Why 'Netflix with ads' makes no sense

At time of writing, Netflix’s Standard plan costs 15.49 USD, while its Standard with ads plan costs 6.99 USD. The difference between those prices is 8.50 USD; it costs more than twice as much to watch without ads.

What’s the math on that one? Advertisers are estimated to pay up to 50 USD per thousand ad views. That’s five cents per view. In 2019, the average Netflix viewer watched about 2 hours per day—this number went up in 2020 during quarantine, but has likely come back down since. With the service showing 4 minutes of ads per hour and a rough estimate of 20 seconds per ad, we can expect the average viewer to watch 24 ads per day. Over 30 days, that’s 36.00 USD of ad revenue from a single subscriber.

If ads are so profitable for Netflix, why do they charge at all for their ad-supported plan? Or, alternately, why don’t they charge $42.99 per month for their ad-free plan?

It’s because pricing has very little to do with math.

Economics 101: a for-profit company wants to sell its product to each customer for the maximum price that customer is willing to pay, even if it’s not the same as other customers. As long as the price is higher than the cost of production, it’s better to sell than not. Sellers try to achieve this (imperfectly) using price discrimination, a term for any strategy that sorts customers into different categories and charges a different price to each category.

Price discrimination is everywhere:

• Many stores send out coupons in their weekly mailer. Customers who have high price sensitivity (that is, they decide whether or not to buy something depending on its price) will clip the coupons and bring them in to save a few bucks. Customers who aren’t price sensitive usually won’t go to the trouble.
• Some stores white label products from popular brands, slapping a store-brand label on them and selling them for a discount. They won’t tell you which products they’ve done this to, but if you get the same results out of Kroger detergent and Tide detergent, or find that Target’s Good & Gather pickles are suspiciously similar to Vlasic, there’s a chance the big brand is actually manufacturing both—the store brand just costs a lot less.
• Stores sell products in various sizes and degrees of quality to try to capture every customer’s ideal price point.

From the moment you enter until you pay at the register (or close the browser window), you’re swimming in a sea of price discrimination. There’s no escaping it.

Netflix wants price discrimination. They want it so, so bad. Streaming video has an ultra-low cost per customer; they can make a profit charging one dollar per month or 50, so they’re up at night trying to figure out how to charge you exactly as much as you’re willing to pay. If they thought they could persuade you to connect your bank account so they could see how much spare cash you have, they’d do it in a heartbeat. But until that particular dystopia takes hold, they’re stuck with blunter methods. Their strategy up through 2022 was to offer higher-quality video on more expensive plans. Now they’re going the opposite direction: by offering a dirt-cheap plan to people who are willing to put up with ads, they’re creating yet another tier of price discrimination (and double-dipping by selling your attention to advertisers). They know they could get a few more subscribers by offering a free tier—but by their reckoning, a majority of the price-sensitive group is willing to pay $6.99 a month, and they’d rather die than leave that $6.99 on the table. Plus, if you get hooked on a show on a different service (or take up canoeing or something) and don’t watch any Netflix for a month, they still get your monthly fee for doing literally nothing.

The only way to beat a price discriminator at their own game is to price-discriminate yourself, independently. Let’s start with this: say you’re settling in for a quiet night at home and your choices are to watch Netflix or nothing at all. Imagine they’re charging per day instead of per month; what price for a single night of Netflix access would put you on the fence between paying and not paying? I know I’d pay 50 cents without question, but $8 would be too steep unless there was something I was really dying to watch. At $5 I’d hesitate—I’d need to have a block of uninterrupted time scheduled and know for sure what I wanted to watch. The on-the-fence price on a normal Tuesday is probably about $2. “That’s $60 a month,” you might say. “That’s ridiculous.” Yeah, but I don’t watch Netflix every day. Some months I barely watch it at all. I probably average two nights a week; that comes out to $16 a month. And hey, that’s about the price of the Standard plan without ads.

You could make an argument for a lot of different prices here. We don’t value all our entertainment the same. I’ll pay up to $15 to see a two-hour movie, or $20 for a video game that may keep my interest for 20 to 30 hours (I always wait for a sale—price discrimination in action). At the top end of the scale, I paid about $150 to see Hamilton: The Musical, which is only three hours long. And at the bottom end, I won’t go to a hockey game unless I won free tickets in a raffle.

So how much is an hour of entertainment worth to me? Somewhere between 0 and 50 dollars. If I watch 16 hours of Netflix in a month, you could argue that’s worth up to $800. But let’s be real, nothing on Netflix will ever live up to a five-star Broadway show—and I won’t even pay to watch Broadway more than once a year. I stand by my earlier calculation: Netflix is pushing its limits at $15.49 a month. My wife and I are already debating whether to cancel our subscription.

Still, it’s almost certain another price increase is coming. Raising prices is the easiest way to get more money without doing more work. And most people will pay up as long as it doesn’t happen too often. That’s the secret ingredient in pricing, and also the only ingredient: psychology. If you charge what people expect, they’ll pay it. And if you put them on a subscription plan where they pay that amount so often it becomes routine, you can raise prices year after year without too much fallout.

Is Netflix destined to overplay its hand at some point, raising prices to the point where most people will bow out? Well, maybe. Netflix doesn’t compete in an open market. If Chevron decided to charge 50 bucks a gallon for gas, you’d just go to Shell or Texaco instead. Gas is gas. But if Netflix decided to charge 50 bucks a month for streaming, you couldn’t get all the same shows on Hulu or HBO Max. You’d have to give up Breaking Bad, Stranger Things, even Warrior Nun. Netflix doesn’t have a (horizontal) monopoly on streaming entertainment, but they do have a (horizontal and vertical) monopoly on several TV shows.

^{Of course, you could buy the box set of any show you care about, but who knows how to use a DVD player anymore?}

This gives them a lot of market power. They don’t have to compete with Hulu because they don’t sell the same products, despite being in exactly the same product category! It’s undeniably a raw deal for consumers. If Netflix were only a distributor, not a multi-billion dollar TV studio that happens to sign exclusive distribution deals with itself, you’d have multiple choices of where to watch the latest hit show. The streaming services would have to actually compete. Maybe there wouldn’t be so many of them. Maybe one of them would actually be good. But since everybody’s decided to do things Netflix’s way, we now have the privilege of trying to figure out which of 15 streaming services deserve our monthly TV budget, and the decision is not based on their literal product (software) but on their market power (content library). They get everything they want, and we get almost nothing.

Even so, there is a limit. Price-raising and cost-cutting always go too far, it’s just a matter of when. At some point the software will become unreliable, the price will become a burden on the average person’s budget, the content studio will run out of luck, or a new form of media consumption will rise up. Maybe DVDs will make a comeback?

Until then, it’s all psychology.