Paul Papadimitriou

Netflix has been making the headlines this week for its strategic move —dividing the company in two, one dedicated to its DVD business, one to its nascent streaming offering.

I think it’s a smart move. Mark Suster tells it better than I ever could:

the real threat comes from the change in technologies that rule the old business obsolete. Streaming. It’s clear that in the future movies & TV will be delivered to our homes from the cloud. Indeed for many this is already the case.

To win the future he needs to attack his core assets by building new ones. Very few companies ever do this. It would be like if Microsoft undermined its Office franchise by aggressively pursuing a Google-Docs-like strategy. Yeah, I know they did, but too little, too late, too lame.

Having two entities focusing on separate business models will allow them to iterate individually, unconstrained by the limits of each other.

But it’s smart move with a caveat.

Let’s put the branding decision aside ^[1] and consider this: consumers exhibit latent inertia in favor of repeat purchases.

Repeat that sentence again. Mark brilliantly shows why it makes sense for a company to adopt such a strategy, I’m reversing the stance and tackling the problem from the consumers’ prism.

A prism? More like a brouhaha of discontent. An uproar that reminds me a lot of the deluge of expletives following each and every one of Facebook’s UI change ^[2].

Let’s trim my sentence to its essence: consumers exhibit inertia. It is how we, as humans, are hard-wired. Whatever it is we say, we tend to favor comfort and the well-known instead of the relative darkness that novelty is. And it is a reality businesses cannot discount. Netflix shouldn’t.

Inertia

Inertia has two components.

One, the body in motion has a tendency to remain in motion. In the Netflix example, consumers buying DVDs keep on buying DVDs, small price changes notwithstanding.

Two, resistance to change. People buying DVDs resist the idea switching their content viewing pleasure towards a new —unknown— form of content digestion.

There will always be some form of persistence in consumers choice, a higher probability of choosing a product that we have purchased in the past. It has to do with loyalty. It has to do with security. We’ve had videotapes and discs for years. We know them. We feel safe with them.

Loss aversion

The correlated effect of inertia is loss aversion, a potent dynamic in human behavior. There is a utility premium required to trigger purchases of novelties.

In order to watch DVDs, you have your home entertainment system set up accordingly. Streaming movies requires a different set of tools. Not only consumers show inertia in their will —and ability— to adapt to a new form of technology, they show some aversion to losing a place where they feel comfortable in, their current —and more than satisfactory— setup ^[3].

My father still records memos on micro cassettes ^[4]. Have you tried to find those nowadays? Unless you go to specialty shops in Akihabara, you probably will have a hard time. The market has moved towards flash memory devices. But it just doesn’t work for my father, he has a series of equipment all based on micro cassettes and doesn’t want to lose the comfort and habit that has allowed his current rate of productivity ^[5].

The learning curve of a new technology is hindering —once familiarized with one system, consumers tend to stick with it ^[6].

In our current case, early adopters and generations that have not lived long enough with physical containers of content will easily switch to content streaming, the others will take longer and will need to be provided with incentives.

The dynamics of catering for those two types of consumers are widely different. The rate at which consumers adapt to change varies a great lot and, in order to iterate fast enough, dividing the company makes perfect sense.

Even more sense as we’re witnessing virtual goods at work.

Content as a virtual good

Content is a virtual good. It has always been. You could touch its container, whether a videotape or a disc, but you were and will never be able to actually touch the content. Still, that content is the reason why you buy or rent the physical container.

The physical touch versus a creation of the mind. This is one of the forces behind content disruption. Music is going through it. Information —as in newspaper— is struggling with it. The movie industry experiences the same.

The absence of physical touch or the endowment effect at work.

The —disputed— theory of the endowment effect states that all of us tend to value a product or a service more once we own it ^[7]. When you negotiate the price of a product you own and want to sell, the fact that you’re setting the price higher than the one of the potential buyer is obviously due of your will to maximize your past investment in it —thus not underselling it— but, less evidently, because you feel its value higher as it is …yours.

Now it can be stated that a purely virtual good diminishes this endowment feeling. Streaming unwillingly diminishes the value of a DVD content: it’s harder to grasp that you own —or temporarily own, as in renting— content without its physical container. The DVD yields higher value not only because of its actual manufacturing, but also because of its feel.

This is why the entertainment industry as a whole struggles. Content is valued higher if endowment is at play. Netflix’s and Qwikster’s futures are offering us a non-endowment world versus a endowment world experiment ^[8].

A real life lab experiment

Will consumers move away from DVDs and adopt streaming? I’m dead certain of it.
Will Netflix be able to move customers away from Qwikster over time? Probably. But fast enough?

There’s the caveat.

How will Netflix educate its Qwikster customers about streaming? How will it display compelling offers to move from one model to another to customers who undoubtedly will become ready over time?

There’s no bridge.

Take one example: the movie review systems will be totally separate. If I rate a film on Qwikster, it’s not showing up on Netflix. I don’t want to lose my history of votes and the community reviews that I might have carefully curated.

Talk about adding another hurdle into my loss aversion!

Will consumers display a preference for an immediate reward —the known DVD mail-in model— and discount the value of a later reward —the new world of streaming? ^[9]

It’s up to Reed Hastings. But if Qwikster cuddles its customers in a cocoon of nice red enveloppes too much, Netflix will inadvertently have slowed the market switch towards its new and daring business model.

1. although, why not Mailflix indeed? [↩]
2. a notable one happened this week  [↩]
3. not to mention the simple time lag, as Alchian and Allen have demonstrated in 1972: if you increase the price of water by 100 percent, the immediate rate of consumption decreases —but it would decrease a great more within a few month, after people had made adjustments in associated activity and water-using equipment. [↩]
4. the Wikipedia entry for those who want to make me feel old [↩]
5. price sensitivity is irrelevant here, as my father could very well afford to buy all the new equipment [↩]
6. see: Beggs A. and P. Klemperer, Multi-period competition with switching costs, Econometrica 60, p. 651-666. [↩]
7. see: Experimental Tests of the Endowment Effect and the Coase Theorem, Journal of Political Economy, Vol. 98, N. 6, December 1990 [↩]
8. I’m aware of the simplification of this statement. [↩]
9. this consumer preference is called hyperbolic discounting [↩]