This issue is perplexing many of us who teach in business schools – are we going to have to change our classes as one of the firms in many of our key examples goes bankrupt?

We are not sure we have a good answer to our question so we will satisfy ourselves with a brain dump.

First, it may very well be true that, as CEO Reed Hastings is saying, Netflix does not want to end up like Borders or AOL in the garbage can of history when the next new technology comes along.  After all, Blockbuster has never really recovered from missteps when Netflix DVDs arrived on the scene.

Therefore, Netflix wants to be ahead of the curve when DVD technology dies and everyone watches streaming movies.   Here is one way to do this:  keep the total price of 1 DVD at a time +streaming at $10 but price streaming alone at $6 and 1 DVD alone at $8.  What they did instead, to maintain margins we assume, is raise prices by 60% so I DVD at a time + streaming is now $16.   Of course this going to cause some serious fall in demand and also create a media frenzy.

There is a broader point: we gave one example of how Netflix might shuffle prices to create switching but we do not have the internal data on revenue and costs so the optimal pricing might be different.  But whatever it is, the optimal pricing requires the DVD and streaming prices to be coordinated. If you split these two services into different (competing?) companies, you might create a price war and not only undermines your whole strategy but destroys your profits….

Even if completely separating the two businesses is the only way Netflix feels it can incentivize its streaming business to move ahead properly, there is absolutely no reason the company should expect consumers to care about its internal strategy issues – the strange angle taken by Hastings’ blog postings and emails to customers. It seems to us that it is the large price hike, far more than any other aspect, which has upset customers.

As a final comment, even if Netflix gets everything right operationally in its streaming business, it is hard to see how they plan to maintain margins and demand given that their suppliers (the content producers and owners) have a great deal of bargaining power and have every incentive to treat Netflix as only one outlet among many competing ones for their product. Other companies in the content delivery business, such as cable & satellite operators, face similar issues, but have the advantage of higher barriers to entry in terms of local franchise rights and physical infrastructure that gives them greater scope to raise prices……Our guess is that we will have more posts as more information arrives.

Sandeep Baliga and Peter Klibanoff

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