Can Netflix Defy Pricing Gravity? And Why Is It Trying to Do So?

Surely the most dramatic news of last week in the area of content distribution was the announcement by Netflix that it was raising its prices for DVD and streaming plans. Netflix is the U.S. company that has become a darling of business school thinking because of its successful make-over from being a pioneer in the overnight delivery of DVDs to a leading player in the content streaming business. Netflix is still US-centric, but it recently announced its plans to roll out the service in Latin America and the Caribbean (nothing yet though for Europe, Middle East or Asia).

The stir was caused by Netflix's announcement that it was raising its pricing structure from $9.99 for both a one-at-a time DVD rental and unlimited streaming of contents to $15.98 per month (i.e., each of the two services is being separately charged, $7.99 for unlimited streaming and $7.99 for a one-at-a-time DVD rental). Writing on its blog, the company explained part of the rationale for its decision thus:

"Given the long life we think DVDs by mail will have, treating DVDs as a $2 add-on to our unlimited streaming plan neither makes great financial sense nor satisfies people who just want DVDs," .... "Creating an unlimited-DVDs-by-mail plan (no streaming) at our lowest price ever, $7.99, does make sense and will ensure a long life for our DVDs-by-mail offering."

Not surprisingly, consumer response was rapid and it has been nearly universally irate. For example, as reported on CNET, "On Netflix's Facebook page, just six hours after the company posted a link to the announcement that appeared on its company blog, more than 9,000 comments have been posted in response. I read a sample of about 100 comments, and only one defended the Netflix decision." Threats to migrate to a competing platform are legion. Yet Netflix does not appear to be backing down on its plan and seems confident that its new pricing will stick with consumers.

Given that the business media continues to be awash with expressions of concern about the risk of either price disinflation or outright deflation in the economy, the prospect of a company successfully upping its price by 60% for a discretionary service providing entertainment contents, for which there are presumably competitive substitutes, is remarkable. My expression of amazement is directed first and foremost at the expected behaviour of consumers to eschew price elasticity and embrace the price increase. Either Netflix has achieved significant brand loyalty and/or the quality of its service means that there are fewer substitutes than might meet the eye. In either event, if the price hike sticks, it certainly merits the attention of those interested in parsing micro-economic behaviour that goes against the grain of greater macro-economic developments.

Even if all of this is true,and Netflix can buck of the trend of current economic developments, surely there must a further back story for its decision. One edifying discussion in this vein appears on the July 19 edition of cnet.com ("What was Holywood's role in Netflix Price Rise?", writen by veteran high-tech journalist Greg Sandavol here). Sandavol makes the following points:

1. "Some of those searching for clues about why Netflix unexpectedly raised prices last week appear to be convinced that the trail leads to Hollywood, the home of the top six film studios. After Netflix announced Tuesday that prices would rise by 60 percent, a popular theory was that CEO Reed Hastings sought to build up his war chest. Acquisition costs for streaming content are soaring." 

2. It is widely stated that, in Sandavol's words, "subscribers are figuring out that Netflix's streaming library leaves a lot to be desired." This potential disatisfaction will only grow as subscriptions increase. The upshot is that Netflix needs to take all the measures it can to obtain more and more quality content (read "movies") to satisfy its subscribers.

3. Content can only come from one of two sources. Either Netflix develops contents on its own and/or it gains access from content providers. While Netflix has taken some initial steps to develop original contents, no matter how successful these efforts may be, the company will continue to rely on third-party content providers for the bulk of their offerings. That means paying (more and more) for the contents necessary to keep subscribers content.

4. The numbers facing the company as it seeks to ramp up its own on-line contents are certainly daunting. According to Sandavol:

"... Netflix renewed a multiyear licensing agreement with NBC Universal for a fee of as much as $300 million a year. That's more than 10 times the $22 million a year Netflix paid for NBC content in the prior deal. Starz, the premium pay-TV channel that owns the streaming rights to movies and shows from Sony Pictures and Disney, is also looking for a bump. Starz receives $25 million to $30 million a year from the current contract, but Rich Greenfield, an analyst with BTIG Research, predicts Starz could get about $250 million this time around."

5. Stated otherwise, and according to Michael Pachter, an analyst with Wedbush Securities, Netflix could see its streaming costs increase from $180 million in 2010 to almost $2 billion in 2012.

6. Neverthless, Netflix seems to be denying that the price increase is directly tied to the increased funding needs for contents. According to Reed Hastings, the company's CEO, "Films and TV shows will pay for themselves by attracting larger and larger numbers of streaming subscribers, which pumps more subscription fees into Netflix's coffers."

7. In other words, the price increase might serve more strategic considerations. Certainly the most interesting such consideration was expressed by Eric Garland of Big Champaign, a company that analyses content consumption online. Garland suggests that Netflix is engaged in "Apple-like power move on Hollywood":

"Reed is deliberately creating dissatisfaction," Garland says. "He's creating dissonance precisely because that title availability, those first-run titles, need to be more immediately and widely available as a (video on demand) or a streamed offering. So this is a leverage play. This is Reed saying (to the studios) you can't bifurcate. He's saying you're going to have to make all of your content available in a way that your customer has clearly indicated that he or she wants...that dissonance is going to demand remedy."

One can choose to believe Reed or Garland or the other commentators out there, all trying to figure out what Netflix is up to. Somehow, I don't think that this will be my last blog on the company.

More on Netflix here.