Game Theory and the Online DVD Rental Market
Introduction
This paper explores the application of Game Theory to the Online DVD Rental Industry.
At approximately five years of age, the Online DVD Rental industry is a young industry, and is
therefore still in the growth phase of its lifecycle. The dynamics of the industry are changing
rapidly and the industry is finally seeing entry of new players, a trend we expect to continue.
Because of its rapid rate of change, the Online DVD Rental industry provides fertile ground for
many game theory situations to arise. Signaling, in particular, plays a rich and potentially pivotal
role in markets marked by such rapid change. Throughout our discussion we will point out
various players’ attempts at signaling and the resultant effects on the market. We will primarily
explore these game theoretic issues from the perspective of industry pioneer, NetFlix, but where
applicable, we’ll address the perspectives of Blockbuster and also potential rival, Amazon.
We start with assumptions and a brief background of the Online DVD Rental Industry.
Then we present the current competitive situation, and by developing a payoff model for industry
participants, describe how the industry evolved. Building on that foundation, we’ll provide
possible explanations for the behavior of current industry participants and go on to analyze
potential threats to the industry. We’ll conclude with our predictions for the effect of new
entrants on the industry and propose recommended actions for NetFlix.
Assumptions
In the following sections, we analyze the game-theoretic aspects of the Online DVD Rental
Industry and seek to understand how the industry evolved into its current state. In order to
perform the analysis, we developed a payoff model for each of the players. Our analysis going
forward is predicated on the following assumptions.
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Game Theory and the Online DVD Rental Market

For simplicity, we consider the US Online DVD Rental Market only. In doing so we
recognize there are international components to some of our players’ strategies, but we
expect these to have a negligible effect on our analysis.

We consider only the “all-you-can-eat” plans which allow unlimited monthly rentals for a
fixed monthly fee. These are by far the most popular plans. Although other plans and
pricing options have become available as of late, they are not considered.

For our first set of games we only consider NetFlix v. Blockbuster, since they are the two
largest players in the US market.
o We ignore extremely small players. These players are statistical outliers and are
unlikely to have a large influence on the overall market. Wal-Mart, for example,
provides an Online DVD Rental service but its customer base and growth rates
are negligible in comparison with Netflix. Further, we feel there is minimal
overlap between Wal-Mart’s customers and those of NetFlix and to a lesser
extent, Blockbuster.

We assume that participants are trying to maximize long term value of their online
operations.

We use NPV as a measure of company value. This assumption is reasonable if the
participants are trying to maximize long-term value.

We compare only companies’ online units to each other. Therefore, we compare NetFlix
to Blockbuster’s online unit, but we do not consider the effect of NetFlix competing with
Blockbuster as a whole.

We assume the maximum size of the Online DVD Rental Market is approximately 20
million customers. This estimate is based on estimates from multiple sources.
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Game Theory and the Online DVD Rental Market

