunction to block the sale of the Betamax.

And in 1981, under normal circumstances, the VCR would have been banned then and there. Sony faced liability well beyond its net worth, so it may well have been the end of Sony, or at least its U.S. subsidiary, and the end of the VCR. Millions of private citizens could have been liable for damages for copyright infringement for recording television shows for personal use. But Sony appealed this ruling to the Supreme Court. In 1982, the Supreme Court granted certiorari and agreed to hear the case.

After an oral hearing, the justices took a vote internally, and originally only one of them was persuaded to keep the VCR as legal (the number of justices would eventually increase to four). According to Supreme Court Justice Blackmun’s papers, there were five votes to affirm the previous ruling – the Betamax was to be illegal in the United States.

But then, something even more unusual happened – which is why we have the VCR and subsequent technologies: The Supreme Court decided for both sides to re-argue a portion of the case. Under the Burger Court, this only happened in 2.6 percent of the cases that received oral argument. In the re-argument of the case, a crucial vote switched sides, which resulted in a 5-4 decision in favor of Sony. The VCR was legal.

The majority opinion characterized the lawsuit as an “unprecedented attempt to impose copyright liability upon the distributors of copying equipment and rejected “[s]uch an expansion of the copyright privilege” as “beyond the limits” given by Congress.

On the absolute narrowest of legal grounds, through a highly unusual legal process (and significant luck), the VCR was saved by one vote at the Supreme Court in 1984.

Regulation Attack

In 1982 legislation was introduced in Congress to give copyright holders the exclusive right to authorize the rental of prerecorded videos. Legislation was reintroduced in 1983, the Consumer Video Sales Rental Act of 1983. With this legislation, it would have allowed for the content industry to shut down the rental market, or charge exorbitant fees, by making it a crime to rent out movies purchased commercially. In effect, this legislation would have ended the existing market model of rental stores. With 34 co-sponsors, lobbyists and campaign contributions to support it, this legislation had substantial support at the time.

Video stores saw the Consumer Video Sales Rental Act as an existential threat, and on October 21, 1983, about 30 years before the SOPA/PIPA protests, video stores across the country closed down for several hours in protest. While the 1983 legislation died in committee, the legislation would be reintroduced in 1984. In 1984, similar legislation was enacted, The Record Rental Amendment of 1984, which banned the renting and leasing of music. In 1990, Congress banned the renting of computer software.

But in the face of public backlash from video retailers and customers, Congress did not pass the Consumer Video Sales Rental Act.

At the same time, the movie studios tried to ban the Betamax through legislation. Eventually they decided to support legislation that would require compulsory licensing rather than an outright ban. But such a compulsory licensing scheme would have drastically driven up the costs of video tape players and may have effectively banned the technology (similar regulations did ban other technologies).

For the content industry, this was a feature, not a bug.

As Jack Valenti, president of the Motion Picture Association of America (MPAA), explained before Congress in 1982:

We are going to bleed and hemorrhage, unless this Congress at least protects [our industry]. . .we cannot live in a marketplace. . . where there is one unleashed animal in that marketplace, unlicensed. It would no longer be a marketplace; it would be a kind of a jungle, where this one unlicensed instrument is capable of devouring all that people had invested in…

Valenti’s comments were stark and designed to scare Congress to act: “I say to you that the VCR is to the American film producer and the American public as the Boston strangler is to the woman home alone.” Jack Valenti even threatened that if Congress didn’t regulate the VCR then movie producers may cut their movie production in half.

But Congress decided to wait until the Sony v. Universal case was decided by the Supreme Court. And with the 5-4 decision of the Court upholding the VCR under fair use grounds, the VCR was declared legal in 1984. The ruling created a groundswell; it received overwhelming support from the media and the American people. And the Sony Betamax player was exploding in popularity with 2.3 million units manufactured worldwide.

As more Americans bought this technology, the content industry’s ability to regulate it slipped away. Given the groundswell of support for the VCR, the content industry was not able to scare Congress to regulate this nascent industry out of existence (or perhaps, they started to realize that they would actually make more money from the VCR). The content industry learned an important lesson: If they want to ban technologies, they must do so before the technology has wide adoption from the American people. Congress is quick to ban technologies it doesn’t understand and that the American people don’t have yet, but reluctant to ban widely used technologies with clear economic consequences.

