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.

A Great Product at a Great Price

Jack Welch, former CEO of General Electric, was asked this at a business school Q&A forum: what do you think about short term government subsidies so that small businesses can compete with big companies like GE?

Welch’s response: It’s a terrible idea.  The only way for a small company to compete is to offer a great product at a great price.  If you need a subsidy then you don’t have a competitive offering.

Jack Welch is right.

Look at the past few years for online companies alone.  Google, LinkedIn and Facebook.  And consider what could well happen with Zynga, Twitter, Groupon,  Dropbox and Vimeo.

Sure, they’re VC-backed, but none of them started out as sure things.  Each conceived of and delivered a unique offering along with a unique pricing model.  And for some, an entirely new distribution model.  The value proposition is so compelling and believable that each of these companies was able to grow at lightning speed.

A well-marketed product does not mean merely a well-promoted product.  There’s a good reason that business schools still teach the four Ps.  

Find the potholes that are ignored or overlooked in the market.  Do the homework on the competition to understand why they cannot - or choose not to - address that need.  Find a need that, satisfied, affects millions and moves mountains.  Use that as the benchmark to build out an offering that stands apart from the competition, and is strong enough to fill a wide and deep moat around your business.

Pricing to Value

F. Lee Bailey is a retired criminal defense lawyer who, in the 1960s and 1970s, defended famous clients including Albert DeSalvo (the “Boston Strangler”) and Dr. Sam Sheppard (inspiration for the film and TV series, The Fugitive) and Patty Hearst.  As an attorney he was a brash risk-taker, a showman who loved the stage, and a public figure who gained celebrity status by successfully litigating high-profile cases.

While being interviewed on a prime time TV talk show he was asked an interesting question: what was his fee for defending a client accused of murder?  His response: if successful, all of his client’s net worth.

The interviewer commented that it seemed quite a steep fee.  Bailey then asked his host: if you were charged with murder and faced the death penalty, would you go with an attorney other than me to save money you might never spend?

Few today would argue that Bailey was one of America’s best trial lawyers.  But at the time he was believed to be.  And that’s what mattered.  He realized that he held a unique position (albeit briefly so) in the public’s perception: there were thousands of trial lawyers, but there was only one F. Lee Bailey.

Bailey intuitively understood the value he offered in a very small market, and how to set his price.

I watched that show.  I could not get over the arrogance of the man, but the lesson was not lost on me.