Microeconomic Analysis of Netflix

Introduction

This paper will assess the business operations of the Netflix Company from a microeconomics viewpoint examining and discussing how factors such as products supply and demand conditions, price elasticity of demand, cost of production, market entry barriers, market share, and market structure effect Netflix’s performance in their market. The paper will start with historical overview of the Netflix Company and conclude with recommendations based on the analysis suggesting how Netflix could run its future operations to stay competitive in the entertainment market and Industry.

Netflix History

Netflix began operation in 1997 as a DVD by mail rental service (About Netflix, 2017).

After many years, it has morphed into the largest online television network, with over 100 million members worldwide which streams over 125 million hours of programming per day. Its members are able to watch on multiple different devices from just about anywhere, at any time. These entertainment choices include films, television, documentaries, and original programming (About Netflix, 2017). With an enterprise value of $71.47 billion, this internet giant has changed the way we consume modern media and entertainment (Netflix Enterprise Value, 2017). Netflix has frequently invested in original programming that is generated strongly based on the trends of the consumer. This company has market insight that Nielsen ratings can’t compare with. In addition to the number of people watching programming, Netflix can also tell when users watch, how long they typically watch for, what people want to see, and much more. This information is used to provide the highest quality experience for the consumer. With a large share of the online streaming market cornered, Netflix has openly said that their biggest current competitor is sleep (Netflix’s View: Internet TV is replacing linear TV, 2017).

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Supply and Demand Conditions

Supply and demand is the availability of an outcome for a certain product and the demand for that product has on cost. Meaning that if there is a low supply with a high demand the price increases or if the supply is greater with a demand that is lower than the price will likely drop. When it comes to Netflix and its supply and demand conditions, you can see that they are also vulnerable to the same supply and demand stress as other business organizations. Netflix is constantly expanding the streaming list of content providers along with their competitors such as Hulu, Amazon Prime, HBO and other premium networks. The demand for growth in these streaming companies has driven prices upwards over the last few years.

The cable industry, which is what Netflix is classified under, is continuously and quickly changing.  Advances in technology have driven the demand for cable television and companies like Netflix to have easily and quickly accessible content. In 1948, cable television originated in Arkansas, Oregon, and Pennsylvania to enhance poor reception of traditional broadcast television signals in remote areas. (History of Cable, n.d.) During the 50’s and 60’s, cable subscriptions grew from 14,000 subscribers to 850,000 subscribers. From the 1990’s into the present, cable has continued to rapidly grow due to the different services that it offered customers.

As customers started demanding higher quality cable service, the demand for basic cable started to decline. Satellite television originally provided more channels to their customers which increased the demand for these more extensive systems over the traditional basic cable system. Due to this high demand, the costs for these products continues to grow. The latest movement in the cable television industry is media streaming. This has caused massive growth for Netflix and similar services.

Netflix has positioned itself to be a frontrunner in the media streaming industry. As a streaming provider, Netflix gives its customers the ability to watch ad free content from a large array of devices, at any time. This makes for a high demand as it gives customers more freedom than traditional cable packages. One other factor is the low cost of Netflix compared to the cost of cable subscriptions. The average monthly cable bill is over $120, which is more than a $35 average increase from the cost in 2011, while the average monthly fee for streaming services is $8 per month.  With the demand for streaming services on the rise, it is understandable that Netflix subscriptions would increase.

If Netflix continues to grow its internet television concept of providing TV shows and movies that customers demand, it will hold their spot as an industry leader in the marketplace.  With very strong reception from critics and customers alike, they will need to continue with the production of original content, such as original TV series and movies, which have not only increased the demand for services, but has also increased their profits.

There are few supply issues facing Netflix. In the streaming market, there are few competing firms that may threaten the market share of Netflix. These firms offer alike services at a comparable price to Netflix This means that the amount of substitutes that can supply similar quality services as Netflix are few.  The largest supply issue Netflix faces is technological change.  However, keeping up relations with various electronic devices, remaining relevant should be fairly easy.

