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Why Netflixs' price hike is a brilliant move

Why Netflixs' price hike is a brilliant move

Yesterday I--and millions of other Netflix customers--received an email similar to the one below:

This email states clearly that beginning 2011 Sep 1 Netflix will not longer have a DVD/streaming bundle, but rather begin charging separate fees for each service. Now, most people interpreted this as a major price hike and a "bonehead" move on the part of Netflix.

Here, I argue that not only was this a brilliant move on Netflix's part, but that ultimately that it will be better for all of us, their customers, leading to MORE streaming content.

In fact, if I worked for Netflix, I would have advised this move 12-24 months ago. I'm surprised they waited this long. (My science and analytics consulting fees are steep.)

The only ones who should be worried about this are the USPS.

You see, according to Netflix CEO Reed Hastings over on Quora, Netflix spends $500M - $600M per year on postage. This is a huge cost of doing business, and this is what I'm sure is driving this decision.

What follows is what I believe to be the most likely process that lead Netflix to this decision. I will make several assumptions, but if I were involved in Netflix these assumptions would have been corroborated by exact metrics and market testing. This will be back-of-the-envelope math, but I could easily run some simulations to show that for any given range of realistic values for each of my assumed variables this is still a good move.

First, assume a spherical cow that this move will cause several customers to abandon Netflix altogether out of some consumer rage . Let's assume 10%. This will roughly equal a loss in revenue equal to the average revenue per user times 10% of total users.

Next, there will be some proportion of users with streaming who will bite the bullet and pay the extra $10/month for a DVD. Let's assume this is much less than the proportion of users who leave, so that we go in with a "more worse" scenario. This seems more likely to me and, in fact, this won't drive

Finally, there will be many users with streaming who will say "F you Netflix I'm not paying an extra $10/month for one DVD!" (See Louis CK video)

This again represents a potentially huge loss in revenue. But it's a much BETTER gain for Netflix in that they don't have to pay all that damned postage!

Let's say that the difference between the proportion of users who pay the extra $10 for the DVD and those who leave represents a $100 MILLION annual loss in revenue. On the surface, this looks awful. (And I'm sure it can't possibly be even this much, but we're going worst-case here).

But then let's say that a massive proportion of users (smartly) drop the DVD option and move over to streaming-only, which is what I'm sure Netflix wants. Let's say 75% of users are reasonable and choose this option.

This means that cost of postage for Netflix drops to only $125-$150M per year. This represents a SAVINGS of at least $375M annually. Removing the $100M/year lost revenue from users who cancel, this still nets Netflix $275M annually.

Now Netflix could rest happily and stash this $275M/year. But what I guarantee they will do instead is use that huge amount of in-pocket savings to leverage distributors to allow them to stream more content.

And extra couple hundred million a year can go a looooooong way.

So yes, on the surface, this move seems to suck for us, the consumers. The streaming content sucks. It's spotty. But in the LONG RUN Netflix will be in a much better position to afford to stream more content.

Which is really what all of us want.


  1. Dan H07:49

    I'm not buying your math. First, they already had options for separate streaming & DVD mail services. To mail someone 1 DVD at a time means most users get 1-4 movies per month. For the formerly extra ~$5/month for that part of the service, they were earning a profit, they just wanted to increase that profit.

    Your whole model is in a world where Netflix is the only option. Netflix's market power is that it could get you pretty much anything you want by mail and a decent selection online for less than any other option. In the new system, many other companies, including the remaining video stores, can undercut them on price. Add to that more companies getting into the streaming market with similar prices to Netflix, they just lost their uniqueness.

    I suspect they also underestimate the customer loyalty that's due to mail delivery. If you have a couple of netflix DVDs in your home, it's just a bit harder to cancel if it means stopping payment & mailing all DVDs back in a short time window. It's easy to bounce between online companies with similar products and I wouldn't be surprised if someone comes out with a way to migrate a list of what you watched & your queue to other services. I also don't know the advertising value of those red envelopes with suggested future movies that show up at people's houses, but that's also about to be lost.

