Are there any flaws in the Netflix market? The Economics of Netflix in a Nutshell

Netflix, founded in 1997, has evolved from a DVD rental service to a global streaming powerhouse, revolutionizing the way people consume entertainment.

The low Income Elasticity of Demand (YED) of basic entertainment products, such as audiovisual content, allows for flexible pricing, as a decrease in consumer income doesn't substantially affect the

demand for its content. As a result of its flexibility, Netflix boasts 247.15 millions of subscribers globally, cementing its position as a leading player in the streaming industry shown by its pricing power (Whitten, S., 2023).

With Netflix's soaring success, it's natural to wonder about the challenges it might encounter and how it overcomes them. Given its significant expansion, it begs the question: Are there any flaws in the Netflix market?

Suppose that you are trading as a consumer in a physical market, where only high quality products and low-quality products are being sold. You are willing to pay higher prices for better goods and suppliers of high-quality goods are willing to sell at a higher price. This table gives an example, the reservation price shows the maximum price consumers will buy or the lowest price buyers will sell: 

However, if you are under information disadvantages, which means you cannot distinguish them. Which price you would like to pay?

Varian argues that consumers' willingness to pay will be: 

However, £10.5 is lower than the high-quality goods suppliers’ reservation price, which is £14 and the quantity supplied of high-quality goods will keep decreasing until 0 and only low-quality goods will be sold.

Once consumers notice the majority of goods are of low quality, they will not demand high-quality goods at all, they will be willing to pay no more than £5, instead of £10! (Varian, 2020, p. 742)

Let’s look back Netflix, if we assume Netflix platform is a “market”, the subscription fee, (consumers’ reservation price) is either £17.99, £10.99 or £4.99, with different quality of subscriptions:

Figure 1: Netflix subscription plans

Consumers are willing to pay higher in exchange for access to high-quality content (no advertisements and ultra-High Definition (HD)) and pay less for low-quality.

Unfortunately, consumers are definitely under information disadvantages, because they have little information about the audio-visual content unless they have purchased, which means information asymmetry does exist.

Under information asymmetry, users will be reluctant to pay £17.99, all of the high-quality content will be “crowded out” and eventually, consumers will only pay 4.99 to buy low-quality content.

Economist Akerlof (1970) calls such a situation:

“Market for Lemmon”.

Varian points out that such adverse selection behaviour of consumers, which is a consequence of information asymmetry, may destroy the market. The producers of high quality content need to take action to protect their benefits. (Varian, 2020, p. 746)

It is obvious that nobody wants this situation.

So, what's the solution?

Some methods in the physical market are not feasible in the entertainment market.

The individual audience in the “Netflix” market has less bargaining power than suppliers of the movies or other content. Which means they cannot create a contract to use incentive system like the labour market. (Varian, 2020, p. 754)

It is impractical to manipulate the business behaviours in the entertainment market by authorities, which means restricting choice of consumers, like the mandatory requirements to buy insurance, is not feasible in the “Netflix market”. (Varian, 2020, p. 746)

Signalling is a proper way. Varian defines Signalling as:

producers of high-quality goods providing information to consumers

Once consumers can recognise the high-quality goods, they will be willing to pay higher prices. (Varian, 2020, p. 749)

Advertising is a common method to signal. However, the development of information technology makes Netflix able to provide a better way to signal besides traditional advertising, which is “personalisation & search” function.

Figure 2: Netflix’s search bar

Such recommendation is based on analysis through algorithms and data collected from the users themselves (Netflix, no date), which is more efficient in signalling attractive content to consumers compared to traditional advertising.

The search function on streaming platforms offers users the freedom to discover their favourite shows and movies. For consumers, personalized recommendations outshine traditional ads when it comes to uncovering top-notch content.

Varian claims that the way of providing goods or services plays a more important role than we think, which is the “framing effect” caused by the bias of consumers.

The information of the subscription plan provided by Netflix in Figure 1 is a positive framework, in which the benefits are emphasised, which makes consumers pay more attention to the additional benefits than the fees. (Varian, 2020, p.588)

Other explanations are loss aversion and sunk cost fallacy. 

After subscribing to Netflix, users often let their past payments and experiences influence future decisions, despite knowing they shouldn't. They're reluctant to give up the Netflix experience. Varian (p.594-595, 2020) criticises such a situation is common in the stock market.

CONCLUSION AND INSIGHTS OF THE MARKET

Netflix and the online streaming service market also benefit from many other factors, such as the cost being spread over a large amount of consumers from the whole world, which is economies of scale. Such perspectives from microeconomics can not only explain the blooming of the online audio-visual market but also why many traditional TV service providers, such as BBC, choose to provide online service due to the potential of data science (Hendy, 2018).

REFERENCES

1. Akerlof, G.A. (1970). "The Market for 'Lemons': Quality, Uncertainty, and https://www.bbc.co.uk/historyofthebbc/100- voices/inventingthefuture/bbc-and-digital-revolution/ (Accessed: 14 March 2024)

2. Hendy, D. (2018). The BBC and the Digital Revolution. Available at: https://about.netflix.com/en (Accessed at: 15 April 2024).

3. Netflix (no date). How Netflix’s Recommendations System Works the Market Mechanism", The Quarterly Journal of Economics, 84(3), pp.488-500. [Online]. Available at: https://www.jstor.org/stable/1879431 (Accessed: 15 April 2024).

4. Netflix (no date). The Story of Netflix. Available at: Varian, H.R. (2020). Intermediate Microeconomics with Calculus: A Modern Approach. 1st edn. New York: W.W. Norton.

5. Varian, H.R. (2020). Intermediate Microeconomics with Calculus: A Modern Approach. 1st edn. New York: W.W. Norton.

6. Whitten, S. (2023) Netflix profit beats expectations, AD-tier subscriptions rise, CNBC. Available at: https://www.cnbc.com/2023/10/18/netflixnflxearnings- q3-2023.htmL (Accessed: 04 April 2024).