Netflix Makes An Economic Faux Pas

Aug.23.11 | About: Netflix, Inc. (NFLX)

Netflix (NASDAQ:NFLX) has been a tech favorite for almost 3 years. The company has had everything working in its favor, including patents that were blocking competition. Netflix, however, made an economic faux pas when it raised its prices for the second time in under a year.

Not only is the stock itself overvalued, but the monopoly it once had through patents is about to be washed away as technology advances.

The claim to fame for Netflix started with the basis of renting DVDs. From your computer you could rent as many as you like for only $7.99 a month. For individuals like me it was genius, I was tired of spending $80 on box sets, so $7.99 a month allowed me to reallocate roughly $72.

At this point in time they had no competition to speak of and had already secured both a business model patent and a DVD mailing envelope patent to help block competitors. The final and largest patent came in 2006 when Netflix was awarded a patent for "renting DVDs through the mail".

Flash-forward to 2011 and DVDs are starting to fall by the wayside. Streaming is the next big advance in technology; Verizon (NYSE:VZ), Comcast (NASDAQ:CMCSA), Shaw (NYSE:SHAW), Apple (NASDAQ:AAPL), Google (NASDAQ:GOOG), and Amazon (NASDAQ:AMZN) have all started moving into this particular market.

So, what was the economic faux-pas? The answer is, "Contestability Theory" as stated by William Baumol. Essentially what this theory states is that firms in competitive markets that act like a monopoly, Netflix in this case, will price itself as though it is in competition to avoid competitors.

In other words, as long as Netflix keeps the subscription price low the other companies will avoid trying to compete with Netflix because it will be too costly.

Now that Netflix has raised its prices it will soon face competition from much larger companies with much deeper pockets to bid for new release titles to stream. If the other companies secure streaming titles for new releases and keep the subscription costs within $5 of Netflix I can imagine a mass exodus from Netflix to these companies.

Netflix should have fought tooth and nail to keep the prices low. I understand that bandwidth is expensive, but if Google starts a streaming service with a better selection of titles, then Netflix will only be able to compete with DVDs by mail, and according to contracts made with movie studios they must wait 28 days before they can mail new titles. So, the "Netflix Killer" that many have been looking for may simply be advances in technology and rising costs.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.