Ahhhh Netflix. Nothing quite says “hangover sunday” like mindlessly watching 3 seasons of Friends in your closed-curtain sweat-den. The disruptive video streaming company quickly became a house-hold name in the early 10’s, expanding it’s reach further every year and demolishing cable conglomerates as it does so. With it’s growing capture of market share, the now multi-billion dollar company has been churning out original content since the 2013 debut of Political Drama “House of Cards” starring Kevin Spacey. The lineup of netflix original shows now includes dozens of heavy hitters such as “Orange is the New Black”, “Stranger Things”, and my personal favorite 1930’s Brit-Grit series “Peaky Blinders.” But how is it that their good:shit ratio is so much better than networks like AMC, NBC and too a much lesser extent HBO? There’s a little bit of out-dated business practice here, mixed with some interesting behavioural economics.
Netflix has one source of income. You. Well not you personally, but the collective you’s paying your $10/per month to enjoy their audio visual smorgasbord. Cable networks, on the other hand, make their money in two ways. Firstly, they charge you a subscription fee as part of your TV package. Secondly, and to a greater extent, they are paid by advertisers. A 30 second advert on a national network during a popular TV show can range from $50,000 for almost unheard of shows such as CW networks “Supergirl” to north of an eye-watering $400,000 for a 30 second slot during Fox’s “Empire”. Those these figures seem huge, Empire’s weekly viewer base of just under 5,000,000 means that advertisers are paying less that 10c to force-show you a 30 second video – I’m not an advertising executive, so can’t tell you whether this is money well spent, but we will assume so. Say you pay $2.50 per week (or $10 per month) to get fox, exclusively to watch Empire. The show itself has a 42 minute run-time, with 18 minutes of adverts. For the 42 minutes of runtime that entices the viewers to watch, Fox receives 5,000,000 * $2.50 = $12,500,000, with a cost of production of $3,000,000 netting the network a gross profit of $9,500,000, or $3800 per second. Advertising on the other hand, can rake in $14,500,000 in just 18 minutes – or approximately $13000 per second, more than triple what the show makes. Now, these numbers are loose, but you understand my train of thought. TV advertising is BIG MONEY and the networks want to keep their advertisers around.
When we watch an advertisement, over and over and over again, we begin to subconsciously relate it to it’s surroundings. For some brands, this can work in wondrous, for example Dyson Vaccums, High level make-up brands, and Diane Sawyers books were all advertised a long side “Desperate Housewives”, and sales soared due to their synchronous target demographics, in turn appreciating the “advertising real-estate” and making the network a packet. Now this is all well when the advertisers and producers want to convey the same message, but what happens when they don’t? If a show starts promoting ideologies and lifestyles that do not convey the same message as the brands advertised in the ad-breaks, advertisers can (and will) back out of agreements – costing the network hugely. This burden limits the kind of shows the traditional networks will risk producing, where as advertising-free Netflix can operate without this burden.
The next key difference between the two mediums is viewer retention. A network wants you to watch their channel, right now, in an hour, tomorrow, all the time. Regardless of what is playing. They want to be the most appealing network to the most people possible at any given time, even though they are only playing ONE SHOW. If you don’t like what’s playing, you just change the channel and they lose your viewership. This causes them to produce easy to watch content, that sits somewhere between “Two and a Half Men” and “Greys Anatomy” – I’m not saying they are bad, I am just saying they are widely popular, predictable and safe. Think of all the idiots you meet, all the terrible senses of humor and “instant gratification” that is now common place. Cable networks do not differentiate the tastes or quality viewers, only the number of viewers, and they always want more.
Netflix on the other hand has you in their clutches. If you are watching Netflix, and decide you don’t like what you are watching, you don’t go back to regular television and mindlessly channel surf, no, you find something else on Netflix and watch that instead. You never miss something, it’s always available. They have a much more captive audience than traditional cable channels, which allows them to cater to a much move varied audience, much more specifically. Series like the Pablo Escobar pseduo-biography “Narco’s” convey this point perfectly. It’s a high budget american-made series, that is 80% in SPANISH with English subtitles. If this was a network show it would be in English, without a doubt. Don’t believe me? The LifeTime series “Devious Maids” is about Latino maids, who speak almost exclusively in English. Spanish is only used to add emphasis and variety. A captive audience has allowed netflix to explore, hire creative directors, and get some highly compelling series made as a result. After all, Netflix is asking “Is this worth making” where as networks are asking “Is the the MOST worth making.”
