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Information Cascades, Network Effects, and Netflix

Over the summer, Netflix released its new plan to divide its business into a streaming service and a BD/DVD rental service. Netflix stopped its popular $9.99/month combined streaming and movie delivery service offering the two options separate for $7.99/month. Effectively if customers wanted to maintain the same service they had prior to the change, the monthly fee rose from $9.99 to $15.98. Following the announcement, Netflix users took their grievances to the Internet and Twitter exploded with posts containing the hashtag #DearNetflix. This overwhelming negative response caused an information cascade which would lead to a loss of subscribers to popular service.

At the close of the third quarter, Netflix reported a loss of 800,000 subscribers exceeding their predicted number of 600,000. The outrage over the price increase resulted in a cascade of service cancellations. After raising prices, the flood of complaints revealed that many did not find the service to be worth the proposed price hike. When millions of people threaten to cancel their subscription to Netflix, it made many current subscribers question the value of the service. As in an information cascade, the negative sentiment pervading the Internet reached millions of people many of which may have been influenced to cancel the service due the response. In addition to affecting current users, the negative response must also have influenced people who did not subscribe to the service. If someone was considering purchasing a Netflix subscription, the public’s reaction to the price hike may have pushed a potential user away from purchasing the service. Potential users would be less inclined to subscribe to a service after seeing a large negative response from most users. One would not purchase a product if the current owners of the product feel it is overvalued. This is an example of a network effect in which people value the product less when less people own it. In the case of Netflix, losing costumers translated to a loss of profit affecting the company’s ability to afford premium streaming content perpetuating the cycle of customer loss. Not surprisingly, Netflix soon suffered the loss of it’s content agreement with Starz, contributing to more cancelled subscriptions.

Not long after the Netflix price hike, the Starz media holding company declined to renew its contract with Starz. Unconfident that Netflix was the best way to distribute its content, Starz will remove over 1000 premium movies from the Netflix streaming site when the contract expires in February 2012. After anticipating a large loss of customers from Netflix, Starz believed other venues were better to distribute its content in order to reach as wide an audience as possible. A service with a small user base is likely to have less content made specifically for the service than one with a larger user base. As customers disappeared, the company became less attractive to content distributers such as Starz.

http://www.bloomberg.com/news/2011-10-24/netflix-3q-subscriber-losses-worse-than-forecast.html

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