Price Elasticity and Demand

Price elasticity of demand the relationship between change in the demanded quantity of a product and a change in the products price. If the price of services increase, it could affect the quantity of services demanded. There are a handful of quality substitutes for Netflix. In the cable industry itself, AT&T, Comcast, and Time-Warner, are all providers of services that compete for the same customers as Netflix. In the streaming market, Netflix competitors are other content providers such as Amazon Prime and Hulu. The major factor in this competition is pricing and content availability.  

In 2014, Netflix increased consumer cost by $1-2 each month. While the price increase was a risky choice, it was necessary because of the rising prices of acquiring more content. Before this change, subscription plans for streaming and DVD rentals rose to $8 a month for streaming and $10 a month for streaming and DVD rentals. In 2011, this was raised again. All subscribers would have to pay $16 a month for both streaming and DVD rentals which is nearly a 60% rise in cost for the consumer. There was a large backlash from consumers as they felt that the small streaming library was not enough to justify those costs. This price increase was a way for Netflix to upgrade and expand the library content they were offering for streaming. With this price increase, Netflix lost nearly 750,000 subscribers and its stock tumbled in the following months. However, with Netflix expanding the production of their original series, this decrease of subscriber growth was only temporary. Netflix doesn’t appear to see price elasticity as risk for their organization, but more of a prospect.

The stock and earnings of Netflix have proven to be growing at a steady rate over the last few years. Netflix has reported that the amount of watching from the average subscriber has grown in every quarter after the fourth quarter since 2011. Netflix continues to grow. In Argentina, United Kingdom, Brazil, Irelands, Chile, and Mexico is expected to make up more than a third of TV in the average household by 2020.

If Netflix raised prices again, it could cause customers to other platforms because of the lower cost. On the other hand, if Netflix would lower its price, then the demand for its service could potentially increase. Netflix is a service that could be considered a luxury and not a necessity. This would provide Netflix a higher elasticity of demand. This may not be the case in the future as many people are beginning to use Netflix as their primary entertainment source. This means that in the customer’s budget, Netflix has already started to become a monthly expense, replacing standard cable services. As time goes on, it is expected that consumers will change their spending habits to completely move away from cable and move directly to streaming services which would increase the elasticity of Netflix. Although the expense is monthly, it will only be a small percentage of the consumer budget making it an inelastic demand. Because the market for media streaming is broadly defined, the number of available substitutes is low therefore it is inelastic.

Netflix has shown to be profitably consistent, which allows shareholders to expand its equity as earnings are built up over time making Netflix more valuable. Money is being spent by Netflix to expand into more international markets after seeing huge success in its international growth into countries like the United Kingdom, Mexico, and Canada. This has allowed Netflix to study the trends of consumers across the world to create content that is palatable in many nations. This expansion should assist in lowering overall costs and increase the company’s profitability.

Costs of Production

Currently, Netflix offers streaming services on movies and TV shows. They have three subscription levels: Basic, Standard, and Premium. Netflix is currently working to grow their offerings and continue with original programming.

The main cost that Netflix incurs comes from the licensing and production of their streamable titles. The cost of maintaining their content library has been quickly rising over the last five years as they expand the choices that they are offering to consumers, which can be seen in the chart below. While the largest cost for Netflix is their content, they also have various SG&A expenses, otherwise known as selling, general and administrative expenses. These expenses have also grown as the demand for their rises. From 2012 to 2015, these SG&A expenses had more than doubled.

These costs have been growing as the consumer’s demand for more varied content grows and as Netflix expands into the international marketplace. This demand by consumers that Netflix has met, has resulted in a continuous growth for the Netflix Company. In 2016, the COGS had a nearly 32% increase in from the year previous.

These growing costs for the most part have not prevented company growth. As you can see below, by continuing to increase the content available, Netflix has also helped itself to create strong sales growth. In 2016, Netflix experienced sales growth of 30.26%.