Thanks for reading!
A key principle of microeconomics is that of market competition. This is essentially a question of barriers to entry, where industries with high barriers to entry generally have higher profit margins than businesses with low barriers to entry. On one end of the spectrum we have monopolies (eg Monsanto – seed & pesticide multinational) and on the other we have businesses in perfect competition (eg gas station or corner stores.)
As a general rule, we can say that businesses with less competition have more market power, giving them the ability to inflate prices, push margins, and can thus be more profitable. For this reason we can see why it would be beneficial for a business to decrease competition within its industry, and inversely, why it is beneficial for consumers for company market share to be limited.
Not necessarily a brand name you know, but you likely own something which they produce. In the late 1980s Luxxotica began purchasing the rights to produce sunglasses for luxury brand names including Armani, Oakley, Ray-Bans and literally dozens of others. In the early 2000s it was estimated that Luxxotica controlled up to 80% of the sunglasses market, although this exact number was questions by Euromoniter, the world’s largest business monitor, who disagreed with this saying they only controlled approximately 10% of the world’s 950 Million pairs of glasses produced annually. Though their is some ambivalence and secrecy about the exact market share of Luxxotica, what is clear is that they are the largest producer in the market by a measure of magnitude, which can lead to price gouging – especially in areas where consumer demand is not flexible, such as prescription glasses.
In the past week it was announced that Luxxotica has planned $49Billion merger with Essilor, a French lens manufacturer. Normally, business mergers like this are commonplace, as both companies can take advantage of the synergy between the two businesses – which make the businesses more valuable to each other than they would be to a non-related business. In this example Luxxotica benefits by receiving cheaper lens’ (and thus increasing profits) and Essilor benefits by becoming the go-to lens manufacturer for Luxxotica, no doubt also increasing their profits. Here are some numbers which explain the idea:
For a non-related company:
Company value = annual profit / % required return
Essilor Value = 5B/12.5% = 40B
For a company with synergy:
Company Value = (annual profit / % required return) + (annual value of synergy)/%required return.
Essilor Value = 5B/12.5% + 1B/12.5% = 48B
Though these synergy-mergers make a lot of sense, when you start dealing with companies of this size consumers can come out significantly worse off. Over the next 6 months the two companies both require regulatory approval, as well as shareholder approval. Largely this will rest on whether the companies are doing this to increase market size, and thus gain pricing leverage, or if they can indeed prove that synergy exists between the two companies to an extent where shareholders will benefit without significant pricing increases to consumers. So who knows, this time next year your Ray-Bans may no longer bare the Luxxotica mark, but rather the EssilorLuxxotica mark. Thanks for reading.
The year is 1896, somewhere in western Europe an Italian economist by the name of Vilfriedo Pareto is tending to his garden, and notices a pattern. Pareto’s peas follow an unequal distribution, with a small portion of the plants producing the most peas, while the rest produce very few. This small observation of a seemingly meaningless pattern would lead to Pareto’s name-sake discovery and become one of the most popular theories in modern economics. Though he is a life-long academic with published papers in Mathematics, Engineering and political science, it is in his 50th year that he will publish his masterpiece – simply titled “Cours d’économie politique” or “Course of Political Economy.”
Pareto’s paper, inspired by the distribution of his peas, looks into the distribution of land ownership in Italy, and finds that approximately 80% of the land is owned by 20% of the people. Pareto’s peas also followed this 80/20 split, and he began to see it everywhere. Pareto’s discovery boils down to a simple idea: 80% of the results come from 20% of the actions, or more accurately, 80% of the effect comes from 20% of the causes. Though this law may be explained in some part by Capitalism and the structure of modern society, it does indeed appear a lot in the natural world, leading Pareto to believe that this is not only a law driven by man, but an underlying principle of the universe itself. We can observe Pareto’s law in many situations such as:
People spend 80% of their time with 20% of their friends.
Businesses earn 80% of their profits from 20% of their customers.
20% of the population uses 80% of healthcare.
