How Netflix Killed Itself with Kindness

During the dot-com boom of the early oughts, the New Yorkermagazine’s financial columnist  JamesSurowiecki wrote a piece called “How Kozmo is Getting Killed By Its Customers.”He explained the plight of dotcom delivery service, which lostmillions of dollars because its customers took advantage of its low deliveryfees to purchase one-off items, like a pint of ice cream. This caused Kosmo’sdelivery costs to outpace its revenue at rate of almost two to one. Surowieckirailed not against Kosmo’s flawed business model but against the bad behaviorof its customers; he called them “little terrors” and claimed that theirprofound sense of entitlement required a “New Economy mantra: Know when to fire your customers.”

I wonder if anyone at Netflix had occasion to readSurowiecki’s piece in the last month. Right now the once-beloved dotcom, if notexactly being killed by its customers, is at least being taken behind thewoodshed for a serious thrashing. Netflix’s former business model – a singlelow price for streaming and DVD rentals – was simply unsustainable. The companycouldn’t pay the licensing fees demanded by studios, win the rights to newstreaming content, and continue to ship DVDs at the same price it once chargedfor DVDs alone. But Netflix was in a precarious position precisely because ithad provided its customers with something that was too good to be true – anexcessively dangerous position that has sunk many more dotcoms than Kozmo. Ingame theory terms, Netflix’s predicament was the patsy position, in which thecustomer has very little incentive to continue the relationship if the branddoes anything to upset the delicate balance of cost vs. services. When Netflixdefected by raising their fees for the combined services, did their customershappily agree to it, reasoning that a price increase should be expected? Um,no. Naturally, they voted with their feet and left in droves; more than 800,000customers have given the brand the boot in the last quarter alone.
Netflix was missing a core insight than any behavioraleconomist could have given them: when pricing models in a given market – inthis case, the streaming content market – aren’t well established, you’reentirely at the mercy of your customers’ own perceptions, however irrational.Since Netflix customers had been given streaming content for absolutely nothingfor several years, their perception was that the streaming content is worth,well, absolutely nothing. If Netflix had never provided that streaming servicebefore, but instead introduced it in August for an additional six bucks amonth, they would not have lost customers, and their streaming service wouldhave taken off like gangbusters. Exact same price, vastly different priceperception. In the latter scenario, Netflix’s price increase would have beenseen as a form of cooperation, not defection – another triumph for a brandknown for delivering great service at low cost.
So what’s the lesson here? Online business models that keep prices low in order to fuel growth haveto pay attention to the end-game. Consumer perception accrues quickly to thestatus quo; that’s why it’s easy to sell taxpayers on the idea that letting atax cut expire on schedule is actually a “tax hike.” Above all, know what yourcontent is worth and charge accordingly. Believe it or not, your customers willthank you.

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