The Behavioral Psychology of Netflix's Plan to Charge Higher Prices

When it comes to prices, people don't behave rationally. And the best companies know.
More
Reuters

Netflix is crushing it. But now, the company untying cable's $60 billion stranglehold on American TV is apparently trying to accomplish something simple—something it hasn't done in more than two years in the U.S.

It's trying to raise prices.

Netflix costs $7.99 per month. Last year, it cost $7.99 per month. The year before that, it cost $7.99 per month. While cable and Internet costs has grown inexorably, the inflation-adjusted price of Netflix has actually fallen in the last three years. And its executive is starting to think three years is enough.

“It’s not clear that one price fits all,” CEO Reed Hastings said last week, discussing an experiment in Ireland to raise prices for new customers by one euro to €7.99 ($10.94) per month. Later on the earnings call, Netflix told analysts that it's thinking about offering "good, better, best price tiering" in America, as well. CFO David Wells drew back the curtain to explain the psychology behind the economics (the full exchange is pasted at the bottom of this post):

In pricing theory there's also a sense that consumers make choices around heuristics. And so $1 might not sound like a lot on a logical basis but consumers may have shortcuts that they make they take the middle or the upper or the low and so that factors into the right course as well.

 

In human-speak: You don't understand prices. You don't buy things based on anything resembling "logic." You buy things based on, well, something else— mental "shortcuts." And Netflix wants to hack your mental shortcuts. 

One way companies use prices to trick us is to offer cheapo, inferior goods to get us hooked on a product that we'll eventually spend more on. Time Warner Cable, for example, experimented with an "Essentials" package that offered cable without the most popular channels at a discount, expecting (and, as I've been told, often discovering) that customers would upgrade to full cable when they realized how much they love TV.  In a way, Netflix is already doing this: In December, it introduced a $6.99 plan ($1 discount) that allows streaming to one screen only.

The more sophisticated strategy isn't to offer two prices, but three. In Hasting's words: "good," "better," and "best" price tiering. Why three? Because of the magic of the Goldilocks effect in pricing.

In the early 1980s, Joel Huber and Christopher Puto at Duke University offered their students four varieties of beer (super-bargain, bargain, premium, and super-premium)—in three separate experiments.

- In the first experiment, they offered just two varieties: a bargain beer (at $1.80) or a slightly better premium beer (at $2.60). Two-thirds of their students went for the premium.

- In the second experiment, they added an inferior, super-discount beer at $1.60. Nobody selected this cheapo option. But the bargain beer, now the middle of three choices, saw its share rise from 33 percent to 47 percent.

- Finally, the researchers took away the super-bargain and added a super-premium option at $3.40. Suddenly, it was the premium beer that was the middle of three options, and guess what? Its popularity share rose from 66 percent to 90 percent.

That's a lotta numbers with one simple insight: We are all Goldilocks. You can jerk us around to pay just about anything, so long as it's the middle of three options.

There are many fancy words for these sort of pricing schemes. The attraction effect. Decoy pricing. Decision heuristics. But it all comes down to this: People don't like feeling duped, and we don't like feeling cheap. So we gravitate toward middle prices because they seem "fair," in context.

So look for Netflix to introduce a pricing scheme that offers three options: (a) a cheapo discount with inferior access; (b) a "premium" product that costs more than the current $7.99; and (c) a "super-premium" product whose higher price will make the premium product seem tolerable. 

 

______________________

Rich Greenfield, analyst, BTIG Research: Can we move over to pricing? When you look at your long-term view statement, you actually removed the phrase I believe at some point over the last several months, simplicity is at our core. And there seems to be a change in your philosophy surrounding pricing. I think Reed, you had for a long time talked about the importance of keeping it simple with one price point. Wondering what's changed and how does that now play into the various tiers of Netflix that you're now testing and playing with?

