Netflix Shows Flaws in Marginal Pricing

Megan McCardle looked at Netflix/Qwikster and explains how the problem is a business model over reliant on marginal cost pricing. It's an object lesson that can be extended to, for example, health care costs.

[P]eople were confusing the marginal cost with the average cost. Content providers were willing to license their movies and television shows cheaply to Netflix as long as Netflix had a small customer base: it was extra revenue for the companies, and it was probably mostly substituting for DVD rentals, which they didn't make money off of anyway, so it was essentially free money.

You can get a sweet deal if you are the customer who gets marginal cost pricing. Medicare does this--reimburses hospitals at above their marginal cost, but below their average cost, so that private insurers have to pick up most of the hospital overhead. European countries do this with prescription drugs: reimburse above the marginal cost of producing the pills, but below the total cost of developing the pills, so that the US has to pick up most of the tab for drug development.

The problem is that as voters and as customers, we often get the notion that this can be extrapolated to everyone. So liberal policy wonks want to save money by putting everyone on Medicare, or some equivalent program that uses the government's monopsony pricing power to get lower prices for everyone; thrifty customers think that everyone should drop cable and just pay $14.95 for streaming plus DVDs.

But everyone cannot be the marginal cost consumer. Someone has to cover things like development costs.

That's the point that gets missed. Sure, living off marginal costs may work for a while, but eventually that R & D and infrastructure wears out and has to be replaced or replenished. We can only live off the work of previous generations for so long. No free lunch and all that. Eventually you have to pay to keep the same level of service.