Business model of Netflix

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Netflix is an American digital entertainment company, which specializes in video-on- demand content. In January 2016, Netflix hiked the monthly subscription rate for its new customer base by 1$. The new price of the two-stream HD tier was announced to be 10.99$ per month whereas the existing subscribers will be continuing to pay the existing rates for the next several months (Spangler, 2017).  Similar revision of price model was made for its international subscribers. Increase in prices was applicable only for its new customer base whereas the existing customer base would continue to pay the same price for several more months. The company announced the monthly fee for its four-stream ‘family plan’ would be increasing from 11.99$ to 13.99$ (Spangler, 2017). In May, 2014, Netflix had hiked its subscription rates for new customers but allowed its existing consumers to continue with the previous rates till May 2016 (Team, 2014).

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Pricing changes made by Netflix and the consumer reaction

A survey estimated that the increase in prices would be affecting around 35% or 17 million American Netflix subscribers. 41% of the respondents declared that they would not be accepting any price hike. However, there is also an estimation that only 3-4 % of subscribers would be actually cancelling the subscription of the streaming service (Team, 2016). The price increase of 2011 had resulted in a drastic exodus of its subscriber base, but the subsequent pricing strategy of 2014 and 2016 was better planned and communicated than before (Team, 2014). Thus, it did not lead to the same subscriber churn rate as before. The recent increase in subscription rates have added about 500 million dollars’ worth additional revenue for the streaming giant in 2017 alone (Team, 2014).Despite the price hike in the third quarter of 2017, Netflix added 5.3 million new subscribers, surpassing its own forecast of 4.4 million. (Felman, 2017).

People’s response to incentives

The primary incentive that Netflix offers its consumers is the quality of its original content. It justifies the hike in its prices by offering superior quality of original content. A survey by Cowen investment bank revealed that 58% of existing customers subscribed to Netflix only for its original programs. The number has increased by 37% percent from December 2014, which proves that people have responded very well to the incentive (Team, 2016). The streaming giant Netflix has kept on focusing on its goal to create, produce and own as much original content as possible instead of only licensing studio and network created content. The streaming giant has been investing upfront on its high quality shows and then receiving a high return on the investment. Along with rise in prices, Netflix has also raised the number of shows by 25% from 2016 to 2017 (Felman, 2017). The streaming giant keeps on increasing the number of shows and currently the total number of shows stands at 1500Netflix’s leadership in the original content space and high level of customer gratification was the primary factor behind the reduction of the company’s subscriber churn rate (Team, 2016).

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Optimal pricing decisions

The entry of many new players in the digital streaming market has resulted in Netflix losing its first-mover advantage. Hence, the pricing power and competitive edge of the company has become limited. Rivals like Amazon Prime and Hulu are also giving stiff competition to Netflix by offering original programming and access to exclusive content from movie studios (Trainer, 2017).  Hulu is Netflix’s closest rival and even though its subscriber base lags significantly behind Netflix, the viability of the latter’s business model has been curbed largely. The company’s investment rates in high quality original content has outpaced its revenue growth rate (Trainer, 2017). This has threatened the profit margins of the streaming giant. Netflix had to elevate its subscription rates so that it could fund its enormous budget of original content and the expenses needed for the modernization of technology .The price hike is an optimal decision, as without pricing power Netflix cannot afford to make the investments that have helped in the valuation of its stock (Trainer, 2017).

Price elasticity of demand and behavioral economics

There are currently 128 million subscribers in the U.S. after a 6.6% rise from 2016 and its revenue is projected to cross 11 billion dollars by the end of 2017(Felman, 2017). The streaming giant announces its plans of price rise strategically 30 days in advance. Despite the increase in the subscription rates, the shares of the company hit a record high. This low price elasticity of demand can be explained through behavioral economics. There is a consumer behavior theory which states that consumers make heuristic choices (Thompson, 2014). The basic rationality that causes the lack of price elasticity is that consumers value a product largely on the basis of its quality of the product. Consumers are generally ready to pay extra if they are satisfied with the quality of the product. The collection of Netflix’s original programming keeps its existing consumer base excited, as well as draws in new subscribers every year.

One of the pricing strategies of companies to trick consumers into buying inferior quality goods is launching a product in the market that consumers will keep on buying repeatedly. The CEO of the streaming company declared to analysts that it was going to offer a 3-tier global model of good, better and best pricing (Thompson, 2014). The pricing scheme of Netflix is based on attraction effect, decision heuristics and distraction pricing. The pricing scheme at Netflix offers three options namely discounts with inferior access, a premium product that would be priced above the standard product and a super-premium product, which will be priced even higher than the premium products. (Thompson, 2014).

Change in market equilibrium

As Netflix increased its monthly subscription rate by 1$, both the quantity demanded and quantity supplied shifts away to a new point from the market equilibrium and shifted to a new point. In Figure 1, it is assumed that pe    increases to p1 and in Figure 2,   p1 again falls back to pe. Quantity demanded fell and the curve moved to the left. The reason for the inverse law of demand to occur is because of substitution and income effects (Nicholson & Snyder, 2014). Substitution effect implies that the increase in price of one product will make a similar product relatively cheaper and will increase the consumers’ demand towards the latter. In case of increase in subscription rates of Netflix, some of its existing and potential consumer base is likely to shift to less expensive alternative streaming services like Amazon Prime and Hulu (Nicholson& Snyder, 2014). Income effect pertains to the purchasing capacity of the consumer. The increase in the subscription rates of the streaming giant will affect the consumers’ real purchasing power and thus the demand for the services of Netflix will fall. This is evidenced by the fall in the number in the new addition of subscribers.

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Increase in Netflix’s price will result in the increase of quantity supplied, moving the supply curve to the right (Nicholson & Snyder, 2014). These shifts in the demand and supply curves result in a surplus in the market as the quantity of monthly subscription supplied exceeds the quantity demanded of the same. The excess supply will cause the company to drop its prices again, which will again increase the subscriber base. Market equilibrium will again be achieved (Nicholson & Snyder, 2014).

Conclusion

The maturity of Netflix’s business model is indicated by its ability to minimize the window of delay for the syndication of its original content in international markets.  Netflix keeps on increasing its investment in original content line-up. The popularity of these shows has retained the company’s subscriber base as well as kept it growing despite increase in rates. Increase in revenue have been driven more by a lower subscription churn rate than an  addition in  strength of  gross subscriber base.  Economists already expected this outcome of price rise and they predict hikes in subscription rates to keep on happening in the future as well.  However, such hikes will not be able to cut down the streaming giant’s customer base significantly. Analysts expect Netflix to continue dominating the virtual content streaming market.

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Did you like this sample?
  1. Felman, D. (2017). Netflix Is On Track To Exceed $11B In Revenue This Year. Forbes. Nicholson, W., & Snyder, C. M. (2014). Intermediate microeconomics and its application. Connecticut: Cengage Learning.
  2. Spangler, T. (2017). Netflix Raises U.S. Subscription Prices for New and Existing Customers. Variety.
  3. Team, T. (2014). The impact of Netflix’s price rise. Forbes.
  4. Thompson, D. (2014). The Behavioral Psychology of Netflix’s Plan to Charge Higher Prices. The Atlantic.
  5. Trainer, D. (2017). Netflix Price Increase Signals Original Content Is Not Enough. Forbes.
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