Whenever possible, we use actual cost or other financial data. When such data is not
available, we derive our numbers using comparables.
How It Came To Pass – Industry Background
The Online DVD Rental industry was launched in 1999 with the founding of NetFlix by
Reed Hastings. Mr. Hastings was frustrated by late-fees for movie rentals at his local
Blockbuster. A busy professional, he rarely had the time to view and returns movies in the
allotted time and realized that other busy professionals faced a similar predicament. Mr.
Hastings created a service that allowed customers to rent DVDs online and receive them through
the mail, charging no late fees for prolonged rental periods. NetFlix launched with a “pay-perview” model where customers paid for each rental, sans late fees. From the outset, the company
experienced marginal success with this model and Netflix’s long term viability was in question.
The value-add of Netflix was not great enough to counter the strength and convenience of
Blockbuster. Customers perceived few if any cost savings from using NetFlix and were irritated
by the wait times resulting from postal delivery. NetFlix therefore discovered its customers had
a lower willingness to pay than Blockbuster’s customers and that it had to find a means to
compensate them for the inconvenience of using an online service.
After some experimentation, NetFlix innovated the “all-you-can-eat” model where
customers enjoy unlimited rentals for a fixed monthly price (initially about $20 per month). This
model proved to be wildly popular and NetFlix soon attracted scores of subscribers, many of
whom formerly rented from Blockbuster. By mid-2004, NetFlix, flush with confidence over its
rapid growth, raised prices for all subscribers to $22/month. Customer churn didn’t accelerate
appreciably, as would be expected in the absence of any other comparable online competitors.
NetFlix’s success did not go unnoticed however by the traditional video rental industry, and
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various small competitors began encroaching on NetFlix’s turf. In particular, the rising star of
NetFlix caught the attention of Blockbuster, the 800-pound gorilla of the video rental business.
Blockbuster purchased a small NetFlix competitor, FilmCaddy.com, in 2002. It used this
acquisition to study the online rental model for two years, to fully prepare for its market entry in
late 2004. As of early 2005, NetFlix and Blockbuster together represented the largest portion of
the Online DVD Rental Market.
With the entry of Blockbuster, NetFlix faced
its first true competitor. While trying to resolve how
to respond to Blockbuster and the level of threat it
posed, NetFlix was assaulted on another front –
Amazon announced it was considering entering the
market. With one formidable competitor, NetFlix
was still cool, calm and collected, but with two
potentially large competitors, NetFlix sprung into
action and cut prices. From all indications, NetFlix
is more threatened by the entry of Amazon, than the
entry of Blockbuster, most likely because its
customers are more similar and Amazon has
potential cost advantages in customer acquisition.
Hence began the grab for market share, precipitated by the Amazon announcement and
initiated by NetFlix’s price cuts. Blockbuster responded to NetFlix’s drastic moves with two
rounds of price cuts of its own ultimately arriving at $14.99 to maintain its discount relative to
NetFlix. This then brings us to the present situation of a price war between NetFlix and
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Blockbuster. We will next examine the effects such a war has on its players and potential
rationale for its occurrence.
A Look Under the Hood – The Online Rental Business
Model
Before delving into an analysis of the current price war in the Online DVD Rental
industry, it is essential to understand the business model of the online rental space and a few of
the unique attributes of our two players, NetFlix and Blockbuster. Until very recently, this
industry boasted robust margins; about 50%. However, with the current downward price
pressure generated by the market share grab, gross margins decreased to around 38% and are
expected to move even lower in the near future.
One of the first things to note in reviewing the online business model is that the primary
cost drivers for fixed costs are the acquisition costs for the movie library, about $100 MM for
40,000 titles, and setting up distribution centers around the nation, about $30 MM for the first
year and $10 to $15 MM ongoing. The start up time is relatively fast, given that movies can be
procured very quickly and distribution centers are leased with a nominal amount of employees at
each. As a case in point, Blockbuster completely replicated NetFlix’s infrastructure in only eight
months. Therefore, given the national scope of this business, the barriers to entry are fairly low
for companies with deep pockets.
Once the business is up and running, the largest national players require about 30
distribution centers of about 5000 ft2 each with about 12 employees. The technology for pick
and pack is very basic. With 30 distribution centers, online providers can reach 90% of
customers within 1 mailing day and 100% of customers within 2 days. Speed of turn-around is a
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key competitive metric in this industry. The USPS is the method of delivery for large players.
Perhaps the biggest challenge in maintaining margins is limiting the number of movies
customers rent each month. With the advent of the online, fixed fee model, the opportunity cost
to customers for renting a movie, is virtually nill. If they don’t like it, they simply return it
quickly and get another movie from their list. This is in stark contrast to the traditional rental
model where the customer would be out his/her time to drive to the store to pick up and return
the movie as well as about $4.30! Therefore, it makes perfect
sense that the average number of rentals per customer
doubled under the online model vs what they were renting
under the traditional model. The average NetFlix customer
currently rents 6.7 movies/month. If you refer to the table
above that shows the estimated variable costs per movie rented, you can see that at a monthly
rental fee of $18/month, and 6.7 rentals per customer, NetFlix doesn’t have much money left
over ($4.60) to cover marketing, infrastructure, administrative, and library costs. Speaking of
marketing, the current estimated customer acquisition cost is nearly $38! Given these costs, the
name of the game for NetFlix and Blockbuster is to control the number of movies its customers
rent per month.
With an understanding of the online rental business model, we can now discuss the costs,
benefits, and probable outcomes from the current price war.
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The Hatfields & The McCoys – Wars of Attrition
“It’s going to be a much more
competitive market than we ever
expected…” – Netflix CEO, Reed
Hastings
“We have invested a significant amount of money in this
business and we’re not going to allow a competitor to
come in and offer better price value and service…” –
Blockbuster CEO, John Antioco
By engaging in a price war, NetFlix and Blockbuster have chosen to engage in a war of
attrition. In this situation, both competitors pay a price (i.e. lower prices) in the hopes of
outlasting the competition (i.e. competitors raises prices before you do) and winning a payoff for
being the strongest player. “Winning” in this context means, among other things, that the last
man standing gets a larger share of the market going forward, and thus greater revenue given that
both players raise prices to sustainable levels and maintain them for the long term. In examining
this scenario, it is important to note that not all reasons for entering a price war necessarily make
sense from a financial standpoint and we will examine both financial and non-financial drivers of
such wars. The putative reasons for engaging in this price war are:

Leverage economies of scale. It is believed that more customers will translate into lower
average cost to service a customer due to efficiencies in distribution centers and with
utilization of movie libraries, thus resulting in higher margins.

Customers are sticky. Race to build your market share otherwise competitors will have
much of the subscriber base locked in and it will be more difficult to get customers later.
Customers are sticky and will stay with you later when other competitors appear.

