A year ago Netflix CEO Reed Hastings was being lauded as a “Businessperson of the Year” by Fortune.  Today, Netflix investors are furious with Hastings – so much so that he openly admits fearing they may poison his food.  The reason?  Losing 800,000 customers in a single quarter.  So, how did that happen?  Opinion givers seem to fault two basic decisions: increasing prices 60% and attempting to spin-off a portion of Netflix into a new company, “Qwikster”.  While the Qwikster debacle has some impact, as economists we can’t help but focus on the impact of a substantial price change, which has enraged Netflix customers.  In economic terms, it seems Netflix failed in assessing the demand elasticity for their products.  Er… elsati-what?  Let us explain.

Demand elasticity is an economist’s way of describing (and measuring) how responsive consumer purchases are to price changes.  Simply put, elasticity measures the “quantity” change expected from a given “price” change.  If demand (e.g., the quantity purchased by consumers) is very responsive to a price change, we say demand is “elastic” (e.g., a 1% price change causes a GREATER than 1% quantity change).  If demand is not very responsive to a price change, demand is “inelastic” (e.g., a 1% price change causes a LESS than 1% quantity change).  The measure reflects the impact of numerous demand factors, such as competitive conditions of the industry (the availability of substitutes like Hulu and Redbox), current economic conditions (like being in a recession), and even consumers’ emotions.

So, how do we interpret the Netflix debacle?  It seems Netflix likely did NOT appropriately measure demand elasticity when deciding to increase prices 60%.  One survey by Wedbush Securities indicates that, as a result of the Netflix price increases, “22 percent [of Netflix users] planned to cancel their Netflix subscriptions and migrate to Hulu, Redbox and Amazon’s streaming video service.”  While this survey suggests demand for Netflix subscriptions to be inelastic (a 22% quantity change is less than the 60% price change), as an economic consulting firm we have a hard time believing this implication based on current demand conditions – particularly the existence of numerous alternatives (aren’t On Demand, iTunes, and Blockbuster alternatives here too?) and the poor condition of the current economy.

The bottom line is customers actually seem quite sensitive to price changes in this market and whatever figures Netflix used to estimate the responsiveness of customers to a 60% price hike – they seem to have gotten their economic analysis wrong.