1. Introduction

 

The purpose of this project is to analyse the business model of the Netflixcompany. The first part of the report evaluates the suitability of chosen market structure with respect to characteristic of the streaming services market. Further analysis in the second part provides the assessment of the competitive environment and reveals its cost structure. Ultimately, economic models are applied to evaluate dynamic capabilities of the company and how they affect other important economic variables like demand, pricing, consumers’ preferences and innovation.

 

  1. Market structure and power

 

One of key assumptions in most macroeconomic models is that individuals allocate their scarce resources so as to make themselves as well off as possible and firms try to maximize their profits given limited resources and existing technology. Introduction of the new technology in the market causes both consumers and industries to make changes in order to adapt to it. Digital era lead to dramatic change of the balance of power between traditional media and internet streaming services. Netflix is a great example of how company takes an early-mover advantage of technological change to offer type of service that perfectly matches changed consumers’ preferences.

 

The characteristics of industry, number of firms, profits and consumers defined the market structure in which Netflix operates. The power to dominate the streaming services industry and attract over 100 million subscribers in the battle with few other powerful competitors like Hulu and Amazon can only happen in the highly concentrated market-an oligopoly. Because relatively few firms compete in such a market, each can influence the price, and actions of competitors affect rival firms.

 

Market power is the ability of a firm to charge a price above marginal cost and earn a positive profit (Perloff, 2010). When assessing the current power and future prospect of Netflix, the analysis is initially focused on growth drivers. The massive subscriber base and in-house content are undoubtedly critical success factors.

 

When analysing consumers’ preferences, the supply-and-demand model is not the most appropriate tool to answer questions concerning individuals, and a model of individual behaviour is more suitable (Perloff, 2010). Consumers spend their money on the bundle of products that give them the most pleasure and economic theory assumes that consumer is the boss. Underlying our model of consumer behaviour is the belief that consumers can compare various bundles of goods and decide which gives them the greatest pleasure. Netflix is the example how this theory is incorporated in business model in at least three ways:

  • Brand value is created through producing the content audience actually wants. Popular shows contribute to acquisition and retention of subscribers as peoplebecome emotionally attached to drama program.
  • Individual preferences are satisfied through inclusion of user interface that can create personalized algorithms and enable customers get the highest value of content for their money. It can be assumed that this service generated a competitive barrier for potential new entrants, as hours of consumer profiling would be incredibly difficult to obtain.
  • Netflix has addressed video preferences of its consumers by charging a premium for HD service. Awareness of the fact that consumers will spend more money on of products that give them the most pleasure is incorporated in pricing policy of the company.

 

  1. Cost structure and competition

 

  • Cost structure

 

The primary source of revenue for Netflix is subscriptions. However, the question of how does Netflix earns profit cannot be answered without analysing the cost of revenue. Costs structure affects how much firms want to sell of a good or service and knowing the proportion of fixed and variable costs in the cost structure is the key to understanding how cost base can influence profitability.

 

According to Fox Business total cost formula (2016) subscription businesses tend to be built on fixed costs, as the cost to produce whatever content is being sold is the same whether there are one hundred subscribers or one million of them.To licence a certain content for a defined time period, provider is obliged to pay a fixed fee. Costs related to producing original content include development and direct costs and are capitalized. In accordance with accounting standards, both licence fees and capitalized costs are then depreciated over the period content they relate to is available for subscribers. Due to increase in content spending, cash outlays are initially greater than content amortization resulting in lower free cash flow than profit figure.

 

It is expected that in the profit and loss accounts of Netflix two major sources of cost are content amortization and marketing. The supply of third-party contents-licencing costs, and the costs related to the production of in-house contents-production costs, represent the main categories of cost of sales. Because Netflix has to compete with other streaming sites on the internet, it incurs marketing costs that comprise different kinds of advertising expenses. The effort to expand internationally will probably cause marketing costs to grow substantially.