Customers, over time, will use an online DVD service more for the convenience value
than for the ability to watch many movies at a low cost. As a result the average rentals
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per month will go down and profits will go up. In this case, it may be worth losing a large
sum of money up front in order to lock in even larger profits later.

If you can hold out long enough, you will win the majority of the market, forcing an
equilibrium with one overwhelmingly dominant player and many stragglers, similar to
the “Amazon and everyone else” dynamic in the online book market.

It is worth it to sacrifice some profits and potentially shareholder value for pride and
bragging rights. Each firm wants to be a “winner” by being the biggest on the block.
NetFlix pioneered the market and it thinks it should own the market due to first mover
advantage. Blockbuster is the overall king of home entertainment and feels NetFlix is
encroaching on its turf and needs to defend.
With so many assumptions and viewpoints, we can already begin to see the importance of
signaling in this market setting. For instance, Blockbuster has sent NetFlix many signals since
its entry late last summer. Blockbuster’s CEO, John Antioco recently announced, “we are
determined to do whatever it takes to be the leader in the online rental space.” He went on to
posit, “…we believe we have the brand, store base, customer relationships, and the commitment,
as well as the necessary strong balance sheet.” The company is going out of its way to advertise
that its online unit will be at breakeven-to-profitable by Q1 20061 despite another massive round
of capital infusion in FY2005. Another, very commonly seen signal that Blockbuster used was
its projection of customers: at least two million customers by Q1 2006. There’s little question
here, that Blockbuster is telling NetFlix that it is the big fish in the sea, it will stay in the game,
and has built its future around the online space. In short, NetFlix better stay out of its way, or
else! Blockbuster is trying to leverage its supposed operational strengths and years of
entertainment expertise to teach NetFlix its place in the market.
1
Blockbuster Q4 FY2004 Earnings Release
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Not to be pushed around, NetFlix has engaged in its fair share of signaling as well. It’s
intentionally stated several times that it would forego profits for several years should that be
necessary to fight off competitors. Interestingly, this threat was issued soon after Amazon’s
announcement of potential market entry; a very similar phrase we heard Amazon utter in its
infancy. NetFlix has further bolstered its verbal threats by cutting prices drastically. Lastly, its
publicly stated grab for market share before Amazon enters signals to Blockbuster and the
market that NetFlix feels its customers are sticky and will likely stay with NetFlix in the face of
competition. Just as signaling can be intentional, it can also be unintentional and carry some
adverse consequences. For example, NetFlix exhibited its naiveté in announcing, “…we
underestimated the likelihood and significance of competition, primarily from Blockbuster and
Amazon.” This is valuable information for NetFlix’s competitors. NetFlix claims to be tough
and on the ball, but some of its signals indicate otherwise.
Are these threats credible? How concerned should NetFlix be about the threat from
Blockbuster? The answers to these questions depend on what the payoffs for each competitor
are, and what each has to gain or lose by engaging in aggressive price competition.
What’s it Worth? – Projecting Payoffs
To develop a payoff model for the industry participants, we designed a spreadsheet that
allowed us to change key variables and observe the effect on each competitor, as shown in
Figure 1 below.
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Game Theory and the Online DVD Rental Market
BBI
14.99
17.99
38%
48%
15%
22%
Price War Price
Non Price War Price
Price War Gross Margins
Non Price War Gross Margin (calculated)
Discount Rate
"Other" SG&A as percentage of sales
NFLX
17.99
19.99
38%
44%
15%
22%
Effect of Price Differences
on Customer Retention
NFLX
Low
0%
BBI
Low
High
-18%
0%
27%
18%
High
-6%
-27%
-9%
Total subscribers in market
(based on trend towards 20M subscribers in 2013)
2004
3,300,000
2005
5,650,000
2006
8,000,000
2007
9,392,200
2008
11,235,800
2009
13,079,400
2004
WAR
23%
0.75
0.75
14.99
33.73
20.91
12.82
2005
WAR
29%
1.65
2.10
14.99
255.92
158.67
97.25
2006
WAR
36%
2.88
3.66
14.99
517.43
320.81
196.62
2007
WAR
42%
3.94
5.01
14.99
779.55
483.32
296.23
2008
no war
46%
5.17
4.70
17.99
1,048.43
541.63
506.80
2009
no war
50%
6.54
5.95
17.99
1,150.04
594.12
555.92
2010
14,923,000
Blockbuster
Price War (Yes/No)
Blockbuster's % share of total market with Price War
Ending Customers With Price War (Millions)
Actual Ending Customers
Monthly Price
Total Revenue (Millions)
Cost of Revenues
Gross Profit
% of Revenue Spent on Marketing
Marketing for New Customers
Remaining SG&A (Growth proportional to sales)
Total SG&A Costs
Net Profit (EBIT)
110%
37.10
60.00
97.10
$
(84.28) $
Net Margins
-249.9%
NPV
$642.01
30%
76.78
50.00
126.78
20%
103.49
113.84
217.32
(29.53) $
(20.70) $
-11.5%
-4.0%
15%
116.93
171.50
288.43
7.80
1.0%
15%
157.26
230.66
387.92
$
118.88
11.3%
2010
Terminal NPV
no war
no war
50%
50%
7.46
7.46
6.79
6.79
17.99
17.99
1,375.27
1,465.82
710.48
757.25
664.79
708.56
10%
115.00
253.01
368.01
$
187.91
10%
137.53
302.56
440.09
$
16.3%
224.71
10%
146.58
322.48
469.06
$ 1,596.67
16.3%
$822.59
Figure 1. Payoff Model Spreadsheet (Payoffs for Blockbuster Shown)
[Numbers are hard coded were data is available from research]
A detailed view of this spreadsheet is provided in Appendix A at the end of the paper.
In developing this spreadsheet, we were careful not to introduce needless complexity by
adding irrelevant variables or variables which we could not justify as having significant and
predictable effects on the payoffs. At a high-level, the spreadsheet simply calculates Profit as
(Revenue – Expenses) for each year and discounts the profits back to 2005 to calculate NPV. We
allowed several variables to directly or indirectly modify Revenue or Expenses (described in
greater detail in Appendix A):

