How Netflix Killed Itself with Kindness

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

I wonder if anyone at Netflix had occasion to read Surowiecki’s piece in the last month. Right now the once-beloved dotcom, if not exactly being killed by its customers, is at least being taken behind the woodshed for a serious thrashing. Netflix’s former business model – a single low price for streaming and DVD rentals – was simply unsustainable. The company couldn’t pay the licensing fees demanded by studios, win the rights to new streaming content, and continue to ship DVDs at the same price it once charged for DVDs alone. But Netflix was in a precarious position precisely because it had provided its customers with something that was too good to be true – an excessively dangerous position that has sunk many more dotcoms than Kozmo. In game theory terms, Netflix’s predicament was the patsy position, in which the customer has very little incentive to continue the relationship if the brand does anything to upset the delicate balance of cost vs. services. When Netflix defected by raising their fees for the combined services, did their customers happily 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 800,000 customers have given the brand the boot in the last quarter alone.

Netflix was missing a core insight than any behavioral economist could have given them: when pricing models in a given market – in this case, the streaming content market – aren’t well established, you’re entirely at the mercy of your customers’ own perceptions, however irrational. Since Netflix customers had been given streaming content for absolutely nothing for several years, their perception was that the streaming content is worth, well, absolutely nothing. If Netflix had never provided that streaming service before, but instead introduced it in August for an additional six bucks a month, they would not have lost customers, and their streaming service would have taken off like gangbusters. Exact same price, vastly different price perception. In the latter scenario, Netflix’s price increase would have been seen as a form of cooperation, not defection – another triumph for a brand known 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 have to pay attention to the end-game. Consumer perception accrues quickly to the status quo; that’s why it’s easy to sell taxpayers on the idea that letting a tax cut expire on schedule is actually a “tax hike.” Above all, know what your content is worth and charge accordingly. Believe it or not, your customers will thank you.