How gatekeeping by the China Film Group is altering the dynamics of Hollywood blockbusters in China.

Although now used in metaphorical terms, a “gatekeeper” historically referred to the guard at a city gate. Although metaphorical, gatekeepers still exert a powerful influence in today’s world. A modern-day version of gatekeeping that economists worry about is vertical restraints and it looks like a version of it may be playing out in China’s film industry.

Before we get to that, to illustrate the concerns that vertical restraints can create let me use the gatekeeping of old. Imagine that the ancient city of OldTown has a single gate guarded by OldGiant. Outside the city walls are farmers who grow vegetables to sell each day in OldTown. OldGiant is responsible for admitting the farmers through the gate and assigns each of them to one of 34 available stalls in the city. To generate revenue for the city, OldTown’s mayor has set a gate fee of 10 OldGolds collected each time a farmer enters the city. In payment for his services, OldGiant is allowed to keep 22% of the gate fees.

The mayor wants a vibrant market for OldTown’s residents and so he has set the gate fee low enough that all 34 stalls are filled each day. With 34 farmers prices for vegetables are kept reasonably low. OldGiant earns daily wages of 74.8 OldGolds—22% of the daily gate fees of 340.

Being clever, OldGiant has figured out a way to do better. He decides to relocate 17 stalls to less convenient parts of the city and keep the other 17 near the city’s central square. OldGiant then goes to 17 of the farmers and offers them the following deal: “I will allocate a stall to you near the city center if you let me share in your revenues. Otherwise I will not.” As long as OldGiant chooses his share carefully, such a deal will work. With only half as many conveniently-located sellers, the chosen 17 can raise the prices of their vegetables enough to make them better off even after giving OldGiant a cut. OldGiant is also better off as long as the 17 relocated farmers can still sell enough to cover the gate fee—he now gets 74.8 OldGolds in gate fees plus the revenue share.

Economists call OldGiant’s scheme a vertical restraint because he restrains access in the vertical chain—upstream farmers must go through him to access downstream customers—to increase his profits. Although OldGiant is better off, OldTown’s residents are not.[1] Before the restraint the vegetables are conveniently located and cheap. After, they are priced higher and less conveniently located.

The same risk of higher prices and lower quality is at risk in China’s film industry. Recently, China Film Group (CFG) has begun taking equity stakes in Hollywood film productions—for example, a nearly 10% stake in Furious 7 produced by Universal Studios. To understand the risk let’s compare to our story: China is OldTown, CFG is OldGiant, the Hollywood studios are the farmers, and movie watchers in China are OldTown’s residents. CFG is a gatekeeper because the government lets it choose the 34 foreign movies[2] that can be exhibited in China each year. CFG also gets to decide the release timing and number of screens for all imported movies—decisions that can make or break a film. Delaying a film’s China opening can reduce its returns as more copies are pirated after its US but before its China opening. Also, scheduling a movie to open on a weekend when fewer big-name movies are opening boosts its revenues (an issue I previously discussed).

Investments in Hollywood films would give CFG an incentive to give them preferential treatment in timing and number of screens just like OldGiant gave the 17 farmers preferential locations. This could allow CFG to split the resulting increase in profits between itself and the studios and supplement the fees that CFG already receives for distributing the 34 foreign films (CFG’s “gatekeeping” fees for foreign films equal about 22% of their gross revenues). Not allowing the studios to determine their own opening schedules and number of screens based on market forces risks harming China’s movie watchers. They may not get to see the films they want to see at the times that they want. It could also lead to higher ticket prices for movies in the long run if CFG schedules movies to reduce opening weekend competition.

I have no way of knowing whether these investments will alter CFG’s decisions but they provide an incentive to do so. For example, Furious 7 opened on a record 5,454 screens and faced no competition from other big-budget US actions films for a month after its release. Its opening set a record for the biggest first day of a movie in China and it went on to be the second-highest grossing film in China to date. We do not know whether Furious 7 would have the same success if competition for screens and opening weekends had been determined by the market.

The easiest way to eliminate the possibility of unfair restraints is simple—do not allow CFG to make investments in films for which it gets to make timing and release decisions. Otherwise, “coming soon to a theater near you—your favorite movie” may become “coming soon to a theater near you—your regulator’s favorite movie.”

[1] Some vertical restraints are good for consumers but this one is not.

[2] Co-productions between foreign and Chinese studios are not necessarily subject to this restriction.