Monthly Price

Gross Margins under a Price War

Marketing Expenses to acquire new Customers

Other (non-Marketing) SG&A Costs
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Annie Schwab
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Game Theory and the Online DVD Rental Market

Customer Attrition

War/No War Conditions in Each Year

Total Market Size

Discount Rate (for calculating NPV)
A Baker’s Dozen – Interpreting Payoffs
Given the payoff model described above, we simulated the outcome of competition under
both price-war and non-price-war conditions. For the price-war scenario, we simulated a pricewar for three years. We projected outcomes through 2010 and discounted the profits back to
2005 (including a terminal value for 2011 to represent the future value of the firms). We’re
confident our model generates realistic figures with results that are in line with estimates from
our research; hence we believe that the model is at least coarsely reliable, especially when
considering relative outcomes as opposed to actual values. Figure 2 below presents the payoffs
for the market dynamics of NetFlix and Blockbuster.
NFLX
No War
War
BBI
$1050MM
No War
$915MM
$942MM
$891MM
$1021MM
War
$823MM
$921MM
$815MM
Figure 2. Payoffs for Blockbuster (BBI) and NetFlix (NFLX) with a 3-Year Price War.
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Game Theory and the Online DVD Rental Market
The payoff matrix in Figure 2 presents a surprising result – both firms are better off by not
engaging in a price war. This is the only Nash Equilibrium in this scenario.
Based on our earlier discussion regarding price wars and wars of attrition, and also on the
behavior of the firms in the market, we fully expected to find a all-time favorite, prisoner’s
dilemma. We were perplexed that our analysis did not reveal one, and as a check of our model,
we ran through many scenarios with varying assumptions for customer stickiness, cost of sales,
length of price war, etc. Each outcome led to an outcome similar to that presented in Figure 2.
After some deliberation, we were left to conclude that there is in fact no prisoner’s
dilemma in this situation. Both firms would flatly be better off by not engaging in a price war.
This is consistent with the fact that this is a new and growing market, the level of customer
stickiness is questionable, and the market leader, NetFlix, in a bit inexperienced at playing
competitive games. At this point, the price elasticity is simply not sufficiently large to sustain a
prisoner’s dilemma.
Once again, we note the role of signaling in this market. By engaging in a price war, one
firm may be trying to signal to the other that it has the corporate wherewithal to outlast the other.
However, evidence suggests that price signals are generally not very credible, since prices can be
changed with relative ease. Despite this fact, the players may consider the cost of price signaling
to be sufficiently low, as we can see from Figure 2, in which case they may engage in this lowcost tactic.
Are These Guys Nuts? – Competitor Analysis
We can glean other possible explanations for the price war by performing a competitor
(behavioral) analysis on the firms. Since our analysis above didn’t support a prolonged War of
Attrition, we surmise that there may be irrational behavior at play in this market. In particular,
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we can use our competitor analysis tools to arrive at possible explanations for why this war is
needlessly continuing. We will examine both competitors, starting with NetFlix.
NetFlix views itself as an innovator and is immensely proud that it pioneered the Online
DVD Rental industry. In performing a competitor response profile on NetFlix, we uncovered
several inconsistencies in its actions which strongly indicate NetFlix doesn’t fully understand its
market or competitors, thus explaining its seemingly irrational behavior in starting and
perpetuating a price war with Blockbuster.
Based on NetFlix’s public comments, it appears it is suffering from the common
Overconfidence Bias. In response to the market entry of Blockbuster and Amazon’s potential
entry announcement, NetFlix claimed it was shocked. To the outside observer, this seems
absurd. Most any individual could have predicted that Blockbuster would enter the online space
in a straddle strategy to maintain its customer base in the brick and mortar world. There are
numerous examples of companies who’ve done this, but most notable is Barnes & Noble’s
online foray in response to Amazon.
This then brings us to Amazon…while
not as closely linked to Online DVD
Rentals as Blockbuster, Amazon sees
itself as having laid claim to the entire
online world, and given its extensive
DVD sales, it isn’t much of a stretch to
see them entering as well. Another
instance of overconfidence bias is
NetFlix’s assumption about customer
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stickiness. NetFlix feels online customers are relatively sticky, or that they have fairly high lockin. Supporting this premise are its deep price cuts undertaken to capture as much market share as
possible. It is only useful to lower price to acquire customers if you feel the customers will stay
with you after you raise prices. While we acknowledge there may be minimal to moderate