This “snapshot” of economic principle seems like it may just be an observation, and not something that would cause a change in behaviour. Pareto, however, saw beyond this and realized that his 80/20 principle has profound implications for efficient resource allocation. He knew that by tending to his 20% of peas more carefully, he would increase his crop more, and with less effort, than if he were to put the time and effort into tending more to his 80% which are not producing well. He applied this principle to production, as will be explained below using the classic “Butter vs Guns” example.
The above graph is to do with production of goods in an economy. For simplicity sake we have said that the economy only products 2 goods – Guns and Butter. Point B shows a position where all productive capacity is utilized, but a lot of guns are being produced, and very little butter is being produced. As we do not know the relative demand for these goods, we can not say whether this is a bad or good thing, we can however say that it is efficient as all productive capacity is utilized. Likewise, we can say that points D and point C are also both efficient for the same reason. Point A shows a point where more guns than C are being produced, and more Butter than A is being produced – the point is still inefficient though, as at point D more of both are being produced. In essence, the economy can not be internally made more efficient by moving along the blue line, though it can become more efficient by moving from a point within the blue line to a point on the blue line. A shift in productive capacity (more goods can be produced with the same amount of input) would result in the blue line expanding outwards, this is a key goal of any economy. Keep this in mind as we move onto the next section.
OK – maybe I am terrible at explaining things, but if the last part confused you, feel free to skip this next section – things are about to get confusing.
Above we have what is called an Edgeworth box, an idea actually developed before Pareto’s law, but in the context of mathematics, and not economics. Firstly look at our blue-lined graph in the previous section. As discussed earlier, the idea is to expand the blue line outward, while remaining at an efficient point on the blue line. In the above Edgeworth Box the black lines represent the productive capacity of economy A, and the red lines represent the productive capacity of economy B. The idea here is we are trying to redistribute the initial endowment of resources (point q) to a point where no-one can be made better off without making the other party worse off – or as I like to think about it, we are looking for win-wins, or at least win-indifferent. The natural solution for this occurs where the two lines are tangent, as neither party has a trade-incentive where they could be made better off. Make sense? Maybe not really but I will pretend like it did.
In Pareto’s eyes, there was two basic principles behind this – efficiency and allocation. In a business setting, it is always a task to motivate employees to reach their productive capacity (and thus operate on the blue line as seen in graph 1). This is normally seen as the “obvious” way to increase business productivity, and thus customer and client satisfaction. I would propose that this traditional idea of business is flawed, and perhaps effective allocation of effort is just as important as maximizing output. By a business refocusing from “busy work” that is in the inefficient 80% of activities, I would encourage the profit making 20% to be area in which 80% of the effort is assigned. Maybe it’s unnecessary paper work, worthless procedures, company tradition, or just those low-profit customers who take up all your time but likely you need to re-think your time allocation. Think of Pareto, his peas, and his crazy italian beard next time you tell that customer to take a hike and stop wasting your time. You’ll feel better for it knowing there is less on your plate, and you have made your activities more Pareto Efficient.
Thanks for reading!
For lunch today I went to the Winn Dixie by my work, and purchased at whole rotisserie chicken for $5. As far as value/deliciousness ratios go this one is pretty high up there right along side $2 fried rice, and at the complete other end of the spectrum from $750 caviar & lobster tail pizza. I love these chickens, rip that bitch up, throw it in a roll with some mayo and I am happy. That being said, the math on these just somehow doesn’t add up. I pay $8.99 for a fresh whole chicken, but for $4.00 less I can have the entire chicken, seasoned, cooked & ready to rock. Does it really cost less than $5 to raise a chicken from egg to oven – or is there some business trickery at play here?
The most basic form of business is buy/making something, and then selling it for more than it costs you to make. Simple simple. How businesses define this pricing can vary including:
Wholesale a good costs x, so we sell it at x + 50%.
Let’s look at what our competitors are selling it for and then match/beat them.
What is the benefit the consumer gains or punishment the consumer avoids by buying this.
The chicken finds itself falling into the benefit/cost pricing category, but maybe not in the way you would think. The bane of American supermarkets is wastage, with an estimated 30-40% of food produced never being consumed, supermarket wastage not only drives prices up, but ethically stretches earth’s resources more than necessary increasing pollution and waste.