 

Issuing corporate bonds added finance costs to company’s profit and loss account. Interest expenses are non-core type of cost but they have certainly reduced net income figure.

 

As Netflix expands internationally, new taxes and costs associated with operating in various countries can cause general increase in licencing costs.

 

 

  • Competition

 

In any industry with few players, competition is fierce.This results in a high level of competition between service providers for consumers viewing preference and subscription money.Increasing competition on video-on demand market can jeopardise the ability of Netflix to exceed market expectations around future subscriber growth and margin expansion.

 

The streaming video market has grown dramatically and it is expected that, as more television studios and movie networks debut their own streaming services, some of them might be less willing to share content with Netflix. In this sense, some of the company’s suppliers have become its competitors, and that makes competition more difficult.Other threat comes from the fact that competitors are developing strategic alliances or partnerships. The company itself had to turn to partnership deal to secure its content base.

 

In an oligopolistic market, firms do not respond to changes in demand as much as to the actions of its rivals.  Two of Netflix’ largest competitors-Amazon Prime and Hulu, offer a massive amount of on-demand content at a relatively low monthly cost. This means that the most important segments where all streaming services giant firms compete are content and price. Other characteristic of this service industry should not be underestimated and these include user interface and video quality. Since there is no major difference in price they charge for streaming, it can be concluded that content is the most important decision factor among subscribers. This reasoning is even more supported by the amount of funds Netflix has invested in production of original content. The management of the company is willing to take significant financial risk of borrowing €1.6 billion because they believe that constant investing is necessary to grow subscribers’ base.

 

The barriers to enter this market wereinitially very high due to large amount of upfront capital required and, according to Sgmanetlix (2016), the major impediment to becoming an online video streaming service is acquiring, creating, and licensing content. In addition, new firms will face difficulties to enter the market due to economies of scale. Economies of scale state that the big companies that operate for a long time will be able to produce at a lower cost. Due to the economics of scale, the existing company can easily force out new competitors.

 

However, we see the constantly increasing number of established content providers and that must be a consequence of technological advances. One example of market fragmentation is the fact that cable operators started to offer streaming services. Over the years, forms of entertainment will further improve and Netflix will actually compete for a share of member’s time to be spent on relaxation and entertainment.

 

 

  1. Company-specific dynamics

 

Competitive dynamics within the online video streaming industry, where Netflix is the leading player, are evolving and lively. New developments are expected in video streaming industry, as more people are turning to Internet for any kind of video content. When deciding on the future strategy, the management team will conduct risk assessment and prepare optimal answer to threats from the environment. At the same time, it is expected that company like Netflix will benefit from innovations in technology and its global presence.

 

The main trends in industry that can threaten company’s performance in the future are the following:

  • The increase in competition leaves limited pricing power, which is one of the core strengths of Netflix. Additional revenue is required to invest in growing original content, attract new members and maintain large content library.
  • Government rules and regulations affect how much firms want to sell or are allowed to sell. Reaching the customers became more difficult for Netflix due to new regulations introduces by US Federal Communication Commission.
  • Another challenge ahead lies in potential Disney’s acquisition of Fox, a merger that can seriously jeopardize market share and dominance of Netflix.
  • Financial risks Netflix is facing are significant. Both expansion and increased investments in content provide no guarantee for profit, as Netflix cannot guarantee that this will motivate their customers to choose their service over their competitors.

 

In order to evaluate potential of Netflix to remain on the top of the competition, there are a few important factors to consider:

 

  1. Product/service quality

In general, video streaming providers compete on content selection. When it comes to ability to offer current content, there is also very low product differentiation between providers. When entering the battle with competitors to reach customers globally, companies usually have to opt between cost efficiency and differentiation (Mankiw, 2009). The generic strategy adopted by Netflix as the response to fierce competition was actually differentiation. The company is an example how internally created content can be the center of growth and opportunity.