customer stickiness in Online DVD Rentals, we don’t feel it is of the level NetFlix assumes and
don’t support its move of lowering prices to capture market share quickly.
Confirmation bias also helps to explain some of these inaccurate assumptions about
NetFlix’s environment. It appears NetFlix is basing its market assumptions on historical
experiences with the market, where it had a virtual monopoly and lacked any strong direct
competitors. The high expectations for customer stickiness, while validated by past churn rates,
won’t necessarily hold true once Blockbuster hits its full online stride, or if and when a large
online competitor enters such as Amazon.
In sum, there seems to be a significant amount of irrational behavior on NetFlix’s part
which could be distorting the market and contributing to this fight. Probably of greatest concern
to other players is the above mentioned faulty assumption of customer stickiness.
While not afflicted as severely as NetFlix, Blockbuster may also suffer from similar
biases. In contrast to NetFlix, whose false assumptions seems to largely stem from the fact that
it’s a young company, Blockbusters erroneous conclusions developed as a result of its traditional
model being attacked by a substitute offering, namely online rental, and its aversion to customer
loss. We know from studies that while not necessarily rational, companies and people will go to
greater lengths (and costs) to avoid losing an asset than they will to gain the same asset (Loss
Aversion). NetFlix is now threatening Blockbuster’s core business – movie rentals, and it has
vowed to fight to the ends of the Earth to defend its turf. Blockbuster also may be fighting due
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to overconfidence of its probability of
beating NetFlix into submission. It has a
long history of beating down competitors
and has probably factored those past
successes into its present day analysis.
Do the outcomes of this behavioral
analysis completely explain the behavior
of these two firms? To a great extent, yes.
We see that NetFlix has some erroneous
assumptions about the market, namely in
customer stickiness, that are driving it to
quickly grab market share despite the high cost of doing so. Also, we saw that both companies
were more confident of their probabilities of success than it warranted. NetFlix in particular has
made some big moves and big claims, and based on the above it doesn’t seem possible that the
threat of Blockbuster was the only factor. What other threat could elicit such a response as being
willing to forgo profits for up to five years in order to win this market2?
The Pink Elephant – Amazon.com
The main catalyst of all this market upheaval probably is a company that isn’t even in the
Online DVD Rental market – Amazon! Amazon has stated publicly that it may enter the Online
DVD Rental market, and that customers have been requesting such a service from the largest
online retailer. Of late, the company has been sending many and mixed signals to both NetFlix
and Blockbuster. Why would Amazon be interested in entering the Online DVD Rental market?
2
http://www.hackingnetflix.com/netflix/2005/03/reuters_netflix.html
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In many respects, Online DVD Rentals are a departure for Amazon, since the company is for the
most part an internet-based retailer that doesn’t hold inventory or offer fixed fee services. It is
optimized to ship items to customers, but not to accept every item as a return (as would be the
case for rentals). Further, an online rental offering would require much larger capital outlays than
Amazon is accustomed to. Lastly, opening 30 distribution centers is in direct conflict with
Amazon’s stated strategy of winnowing its warehouse footprint and relying increasingly partners
to handle distribution. There are several reasons, however, why a subscription would be
attractive to Amazon.
First, DVD rentals have higher margins that most of Amazon’s other businesses. Amazon’s
average margins are about 24%, but Online DVD Rentals boast around 35-40% gross margins.
Another way in which online rentals builds Amazon’s financial performance is by virtue of its
regularity of revenues and non-seasonality, both of which have the effect of smoothing revenues
and decreasing volatility. From a capability perspective, DVD rentals plays to Amazon’s
operational and marketing expertise. Both of these could be sources of cost advantage,
particularly in customer acquisition costs. Amazon can leverage its massive installed customer
base for marketing, driving its customer acquisition costs to near zero. By cross selling DVDs to
rental customers, Amazon could use the DVD service to bolster sales on the main Amazon.com
web site. And ultimately, DVD rentals are a complementary good to DVD sales, which would
likely receive a boost from cross-promotion and increased exposure.
While it is clear Online DVD Rentals is an appealing market for Amazon, the company’s true
intentions with respect to entry are still murky. Is it seriously considering directly entering the
market as it initially threatened, or is it hatching a more deeply seeded plan more consistent with
its partnering query.
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Game Theory and the Online DVD Rental Market
Give Me Your Lunch Money – The Credibility of Threats
