Netflix and the Lessons of Price Elasticity

Following Netflix’s announcement in late July of price increases of up to 60%, I blogged about the situation, offering some recommendations.  Well, I don’t think anyone at Netflix read it or, if someone did, my advice certainly went unheeded.

To refresh memories, Netflix was besieged by a torrent of customer and analyst criticism resulting from its announcement of price increases.  CEO Reid Hastings publicly offered that “We feel bad about having our customers upset with us”, later adding, “We’re feeling great about the decision, tough as it is.”

Somehow I doubt that Netflix management - and its shareholders, in particular - were feeling in a heady mood on Thursday.

Less than two 2 weeks after the price increase took effect, Netflix was forced to alter its prediction that it would grow its subscription base to 25 million by September-end.  Now, management is forecasting a drop of 1 million subscribers worldwide - 4% of its subscription base.  The market, which has been skittish to say the least the past two months, tanked the stock, selling off to a one-day decline of 18.9% of its value.

Price Elasticity Takes no Prisoners

It is generally true that, over a reasonable range, changes in price have a proportionately small effect on quantities sold.  In other words, even though a price increase will see some customers abandon the offering, total revenue will still be higher than it was at the lower price.

The price elasticity of demand for Netflix services probably is inelastic - just not as much as inelastic as management had assumed, though.  That, I’d wager, is leading to some sleepless nights in Los Gatos.

Then there is the matter of Customer Lifetime Value (CLV) - one of the key attractions of the subscription pricing model.  With a churn rate of 4% of customers lost in just one quarter (who’s to know what it will be next quarter) it’s very unlikely that departing customers have sworn off streaming video.  They’ll take their business elsewhere.

What Will Netflix do in 4Q2011?

In the final calendar quarter of 2011, a safe bet is that Netflix management will have its eyes fixated on that churn rate - and new subscription acquisition, too.  If the churn does not level off soon, it’s also a good bet that Netflix will have to quickly come up with something attractive for the fat old man who comes down the chimney to put in his bag.  For subscribers.  And for shareholders, too.