    The sad change is that there was a lot written about how Netflix greatly benefited older movies & movies without major studios because they'd be available for anyone to rent my mail. The online archive just doesn't have that bench yet so this is going to hurt films off the beaten path.

    It's a gamble & they're probably losing me as a low volume (high profit) customer.

  2. It's definitely a gamble!

    Looks like "analysts" agree with my argument, and with your position that the cost increase is also a simple revenue-increasing move:

    But only time will really tell.

  3. Actually, I think that breaking the plans apart (with NO discount for customers who buy into both DVDs and streaming) will be problematic for Netflix.

    Netflix streaming is such a good deal because even if a movie isn't available streaming, I know that I can get it in two days on DVD. Where this is good for netflix is that it is DATA.

    In order to negotiate streaming rights, they need to know the demand in their customer base for streaming of specific titles. If I was running things at Netflix, I would pay VERY close attention to what DVDs were being rented by my subscribers who mostly stream video. These are the titles that I need to pursue and add to my streaming offerings (thus saving me postage, as you noted). Since they are providing their own alternative, they have the data on what their market wants.

    I think its likely, as you noted, that MANY customers are going to cut their DVD subscriptions and only go with streaming. They will turn to RedBox or iTunes for newer releases that aren't available on Netflix streaming... the problem here for Netflix is that they have lost this market data. They now have NO IDEA where to focus their negotiations for streaming content. Maybe they plan on relying on the remaining DVD-only subscribers to get that data? But that seems unwise, given that you now have two populations which you are trying to generalize results across. By analyzing the DVD rentals made by people who primarily stream, they have clear within-population data.

  4. @neuromusic: man you're speaking my language! Data is *key* here, and Netflix would be stupid if they weren't tracking these metrics. And yeah, losing those data is a dumb move. Maybe they feel like they've collected enough to move forward?

  5. Anonymous12:05

    Primarily I use Netflix to catch up on HBO shows. So I'm moving to DVD only until they stream HBO content. Unfortunately for me, HBO claims that will happen approximately when hell freezes over.

    The costs of postage are high, but fixed per disc. The licensing costs face all sorts of variable challenges, so as you move along the curve towards a full collection, it will eventually exceed the cost of postage (HBO makes it sound like it's current price is infinity dollars). Holdout game theory will dominate long before Netflix ever builds a complete streaming catalog.

    What we really need is to reform the laws to explicitly allow models like Zediva (they skip the licensing and stream a DVD to you on questionable legal grounds).

    This isn't a crazy model to legitimize. Radio stations don't negotiate rights to individual songs. We're extending the monopoly rights to content creators so they can be reimbursed, not so they can create artificial scarcity.

  6. Wait, if you have HBO, just use http://www.hbogo.com/ to stream!

  7. Anonymous17:41

    Thanks for the response, and for letting me hide behind Anonymity.

    I actually don't have HBO, that's why I rely on Netflix to watch its shows.

    But really, that's just the tip of the iceberg. 2/3rds of my queue is nonstreaming.

    I hope they license more content for streaming. But I'm not optimistic that they will ever be fully successful. The general problem is the uneven costs of licensing content.

    Over time, savvy content owners will negotiate away Netflix's profits, until the costs harmonize with DVDs. Some content owners will remain complete holdouts, never offering their content for streaming.

    I agree, the technological efficiency cuts clearly in favor of streaming.

    Unfortunately, the legal efficiency cuts in favor of DVDs (which require no negotiation to ship).

    It's not clear where the equilibrium is here, but we can't hit 100% streaming without the removal of some legal obstacles.

    We can remove these legal obstacles easily with statutory licensing provisions, like we've used for radio, or cover bands. Easy fix.

    Until then, I think you underestimate the number of us who are relying on DVDs to enjoy the long tail of obscure content out there.


  8. Oh, don't get me wrong! I love the obscure DVD content! I'm just hoping that Netflix (or some other company) will get better at digitization and distribution.

    This post was as much wishful thinking as it was honest analysis.