To date in the online DVD market, Amazon has issued a few, very strong signals to
NetFlix and Blockbuster. It first claimed it was interested in entering the Online DVD Rental
market in October of 2004. This sent NetFlix into a price cutting frenzy, almost assuredly
igniting the War of Attrition between current market players. Then, in just April of this year,
Amazon amended its original statement by saying it was interested in a partnership for the
Online DVD Rental market. While it seems obvious now that we can largely blame the current
price war on a non-market participant, it still remains to be seen what designs Amazon has on
this industry and what benefits it expects from its signals.
A first place to start is in assessing the credibility of each signal. We know Amazon has
incurred real costs to enter the Online DVD Rental market in the UK. Incurring real costs is a
surefire way to signal a credible threat. However, it is not clear with what strength this threat
transfers to the US market, a region geographically and operationally distinct from that of the
UK. The costs for Amazon to enter the UK were arguably much lower than for it to enter the
US. Amazon can serve the entire UK through its two existing warehouses. In the US, however,
it’s a different story. Amazon has only six warehouses, not nearly enough to service the US
within one mailing day. It would need to build out about 25 additional distribution centers as
well as build a competitive movie library. Given these increased costs, Amazon may be thinking
twice about the US market, and hence its threat is less credible. Further weakening its initial
claim of entry is the large time lag of inaction on that claim. As more time elapses without
committing activities, the less credible Amazon’s threat.
The plot thickens once Amazon’s more recent announcement of looking for a partner in
the Online DVD Rental market is considered. It seems this may have been Amazon’s original
plan from the beginning and it was using the initial signal to increase its bargaining position with
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Annie Schwab
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EWMBA 217 – Game Theory
Prof. John Morgan
Game Theory and the Online DVD Rental Market
the incumbents, NetFlix and Blockbuster. It cost Amazon nothing to make its market entry
threat, but should a partnership, or even acquisition ensue, Amazon is in a much stronger
position given that its potential partners have been emptying their coffers in a protracted price
war. NetFlix’s valuation in particular has been hit heavily. Based on Blockbuster’s bestalternative-to-a-negotiated-agreement
(BATNA, the opportunity from the
physical stores), NetFlix is the most
realistic target of Amazon’s signaling.
Assuming Amazon is in fact
interested in partnering or acquiring
one of the players, what incentives do these parties have to seriously consider this option?
We’ve established that Amazon benefits by not having to invest the $100 MM plus start up costs
to build a movie library and augment its distribution network. The potential partners could reap
significant advantage from Amazon’s massive installed customer base and marketing expertise.
Amazon claimed that its customer acquisition costs would be near zero and this could represent a
much needed life preserver from the undercurrent of rapidly rising marketing spend. Further,
partners could cross-promote DVD rentals with DVD sales on Amazon, one of Amazon’s
differentiators in the UK market. Lastly, by taking a potential third player out of the market,
prices can resume their higher levels prior to Amazon’s entry threat, and profitability will return.
Given the signaling, most severely impacted party and the benefits, who then is the likely
partner/acquisition target, Blockbuster or NetFlix?
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EWMBA 217 – Game Theory
Prof. John Morgan
Game Theory and the Online DVD Rental Market
Be Vewy, Vewy, Quiet. I’m Hunting NetFlix.
Our analysis shows that if Amazon were to enter the market, it would grow the overall
market by reaching new customers who would not otherwise have tried an Online DVD Rental
service. In estimating the total market size and payoffs with Amazon as a player, we used the
following assumptions. Firs, we started with the 20 million subscribers NetFlix estimates a
mature market will support. Against that number, we weighed the fact that Amazon has a very
large existing customer base to which it could market a DVD rental service and our belief that
NetFlix and Blockbuster have attracted most of the consumers who would be interested in such a
service. Based on the latter observation, we do not believe that a third entrant, even Amazon,
will be able to grow the total size of the market significantly. This led us to predict an Amazon
entry would grow the total size of the market in each year by 15% over what we projected it
would have been without Amazon’s entry. The end result is a market that grows to 23 million
subscribers by 2013. This is shown in Figure 1 of the Appendix.
Of course, Amazon would never enter the market for the prospect of a measly 3 million
total customers, so we assume it would also steal share from Blockbuster and NetFlix. We’re
confident it would impact NetFlix more heavily than Blockbuster for several reasons. First,