 

Focussing greater efforts on creating original material than on licencing existing shows was a significant strategic shift. As a common rule, the firms will invest in project that generate returns above its cost of capital. The decision to invest in creating original content lead to heavy borrowing. On the other hand, number of subscribers increased almost five times, from 23.53 million at the end of 2011 to 109.25 at the end of 2017, which must have had a positive impact on company’s financial performance.

 

  1. Pricing

Consumers’ tastes determine what they buy and the prices significantly affect their purchase decisions. The relationship between price and quantity demanded plays a critical role in determining the market price and quantity in a supply-and-demand analysis (Perloff, 2010). One reason Netflix has become so popular is due to its low subscription costs. People of all different economic statuses can afford a subscription, which is evidenced by such a large number of subscribers. This has resulted in extreme customer resistance to increases in subscription fees.

 

On the other hand, increased capital requirements have certainly put pressure on Netflix’ profit margins and liquidity position. This is why we can consider the increase in subscription price as an expected answer from the management in order to remain competitive and satisfy shareholders.

 

Price increase potentially shows that the company is confident that its streaming video service is compelling enough for consumers to pay more. Another argument here is that price increase might be a sign of Netflix’s competitive advantage has started to wipe away. In order to justify its massive original content budget, it must raise prices if it is to ever meet the shareholders’ expectations (Forbes, 2017).

 

The situation in Ireland after price increase is a good example of how demand for streaming services is very elastic. Reduction in number of subscribers suggests that streaming customers are cost-conscious, as cost of switching services is low.

 

 

  1. Demand generating strategies

Demand generation is the process of creating a desire for a particular product or service.Netflix is deeply comminted to satisfy individual users’ tastes. One strategy for achieving more subscribers to discover Netflix is working with partners. Partnerships assume pioneering new technologies and offering content in new formats such as 4K and HDR.

 

International expansion is currently a main strategy for approaching global audience. Market power of Netflix will definitely be influenced by level of government regulations in each market. Global companies tend to exercise their power to make more profit. Especially in the domain of digital traffic and internet technology, government intervention is often necessary to enable all consumers and companies have equal treatment. ‘Net neutrality’ rule is the form of government intervention to set boundaries and prevent powerful companies taking unfair advantage of their position.

 

  1. Conclusion

 

New technology and innovations continue to alter the customers’ preferences. The “subscription economy” refers to businesses that charge for services rather than physical products. This business model emphasizes long-term relationships with customers.

 

By differentiating its product from those of a rival, an oligopolistic firm like Netflix can shift its demand curve to the right and make it less elastic. The company is a great example of how firm can find the underlying cause of consumer behaviour, in term of identifying what the consumer perceives as offering value.

 

Regardless of Netflix’s established position in the online video streaming market, healthy competition exists and Netflix is making significant efforts to preserve its dominance.  Despite the astonishing numbers shown by the domestic market, growth in the international segment represents the real trigger for the company to definitely become a major corporation. To maintain their title of industry leader, Netflix needs to ensure that they stay a step ahead of their competition.

 

 

 

 

 

 

 

 

 

 

References

 

  1. Fox Business, 2016, Total Cost Formula: How to Break Down Business Expenses

Available at: http://www.foxbusiness.com/markets/total-cost-formula-how-to-break-down-business-expenses[Accessed February 21, 2018].

 

  1. Forbes, 2017, Netflix price increase signals original content is not enough

Available at: https://www.forbes.com/sites/greatspeculations/2017/10/06/netflix-price-increase-signals-original-content-is-not-enough/#51b9509b6d3e[Accessed February 20, 2018].

 

  1. Mankiw G., 2009,Macroeconomics, Harward Univercity Boston, p.525-547.

 

  1. Perloff J., 2010,Microeconomics, Boston USA , Pearson, p. 9-42, 73-11, 436-482.

 

  1. Sgmanetlix, 2016, Netflix-an inside look at the video streaming service that’s shaking the world

Available at: https://sgmanetflix.weebly.com/ [Accessed February 21, 2018].

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