Netflix Is Caught Between a DVD and a Hard Place

Megan McArdle is a Bloomberg View columnist. She wrote for the Daily Beast, Newsweek, the Atlantic and the Economist and founded the blog Asymmetrical Information. She is the author of "“The Up Side of Down: Why Failing Well Is the Key to Success.”
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Everyone knows that Netflix Inc.'s DVD-by-mail service is a sort of transitional phase between the bad old days and the glorious future. Like the socialist state, it was eventually supposed to wither away when the era of plenty arrived. By 2011, every other article I read on the Internet seemed to describe how the author was "cutting the cord," getting rid of cable television in favor of streaming movies and television on Netflix and Hulu. Usually, this was followed by exhortations for readers to do the same and teach those cable companies that they can't charge such outrageous prices for their content. Stupid cable companies! Netflix will show them!

This was, of course, just about the time that Netflix started running into some trouble. There was the ill-fated attempt to relaunch its streaming service as Qwikster. Then it lost its deal with Starz, which had provided most of the best bits of Netflix's movie library. As time wore on, more of its content deals have expired and not been renewed. Its movie library is no longer actually a good substitute for a good movie rental place. It's a place to catch up on television shows, and you can generally find a movie you're willing to watch. But as Felix Salmon astutely notes, Netflix is no longer where you go to find something great -- it's where you go to kill some time with whatever it has available.

Once upon a time, when a movie came out and garnered good reviews, you could add it to your list, long before it was available on DVD, in the knowledge that it would always become available eventually. If you're a streaming subscriber, however, that's not possible: if you give Netflix a list of all the movies you want to watch, the proportion available for streaming is going to be so embarrassingly low that the company decided not to even give you that option any more. While Amazon has orders of magnitude more books than your local bookseller ever had, Netflix probably has fewer movies available for streaming than your local VHS rental store had decades ago. At least if you're looking only in the "short head" -- the films everybody's heard of and is talking about, and which comprise the majority of movie-viewing demand.

So Netflix has been forced to attempt a distant second-best: scouring its own limited library for the films it thinks you'll like, rather than simply looking for the specific movies which it knows (because you told it) that you definitely want to watch. This, from a consumer perspective, is not an improvement.

What's more, with its concentration on streaming rather than DVDs by mail, Netflix has given up on its star-based ratings system, and instead uses what it calls "implicit preferences" derived from "recent plays, ratings, and other interactions". Again, I'm not sure this is an improvement -- but it does fit in a much bigger strategic move chez Netflix. While Madrigal and I might still think of Netflix as an online version of your old neighborhood Blockbuster Video store, Netflix itself wants to replace something which accumulates many more viewer-eyeball-hours than Blockbuster ever did. It doesn't want to be movies: it wants to be TV. That's why it's making original programming, and that's why the options which come up on your Netflix screen when you first sign in are increasingly TV shows rather than movies.

One huge difference between TV and movies is that audiences have much lower quality thresholds for the former than they do for the latter. The average American spends 2.83 hours per day watching TV -- that's not much less than the 3.19 hours per day spent working. And while some TV is extremely good, most of it, frankly, isn't.

The problem is rights. Old-fashioned video rental stores, and Netflix's DVD-by-mail service, are governed by something called "first-sale doctrine": Once I sell you a physical copy of a movie or song, you can do whatever you like with the physical object, except copy it or show it publicly. The Walt Disney Co. cannot prevent you from lending or renting your copy of "Cinderella" to anyone you like; it got its money from the sale, and now it's none of its business to whom you pass it on.

But streaming is governed by a different set of rules for digital content. You can't stream a movie to someone unless the rights holders have agreed to let you do so. And the rights holders have no interest in helping Netflix kill Comcast Corp. and Time Warner Cable Inc. -- not when Comcast and Time Warner Cable, or the networks they carry, are paying them a ton of money for rights.

Essentially, Netflix cannot afford to buy the rights to all the movies you want to watch. They got pretty good deals back when they were small, precisely because they weren't yet much of a threat to the cable companies. Starz was willing to ink a deal to let Netflix carry its content because digital streaming to a few customers cost Starz nothing, and it even brought in some revenue. But when people started talking about using Netflix to drop cable, Starz was no longer willing to share its licenses -- at least, not unless Netflix paid Starz enough to replace the revenue it would lose. And the only way that this would work for Netflix is if you paid a lot more than $7.99 for your subscription.

I can make an argument that you should be willing to pay more than you were paying for premium cable -- that the ability to watch movies on demand is extremely valuable, and you should therefore be willing to shell out extra money to enjoy it. And maybe if Netflix had been rolled out as a cable add-on, that's how it would have happened. But Netflix trained its customers to think that the Internet was supposed to deliver them something better than a premium cable subscription, at maybe a tenth of the price. It would have a very hard time moving people to a much higher price point, and it wisely hasn't tried. Instead, it's trying to optimize its service for much less content.

There's no great loss without some small gain; I've kind of enjoyed rediscovering some of the better 1980s miniseries. (Think"The Winds of War," not "North and South.") But the other night, my husband and I were remarking that we may have to go back to using the DVD-by-mail service for movies. And I wonder if we aren't going to be stuck with that model: streaming for idle watching, but if you want something specific, you'll need to order and wait. In other words, I wonder if the golden era of streaming is not ahead, but already behind us.

That's both good and bad for Netflix. On the one hand, all those warehouses are expensive to maintain and staff, compared with a website. On the other hand, they have a phenomenally high barrier to entry. You can imagine an upstart coming in and beating Netflix at streaming. But it's hard to imagine another movie rental company building a parallel network of massive distribution centers on the off chance that it might be able to knock out the incumbent.

Eventually, of course, some new streaming model will shake out, and DVDs will go away; I doubt our great-grandchildren will still be getting DVDs in the mail a hundred years hence. But in the meantime, the paucity of cheap digital rights may save a lot of jobs in Netflix warehouses -- and may even bail out that other struggling giant, the U.S. Post Office.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

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