Market Share

While Netflix is the largest paid for streaming service, it has a market share of only around 12.7% (Netflix Inc’s Competitiveness, 2017) . The reason for this is that Netflix’s marketplace competitors are well established cable corporations and video providers that have many other products and services that would result in a higher revenue than Netflix. These companies include Amazon, Comcast, Cablevison, and Time Warner Cable. Although Netflix has strong sales growth, their profitability is lower than market competitors, with a net margin of 2.36%. Competitors in this market have an average net margin of just under 11% (NFLX’s Competition by Segment and its Market Share, 2017).

Due to the large capital and resources required to enter this market, Netflix will need to be aware of the streaming services provided by established cable companies and original content providers. These pose the greatest risk due to their large access to streamable content and access to existing customers.

The market structure that Netflix operates under is an oligopoly. In an oligopoly, there are a few companies that control the entire market. In the streaming market, Netflix, Hulu, and Amazon Are the main competitors. In this type of market, price wars have a chance of occurring.  This means if one of these companies decides to drop its prices, the others must also drop prices in order to stay competitive. Taking a look at the current state of the market, this is evident because all of the major providers have comparably priced packages for their product. With Netflix being the market leader, they have large influence over this market. If Netflix decides to reduce prices, then Hulu and Amazon must also reduce consumer cost or risk losing customers to Netflix. 

Recommendations

With streaming quickly becoming the industry standard in television viewing, Netflix is expected to continue to increase its hold on the industry and market. Their current COGS while increasing, has provided Netflix a strong advantage in terms of sales growth due to their original content and variety of offerings. This current strategy seems to be working well for them. While some of the most expensive options to produce are original programming, these expensive productions are key to attracting customers due to the lack of availability from other previously subscribed to services.  This will also be helpful in further securing themselves in the marketplace. As mentioned earlier it will also be important for Netflix to keep developing their technology and continue to partner with different companies to update and keep their technology modern and relevant.

By persistently providing the services and integration that consumers desire, Netflix can continue to expand its service to more consumers than it currently does.  If Netflix can continue to understand the wants of the consumers, then they will remain leaders in their market.

Citations

About Netflix. (n.d.). Retrieved July 15, 2017, from https://media.netflix.com/en/about-netflix

Caporaso, T. (n.d.). Netflix’s pricing strategies are bound by the same laws of supply and demand that affect every other commercial entity’s rates. Retrieved July 30, 2017, from http://www.sdcexec.com/article/11442396/netflixs-pricing-strategies-are-bound-by-the-same-laws-of-supply-and-demand-that-affect-every-other-commercial-entitys-rates

History of Cable. (n.d.). Retrieved August 20, 2017, from https://www.calcable.org/learn/history-of-cable/

NFLX’s Competition by Segment and its Market Share. (2017). Retrieved August 06, 2017, from https://csimarket.com/stocks/competitionSEG2.php?code=NFLX

Netflix Enterprise Value. (n.d.). Retrieved July 15, 2017, from https://ycharts.com/companies/NFLX/enterprise_value

Netflix Inc’s Competitiveness. (2017). Retrieved August 06, 2017, from https://csimarket.com/stocks/compet_glance.php?code=NFLX

Netflix Inc Income Statement. (2017). Retrieved August 06, 2017, from http://quotes.wsj.com/NFLX/financials/annual/income-statement

Netflix, Inc. (NFLX) Stock Chart. (n.d.). Retrieved July 30, 2017, from http://www.nasdaq.com/symbol/nflx/stock-chart

Netflix: revenue in 2016. (n.d.). Retrieved July 30, 2017, from https://www.statista.com/statistics/272545/annual-revenue-of-netflix/

Netflix’s View: Internet TV is replacing linear TV. (n.d.). Retrieved July 15, 2017, from https://ir.netflix.com/long-term-view.cfm

TV Ratings. (n.d.). Retrieved July 15, 2017, from http://www.nielsen.com/us/en/solutions/measurement/television.html