The key to this argument is that rotisserie chickens are NOT a profit generating venture for most supermarkets. They are, however, a loss reduction strategy. Take these numbers for example:
A supermarket buys a whole chicken raw for $3.00, and spends $1.00 worth of labor time receiving and placing the product in their store, they then in turn sell the chicken for $8.99, for a clean $4.99 profit. This is the best case scenario.
Except it’s not the only situation. What if this fresh chicken doesn’t sell? Fresh chickens have a life span of about 5 days where they can sit in the cooler and be available for sale. Once these 5 days are up the supermarket either trashes it, OR cooks it, extending the life by another 3-4 days.
The chicken is not sold, and has 1 day left before it turns bad. Time for baste it, stick it and put it in the rotisserie! For a labor, electricity and packaging cost of $2.00, the supermarket can then sell their chicken for $5.00. It make sense for them to spend $2.00 to gain $5.00, rather than do nothing and lose the initial $3.00. This now cooked chicken is hot and ready to go for consumption, this state preserves it for a day or so, then it gets moved down the line and onto:
The Deli. You want some chicken potato salad? Yeah that chicken in there is quite literally the stuff they would have thrown away if you didn’t come and buy it. Oddly enough this is some of the highest margin products in the store, made largely using products that are at the end of their life.
Anyway, I have the 2nd half of a chicken to get through, so I will leave it there! Thanks for reading.
Publicly provided Healthcare is always a point of contention, especially around election time. Being from New Zealand, I am used to being mostly looked after by the Government. Recently I was involved in a discussion about the costs of taking an Ambulance to the hospital.
In New Zealand, the maximum amount St. John will charge for an Ambulance is $98. St. John is 80% tax-payer funded, with the remaining 20% funded via their near monopoly on First Aid courses, public donations & usage fees. Great, most people would agree that a cheap ambulance ride is a good thing, after all, tax paying residents should be looked after by their Government. No real room to be too badly hurt by this, the Government has got your back – or in Economist speak – Almost all those who demand an Ambulance ride, will be supplied one. Shown below:
As we can see, the supply without subsidy means that the price is high + the quantity demanded is lower.
However, once the subsidy is introduced, the quantity consumed increases, along with the price decreasing. Easy solution, and MOST people are happy.
Our nearest neighbours, Australia, have a similar take on Ambulances, but different mechanism for enforcing it. In Australia, Ambulance services are somewhat subsidized, but not to the extent that New Zealand is. Many aspects of general Ambulance use are heavily subsidized, however, more specialized emergency treatments are not. This means that your Ambulance ride can cost anywhere from $300 to $12,000 with the average cost being in excess $1200. For this reason, it is highly recommended that you have private ambulance insurance – which can cost as little as $100 per year. Let’s have a look at how we can represent this graphically.
As we can see here, if you are insured, you pay the cost of the insurance & the insurance company covers the rest (the difference between your deductible & the actual cost). Demand is essentially the same as the fully subsidized New Zealand solution. Unfortunately, this is not the only situation available in this economy – we haven’t yet represented those who do not have insurance. The downward slope in the demand curve shows that as price decreases, less ambulance rides will be demanded – and vice versa. Ambulance rides do not stick to this standard graph though, as they are often required & will be used regardless of the price. This causes the Demand Curve to be vertical as shown next.
Here we can see, the price is high (think that $12,000 fare) but it is still demanded – this is because often the riders do not have a choice, it is literally life or death! The rider may end up pissed off about being charged so much, but the $100/year they have saved by not having insurance has moved them from the last graph to this one, and in turn, caused them to get burned by the high cost.
This demand situation only really exemplifies those who are in dire need of an ambulance – and can not go without it. This isn’t always the case though, broken bones, burns, more minor accidents may often leave the victim wanting to use an ambulance, but maybe not needing it. This has the interesting effect of the severity of the injury altering the individual demand curve on a case-by-case basis, and only when the financial and physical pain of not getting an ambulance outweigh the financial and physical pain of getting an ambulance then the individual will “bite the bullet” and dial 911/111 whatever. The rest will either suck up the pain & drive themselves, get a mate to drive them – or even dial an Uber, much to the dislike of the driver in this case (fair enough).