Question

Streaming platforms such as Spotify, Hulu, and Netflix, face a particular challenge when setting an optimal price for their service. They want to charge a monthly fee that a consumer pays and in return receives unlimited streaming of everything in their catalog (music, movies, shows).

(a) Why do you think they prefer this approach rather than charging a price per song (or movie or an episode of a series watched)?

(b) Suppose a typical consumer’s inverse demand for Netflix is given by P = 0.56 − 0.0112Q where Q is number of hours of streaming content per month. Let’s assume that the marginal cost of adding another subscriber to Netflix is zero. How much should Netflix charge for a monthly subscription?

(c) What is the name of this pricing strategy? Why does it work here?

Answer 1

a) The companies charge a monthly fee, and consumers receive unlimited streaming, as per their plan chosen. Companies prefer this strategy because it gives them a stable and predictable source of revenue. In a pay-per-use type of approach, it is quite possible that consumers will consume much less, and there will be no way to retain the consumer. In a subscription model, consumers are tied to the company, they use more of the services, and will be more loyal in their usage.

b) Now, P = 0.56 − 0.0112Q and MC = 0

Here, equating P = MC

0.56 - 0.0112Q = 0

0.56 = 0.0112Q

Q = 50 hours

Thus, a typical consumer will stream for 50 hours every month, if price is set to zero. However, this will lead to zero profits as well. Thus, the company cannot follow a marginal-cost pricing.

It has to follow profit maximization, as under:

Now, from the demand curve, obtain the total revenue curve by P*Q

TR = (0.56 − 0.0112Q)*Q

TR = 0.56Q - 0.0112Q2

Thus, MR = 0.56 - 0.0224Q

Now, equate MR = MC

0.56 - 0.0224Q = 0

0.56 = 0.0224Q

Q = 25 hours per month

At this quantity, profit per customer will be maximized for the company

Placing this value in the demand curve:

P = 0.56 − 0.0112Q

P = 0.56 − 0.0112(25)

P = 0.56 - 0.28

P = $0.28 per hour

The company should charge a monthly subscription as per the profit maximization strategy:

Monthly charge = 25 hours X $0.28 per hour

Monthly charge = $7 per month

With this price, the company can be assured that profits are maximized.

c) This is a profit maximization pricing strategy. There is a markup added to the marginal cost.

Only this strategy will work here, because marginal cost is zero. If price is set as per marginal cost, users will stream too many hours, and the company will receive nothing in return.

The company has to set a balance between usage by consumers, and earnings by the company. Thus, it decides the profit maximizing quantity, and then sets a price as per maximum williingness to pay. This maximizes profits.