Netflix’s Unstoppable Economics

Right now, we are seeing the next stage of the evolution of Netflix, as it hits an escape velocity that seems to make it the perfect replacement for much of its competition. They recently announced a $2 price increase, and it is not expected to hurt the companies revenues in the least.

It seems like everybody in Silicon Valley is always talking about “network effects” and how all the best companies have them. For those of you who don’t know, network effects refer to the decreasing effort required to get each additional user for a service. Another way of putting it is: people are attracted to what’s popular.

Netflix does benefit from these effects, but also utilizes a model that has much more complex implications. It is able to win over supply at a lower cost because of the large number of expected viewers. This is similar to network effects, but applied to the supply-side.

Supply-Side Domination

One solid indicator of Netflix’s juggernaut capabilities is the success of Bird Box. Released in early January, the movie is reported to have been watched in 80 million households. Although these users technically got the movie “free”, unlike if they’d gone to a movie theatre, the implications are still very powerful.

With one single movie, Netflix is able to entertain current customers, win over new customers, and retain existing customers that might have been considering leaving. All that is to say, the product is the marketing. So as more suppliers come to the platform, there is a perpetual cycle of more customers being drawn there by the “inventory”.

And there are several big reasons why suppliers are starting to find Netflix more appealing. First, they are available worldwide, which gives them greater purchasing power to work with. And this purchasing power is further increased by Netflix’s projected growth. Unlike a movie theater, the product is going to be available to all future users as well. Finally, much like how biotech companies have tons of projects underway at once so they can benefit from the risk distribution, Netflix has many projects vying for the attention of users. This means that no movie or TV show is monetized in isolation. Therefore, the upside potential is big (Bird Box), but there is lower downside when a flop occurs. This risk profile further increases Netflix’s purchasing power.

The Price Increase

Perhaps this is why Netflix is confident in their ability to increase the price of their subscription service. Analysts expect the user growth to slow down a bit, but the increase in customer value to compensate for that. As Netflix reaches some level of saturation in markets like the U.S.A., it becomes harder to go after the marginal customer, and instead makes sense to increase customer value. If this allows them to syndicate more content, the growth will compound in the long-term.

The final point to make is that Netflix customers are very price elastic. Paying $15/month for a service that essentially replaces cable and many other entertainment needs is seen as a bargain. As the value of the platform continues to increase, users have no dispute with paying more.

The conclusion is that subscribers are given more content and suppliers are paid more for their work. Netflix gets to sit in the middle and increase their revenue, which makes it a great long-term buy based on this economic model.