NetFlix customers are much more similar to Amazon’s than Blockbusters. Second, Blockbuster
has a unique value proposition for its customers by leveraging its brick-and-mortar presence.
Hence, it has a more attractive BATNA than NetFlix. Lastly, Amazon is a direct threat to
NetFlix because it has deep expertise in building user-friendly, convenient web sites, which is a
key differentiator for NetFlix.
What would be the effect on NetFlix if Amazon were to directly enter the market? We
used our payoff analysis to calculate NetFlix’s payoffs in the face of entry by Amazon. We
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EWMBA 217 – Game Theory
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Game Theory and the Online DVD Rental Market
assumed that Amazon would continue its business strategy of being a price leader and would
charge subscribers $13.99 per month, undercutting both NetFlix and Blockbuster. The payoff
matrices are shown below in Figure 4.
Without Amazon
NFLX
No War
War
No War
1050
942
War
1021
921
BBI
With Amazon
NFLX
No War
War
No War
814
709
War
769
702
BBI
Figure 4. Payoffs for NetFlix with and without Amazon Entry.
As we can see from Figure 4, entry by Amazon would deal a serious blow to an already
weakened NetFlix. What should the company do?
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Annie Schwab
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EWMBA 217 – Game Theory
Prof. John Morgan
Game Theory and the Online DVD Rental Market
Our Recommendation: A Shotgun Wedding
Having explored what seems like every facet of the Online DVD Rental market, there’s
little doubt NetFlix and Blockbuster are needlessly mauling one another at the behest of
Amazon. Amazon poses a serious threat to the viability of the market, and individually to
NetFlix. It now seems less likely Amazon will directly enter the Online DVD Rental market in
the US, opting instead for a partnership or acquisition facilitated entry. Taking into account
NetFlix’s bleak prospects as an Amazon pawn, we recommend it call Amazon’s bluff and
preemptively offer a partnership. In doing so, there are benefits to be had for NetFlix, and more
importantly, it prevents an unwanted low-value takeover attempt. Having recognized the
manipulative actions of Amazon, NetFlix should seize this window of opportunity and change
the rules of the game in its favor.
Recalling the predicament of our other player, Blockbuster, we offer some game theoretic
advice for it as well. Blockbuster realizes it is a price taker in this market as it currently doesn’t
offer the same value proposition as NetFlix due to operational start-up bugs and reputational
issues. Therefore, Blockbuster must maintain a price discount relative to NetFlix in order to
equalize customer perception of their services. Because Blockbuster would like to raise prices,
but has little ability to do so, it needs to signal to NetFlix to raise prices and better both their
predicaments. One ideal means of doing so is to leverage the fact discovered earlier that NetFlix
likely made the wrong assumption about its customer stickiness and thus launched the current
price war erroneously. A credible way for Blockbuster signal this mistake would be to
commission an independent on customer loyalty in the Online DVD Rental market and then
release it, showing NetFlix is got the market dynamics wrong. NetFlix would then hopefully
raise prices and Blockbuster could follow suit, ending the war of attrition early. This is an
excellent example of how signaling can be used not to distort market perceptions but actually to
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EWMBA 217 – Game Theory
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Game Theory and the Online DVD Rental Market
correct them. Throughout our discussion of game theory in the Online DVD Rental market,
we’ve seen the profound and often highly disruptive effects of signaling.
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Annie Schwab
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EWMBA 217 – Game Theory
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Game Theory and the Online DVD Rental Market
Appendix Payoff Model
BBI
14.99
17.99
38%
48%
15%
22%
Price War Price
Non Price War Price
Price War Gross Margins
Non Price War Gross Margin (calculated)
Discount Rate
"Other" SG&A as percentage of sales
NFLX
17.99
19.99
38%
44%
15%
22%
Effect of Price Differences
on Customer Retention
NFLX
Low
0%
BBI
Low
High
-18%
0%
27%
18%
High
-6%
-27%
-9%
Total subscribers in market
(based on trend towards 20M subscribers in 2013)
2004
3,300,000
2005
5,650,000
2006
8,000,000
2007
9,392,200
2008
11,235,800
2009
13,079,400
2004
WAR
23%
0.75
0.75
14.99
33.73
20.91
12.82
2005
WAR
29%
1.65
2.10
14.99
255.92
158.67
97.25
2006
WAR
36%
2.88
3.66
14.99
517.43
320.81
196.62
2007
WAR
42%
3.94
5.01
14.99
779.55
483.32
296.23
2008
no war
46%
5.17
4.70
17.99
1,048.43
541.63
506.80
2009
no war
50%
6.54
5.95
17.99
1,150.04
594.12
555.92
2010
14,923,000
Blockbuster
Price War (Yes/No)
Blockbuster's % share of total market with Price War
Ending Customers With Price War (Millions)
Actual Ending Customers
Monthly Price
Total Revenue (Millions)
Cost of Revenues
Gross Profit
% of Revenue Spent on Marketing
Marketing for New Customers
Remaining SG&A (Growth proportional to sales)
Total SG&A Costs
110%
37.10
60.00
97.10
Net Profit (EBIT)
$
(84.28) $
Net Margins
-249.9%