Reed Hastings, CEO, Netflix: That's an interesting story. A friend of mine, I was preaching about simplicity, and a friend of mine pointed out that the simplest iPhone would have no applications but it wouldn't be a better iPhone. In fact, that was the iPhone 1 had no App Store. And that in fact great product is a combination of functionality and ease of use. And that simplicity wasn't always the best choice. And so through the conversations over the last year I think I've shifted away from simplicity to an end goal to simplicity as an input towards ease of use and towards matching functionality that people want. And so we've slightly are more focused on the best functionality independent of its simplicity and we of course try to make it as easy to use and we try to make our pricing as straightforward as possible, but it's not clear that one price fits all. We added the four screen program almost a year ago back in April of last year. And that's met our expectations in terms of the family take rate. So I think we're justified, we're willing to take on a slightly richer offering and realizing that that might be better for consumers and for us.

Anmuth (analyst): Reed, can you also comment on the $6.99 plan, who you're targeting with that offering and does it say anything in your view in terms of penetration and maturity in the US?

Hastings: We're testing lots of things. Some of it's been reported on, some of it's not. One of the things is the $6.99 one stream, I don't think you should read too much into that other then we're probing around the edges. There's no definite plan to do that. I would say generally as we put in the letter we're trying to figure out some models of good, better, best price tiering that makes sense and provide some flexibility for our customers, at least for our new customers. Our existing customers of course we would grandfather very generously.

Greenfield (analyst): When you look at the $6.99 plan, why does somebody who's willing to spend $7.99 -- why does $1 make a difference? Do you really think that there's that much impact from that $1?

Hastings: Well, Rich, of course at your income level, not to be too personal, it doesn't. But in going from 33 million US members to hopefully more than twice that, every bit of savings is important to people. And so we definitely look at those kind of factors. But again I wouldn't read too much into the $6.99 other than we're testing some things and we're continuing to try to figure out how to evolve to a good, better, best plan that makes sense to consumers and feels fair.

Greenfield (analyst): Any early elasticity learnings though you can talk to directly?

Hastings: Once we figure out what we think is the best plan, then we'll talk about that and why we think it is. But we're not specifically taking apart each option that we're testing.

David Wells, CFO, Netflix, Inc: The only thing I would add, this is David, the only thing I'd add on that conversation is just it's not only the question of elasticity and income levels, but in pricing theory there's also a sense that consumers make choices around heuristics. And so $1, Rich, might not sound like a lot on a logical basis but consumers may have shortcuts that they make they take the middle or the upper or the low and so that factors into the right course as well.

Anmuth (analyst): And if we think about it on the other extreme there's likely a large percentage of subscribers that would perhaps pay dramatically more for a Netflix service that had even more content on it. How does the Company address how they might reach that subset of members without risking the growth at lower prices?

Hastings: Yes, it's unlikely for us to be able to do that, Doug, because if we license the content it's almost always exclusive because the other licensors don't want us to have it in addition to them. So we have to pay the full not of getting an exclusive license. And so then that's tricky to say also build a $30 a month program that say has all the new releases or something like that. So I think we'll stick at what we're doing now and just continue to do it a little better year after year after year. And that's worked pretty well for us over the last eight quarters.

Jump to comments
Presented by

Derek Thompson is a senior editor at The Atlantic, where he writes about economics, labor markets, and the entertainment business.

Get Today's Top Stories in Your Inbox (preview)

The Remote Warehouse Where Confiscated Wildlife Ends Up

A government facility outside of Denver houses more than a million products of the illegal wildlife trade, from tigers and bears to bald eagles.


Elsewhere on the web

Join the Discussion

After you comment, click Post. If you’re not already logged in you will be asked to log in or register. blog comments powered by Disqus

Video

Where the Wild Things Go

A government facility outside of Denver houses more than a million products of the illegal wildlife trade, from tigers and bears to bald eagles.

Video

Adults Need Playtime Too

When was the last time you played your favorite childhood game?

Video

Is Wine Healthy?

James Hamblin prepares to impress his date with knowledge about the health benefits of wine.

Video

The World's Largest Balloon Festival

Nine days, more than 700 balloons, and a whole lot of hot air

Writers

Up
Down

More in Business

Just In