Stop whining; Netflix doesn't care if you're going to cancel your subscription

In the New Zealand Herald yesterday:

Reaction to Netflix's incoming 19 per cent price hike amongst Kiwi subscribers has been immediate and passionate.

Many have taken to social media to announce their imminent departure from the streaming service and to question the value for money proposition offered by their subscription.

The price across of all Netflix plan will increase. The basic plan will now cost $11.99 a month, the standard $16.99 and the premium plan $21.99 a month, increases of 4 per cent, 13 per cent and 19 per cent respectively...

Long term subscriber Cameron Anderson seemed to capture the general mood of the nation to the price hike news writing, "Well, it's been fun netflix, years of support, but I think I'll have to cancel my subscription".

Despite all the wailing an gnashing of teeth (see the full article for more of the same), Netflix isn't going to change its mind. When a firm raises its price, some consumers will stop buying from it. That's called the Law of Demand. It will come as zero surprise to Netflix that some consumers will cancel their subscriptions. Jumping onto social media to whine about how it's unfair and therefore you're going to cancel your subscription changes nothing.

And you know why? Netflix doesn't care. Enough people will keep Netflix and pay the higher price, to more than offset the lost revenue and profits from the small number of subscribers who cancel their subscriptions. Netflix has already factored this in when they made the decision to raise the price.

The diagram below illustrates this point. It shows a firm with market power. The original subscription price is P0, and there are Q0 subscribers at that price (Q0 is the quantity demanded at the price of P0). Netflix's producer surplus (its profits, excluding any fixed costs) at that price are shown by the rectangle P0CHF (that's the area between price and cost, for the quantity they have sold). The problem for Netflix is that P0 doesn't maximise profits. Profits are maximised at the quantity where marginal revenue is exactly equal to marginal cost. That's the quantity Q1. Netflix has too many subscribers to maximise profits. It should raise its price to P1, where the quantity demanded (the number of subscribers) is exactly equal to Q1. At the profit maximising quantity, the producer surplus is equal to the rectangle P1BEF. It should be obvious that the area P1BEF is bigger than the area P0CHF. Netflix's profit increases. [*]

By raising the price to P1, Netflix loses the area of producer surplus GCHE, which is essentially the profit they were previously receiving from the people who cancel their subscriptions. But they gain the area P1BGP0, which is extra profit from the people who keep their subscriptions and now pay the higher price.

So, people can whine about it all they like. Netflix is simply engaging in the sort of behaviour that we expect a firm with market power to engage in. Incidentally, Netflix has this market power because so many consumers rushed to subscribe to them and let competitors like neighbourhood video stores close down. Now those other competitors are gone, there's no going back (at least, not easily). If consumers didn't want this to happen, why give Netflix so much market power to begin with?

*****

[*] Of course, it is also possible that Netflix over-shoots the profit-maximising price, and has actually set a price that is higher than P1. In that case, profits would be lower than at the price of P1, but may still be higher than they were at P0. It seems to me, though, that Netflix is more likely to still be under-priced even at the new, higher price. If it priced too high, then it leaves open too much opportunity for lower-priced competitors. In this, maybe I've been influenced by Jeff Bezos' views, as explained in the book The Everything Store (which I reviewed earlier this week).