NPV
$642.01
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Annie Schwab
23 / 26
30%
76.78
50.00
126.78
20%
103.49
113.84
217.32
(29.53) $
(20.70) $
-11.5%
-4.0%
15%
116.93
171.50
288.43
7.80
1.0%
$822.59
EWMBA 217 – Game Theory
Prof. John Morgan
15%
157.26
230.66
387.92
$
118.88
11.3%
2010
Terminal NPV
no war
no war
50%
50%
7.46
7.46
6.79
6.79
17.99
17.99
1,375.27
1,465.82
710.48
757.25
664.79
708.56
10%
115.00
253.01
368.01
$
187.91
16.3%
10%
137.53
302.56
440.09
$
224.71
16.3%
10%
146.58
322.48
469.06
$ 1,596.67
Game Theory and the Online DVD Rental Market
Appendix – Payoff Model
The spreadsheet model used in this report to calculate payoffs allows several critical variables to
be changed to model various aspects of competition in the Online DVD Rental market. The
following is a detailed explanation of each of these variables, along with assumptions used in
calculating the actual numbers presented in the report:
Monthly Prices for each service. These numbers are derived from actual prices in effect as of
this writing. Price War Prices are derived from observed prices during the price slide after
Blockbuster entered the market. NetFlix was then priced at $22/month. Blockbuster entered
at $20/month. NetFlix followed suit, and Blockbuster in turn went down to $18/month.
NetFlix again followed and Blockbuster went down to $15/month. NetFlix did not follow
Blockbuster in this last gambit, and prices have since remained stable at $18/month and
$15/month for NetFlix and Blockbuster, respectively.
Price War Gross Margins. Gross Margins under a price war. This number is derived from
NetFlix’s Q1 ’05 financial statements. The spreadsheet uses this number to calculate margins
under non-price-war conditions. This is done by calculating actual costs, adding the nonprice-war price increment, and then dividing by the non-price-war price. For example, if the
price-war price is $15, gross margins are 50%, and the non price war price is $20, this would
yield (15*50% + (20 – 15)) / 20 = 62.5%.
“Other” SG&A. This number encapsulates all non-marketing expenses. Since we are in a growth
industry, marketing expenses required for customer acquisition will be a significant portion
of sales. In addition, competitors will expend larger portions of their revenue for marketing
when they engage in a price way. This number models all non-marketing expenses as a
percentage of sales. This number is derived from NetFlix’s Q1 ’05 financial statements.
Percentage of Revenue Spent on Marketing. This number is an estimate of how much will be
spent on marketing (i.e. customer acquisition) in any given year. These numbers are derived
from actual numbers and projections based on statements made in earnings releases. This
number is the largest single expense affecting profitability during price war years.
Effect of Price Differences on Customer Retention. This is a measure of customer stickiness.
This is a measure of customer attrition when one firm prices high and the other prices low.
These numbers are measured relative to the maximum number of customers that are available
(when both firms engage in a price war). Hence, when one firm prices high and the other
low, the high firm will typically lose customers while the low-priced firm will gain most of
these customers. The percentages need not be equal, however, since each firm has a
different-sized customer base.
War/No War. This is a toggle that allows us to model whether each firm chooses to engage in a
price war in any particular year. If a firm chooses to engage in a price war, the spreadsheet
will adjust the actual subscribers (and hence the revenues) for the firm by the attrition rates
mentioned above.
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Game Theory and the Online DVD Rental Market
Total Subscribers in the Market. This number is an estimate of the total market size. These
numbers are derived from the existing market size and market shares, project subscriber
acquisitions goals for 2005 and 2006, and analyst projects of total market size. Based on
these estimates, we expect a market of approximately 20 million subscribers by 2013.
Market Share Under Price War. This number allows us to estimate the market share that each
firm will garner under a price war. The spreadsheet will adjust the actual share number based
on price differences. If both firms engage in a price war, they will each garner the market
share given by this number. If one firm engages in a price war and the other does not, their
subscriber count will be modified by the attrition numbers as mentioned above.
Discount Rate. Discount Rate to use for NPV calculations. Since the stock market returns on
average 12%, we used 15% to represent the additional riskiness of these firms in a growing
and unproven market.
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EWMBA 217 – Game Theory
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Game Theory and the Online DVD Rental Market
Appendix – Growth of Market with Amazon
Figure 1 – Estimated effect of Amazon’s entry on size of Online DVD Rental market
Est. market growth based on # of competitors
(measured in number of subscribers)
25,000,000
20,000,000
15,000,000
BBI, NFLX, AMZN
BBI, NFLX
10,000,000
5,000,000
20
04
20
05
20
06
20
07
20
08
20
09
20
10
20
11
20
12
20
13
-
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Prof. John Morgan