Permission-less Innovation

It has been shown numerous times that when the legal terrain is more solid, innovation and competition flourishes. One year after the Sony case with the legal issues on less precarious grounds, David Cook opened the first Blockbuster store in in Dallas, Texas, in 1985. Within two years it would become one of the top 10 video-rental chains with 67 stores. Blockbuster expanded outside the U.S. with over 1,000 stores in 1989. And by 1992, Blockbuster is the undisputed video-rental leader with over 2,800 stores worldwide. In 1994 Viacom bought Blockbuster for $8.4 billion, and in 1999 Viacom took it public. At its peak in the early 2000’s, Blockbuster operated 10,000 stores. But as a demonstration of robust competition, this success is soon disrupted by new market models.

But then Marc Randolph and Reed Hastings founded Netflix in 1997 with a completely different market model. As Larry Downes explains in the Harvard Business Review:

The scrappy start-up built a distribution model that relied exclusively on mailing DVDs to customers through the low-cost U.S. postal service. It was almost as convenient as a neighborhood retail store but at a fraction of the price—and without the late fees that annoyed Blockbuster customers.

Reed Hastings has explained that the idea of Netflix came to him when he was forced to pay $40 in overdue fines after returning Apollo 13 past its due date.

In 2002 Netflix went public. Early on the bandwagon of streaming video, by 2010, Netflix went from “being the fastest-growing first-class mail customer” to being the “biggest source of streaming Web traffic” during peak evening hours. The old brick-and-mortar-style rental market was being disrupted at an incredible pace, and Blockbuster was ultimately unable or unwilling to adapt. By the time Blockbuster realized these market trends and disruption, it was too late.

In 2010, Blockbuster filed for bankruptcy and recently announced plans to close its remaining U.S. stores.

The ups and downs of winners and losers in the market is evidence of dynamic competition – exactly what the free market empowers. The failure of a leading market power and the rise of a new market power with a different market model is evidence of the market working. Consumers win when companies rise and fall and new market models compete with old market models.

This story should be a lesson for both policy-makers and for the content industry: legal and regulatory certainty leads to dynamic competition. The market forces incumbent industries to adapt and compete with emerging technologies and better market models. Innovation comes from this dynamic competition, pushing down costs for consumers and providing better services and products.

Conclusion

The threat of having banned video rentals was quite real; while the content industry failed in banning video rentals, it succeeded in banning the renting of music and software. The industry also instituted regulations that banned new technologies, such as the digital audio-tape player, a successor to the analog audio tape player.

In 1992, the industry succeeded in levying a “private” tax on empty cassettes, blank CDs and CD-recorders. They litigated to ban the first iPod and the first DVR – bankrupting each through litigation costs but ultimately failing to stop these technologies. But the content industry failed to ban or regulate video rentals, and they failed to ban or regulate the VCR and subsequent technologies. This led to the emergence of the VCR, DVDs, Blu-rays, Blockbuster, Netflix and modern home media consumption.

But Netflix, and Blockbuster before them, are not the only winners, or even the most profitable winners, of keeping their market models and underlying technologies legal; ironically, the biggest winner might be the content industry.

Contrary to the fear expressed by Jack Valenti before Congress, “[w]hen there are 20, 30, 40 million of these VCRs in the land, we will be invaded by millions of ‘tapeworms,’ eating away at the very heart and essence of [copyright].” Within two years of the Supreme Court case, in 1986, revenues from video tape sales and rentals were $4.38 billion, eclipsing box office revenues of $3.78 billion. By 2012, consumer spending on home entertainment rose to $18 billion, eclipsing the revenue of Netflix and Blockbuster.

Image via Flickr

Sources: http://qz.com/144372/a-brief-illustrated-history-of-blockbuster-which-is-closing-the-last-of-its-us-stores/
http://www.entmerch.org/press-room/industry-history.html