Lessons from Netflix pricing: Ignoring statistical fallacies … and trolls
Here’s a simple business question for you. Let’s say you had 100 customers and charged $10 per month for your service. You decide to raise your prices by 60% – yes 6-0 – and when the dust settles you still have 97 customers. In every month after that, your customer base grows.
Would you make that deal?
To save you the arithmetic: your revenue after the price increase is $1,552, vs. $1,000 prior to your move. Assuming your costs are constant, your profits have also increased significantly, leaving you plenty of money to invest in product development and further expansion. Oh, and don’t forget, after losing three customers, your customer base starts to grow.
Would you make that deal?
I would. I hope you would as well.
Netflix made that deal in 2011 and has been vilified for it ever since. It took an article earlier this month in Inc. magazine to remind me once again that this vilification is not only misplaced and myopic, but also dangerous. It is dangerous because the response to Netflix’s price increase reveals a few ancient and ugly biases in how investors and managers continue to make business decisions, despite allegedly having unprecedented access to Big Data, Important Information, and so on and so forth.
These ugly biases are an acute short-term focus, vulnerability to statistical fallacies, and a willingness to listen to a tiny minority of shrill voices. Let’s relate that back to Netflix and come up with four alternative lessons to what you’ll find in the Inc. article mentioned above:
Endure the short-term heat: Imagine a soccer match which didn’t end after 90 minutes plus injury time, but instead went on indefinitely. Management and coaches can change their lineups and strategies as they go. You have neither a fixed roster nor a fixed, transparent amount of time to play. Your opponent may even change. The point is that if you plan to play forever, you make much different decisions than if you are on the clock. This lesson is about what happened to Netflix’s share price after the price increase. Netflix shares plunged as you can see here. On July 8, 2011 it stood at $42.16. By August 3, 2012, in the wake of the 60% price increase, the stock price had fallen to $7.70. Three years later in August 2015, the price peaked at $123.52, almost three times as high as the price prior to the “mishandled” price increase. Theory teaches us that Wall Street or the “markets” are all-knowing. The problem is that investors became overly alarmed by a few pieces of data and dismissed Netflix’s healthy long-term prospects until they started to become reality. That leads us to the second lesson.
Put scary numbers into the right context: If I rephrased the challenge above to say that you would lose 800,000 customers if you made your price increase, you might hesitate to say yes. That is roughly the number of subscribers Netflix lost. Scary number, right? Except Netflix had around 24,000,000 customers when it raised prices in 2011. When we subtract the people who departed, it still had 23,200,000 customers, all paying 60% more than they used to. That is hardly a mass exodus. Freaking out about the 800,000 “lost” customers means giving way too much weight to data which is not only small in the grand scheme of things, but also only indirectly relevant. Imagine if we kept score in a soccer match by counting shots on goal, not goals. In marketing speak, you could say that Netflix’s price hike filtered out the customer segment with the greatest price sensitivity. If you would like a quick read on why that is excellent news for most any company, please take a look at the primer on pricing which Harvard Business Review posted last week.
Ignore the trolls: The Inc. article said that “Customer response via social media was swift and fierce, and the cries could be heard all the way in the boardroom”. It later referred to customer outrage. Sigh. The outrage was probably off the charts for the 800,000 people who cancelled. And let’s remember that customers rarely compliment companies who make steep price increase. Have you ever done that? But we have to know the difference between fireflies and fire. Much of this supposed outrage is like watching fireflies on a warm summer night. Interesting, fascinating … and then the fireflies disappear and actually die. Loud, shrill voices attract attention. That is nothing new. Like scary numbers, let’s keep them in perspective.
Recognize what your product is worth: Who gets away with price increases that come across as poorly planned and poorly executed? Two kinds of companies can: ones who sell necessary evils we can’t avoid buying, and ones who sell products we find irresistible even after the price goes up. Netflix falls into the latter category. It turns out that the customers who stuck around after the Netflix price increase – all 97% of them plus all the new ones who were undeterred – emerged as big winners too. They enjoy original content such as the award-winning “House of Cards” TV series and even greater content and service options. And how many subscribers does Netflix have now? Over 60 million worldwide.
The Inc article correctly says that companies should try to communicate better, plan better, and try harder to get inside their customers’ heads. Who shouldn’t? But managers and investors also need to combine that with solid critical thinking and a healthier, long-term perspective.
Frank Luby is co-founder and CEO of Present Tense LLC, a communications company dedicated to helping people express their ideas through better business storytelling. In his former life as a pricing consultant, he co-authored the book “Manage for Profit, Not for Market Share” and wrote about pricing in publications such as The Wall Street Journal and Billboard. To learn more about Present Tense LLC, please visit us at www.presenttensellc.com and follow our regular blogs and posts. You can also follow Frank on Twitter: @FrankLuby