Netflix: The Powerful Combination of Scale and Network Effects

Netflix has the most scale of any streaming service. They have the most subscribers, the most content, and the largest content budget. This scale advantage benefits their business in many ways.

Having the most users allows Netflix to buy content cheaper than their competitors on a per user basis. The cost of a new show gets spread over Netflix’s 139 million paying members while their competitors have to spread that same cost over a far smaller membership base. All things being equal, Netflix can pay more than their competitors for a piece of content and still get the same, or better, return on their investment.

This results in Netflix being able to offer the largest content library for a price that is in line with their competitors—and is probably the cheapest for the amount of content you get. And because content spend is a fixed cost and the cost to serve a new user is basically zero, this advantage should continue to scale as the company grows.

Netflix is also the only streaming service that is fully international as it’s available in over 190 countries. Historically, most media companies have been domestically-focused because distributing their content worldwide would have been too expensive. But thanks to how much easier it is to scale an Internet-based business, Netflix’s international segment actually has more subscribers and is growing faster than their domestic segment. This international scale allows Netflix to produce local content in regions all over the world. Due to Netflix’s vast content library and budget, it will be difficult for local companies to compete in any one country or region.

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Netflix’s scale also benefits them on the other side of their business—the content creators. These are the people who create the shows and movies. Most artists want their work to be seen by the largest audience possible, both to stroke their ego and because increased viewership maximizes the long-term value of their content. And of course, content creators also want to be paid well. Netflix can pay more than their competitors because of their scale.

As an example, Netflix has 139 million paying members and Hulu has around 25 million. If Netflix determines that paying $100 million for a show meets their internal rate of return on a per user basis, Hulu could only pay $18 million to get that same rate of return.

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That calculation is oversimplified, but it gives an idea of how big of an advantage scale is when it comes to acquiring content. Netflix is the place where content creators can get paid the most and have the most people see their work.

Because scale is so beneficial to streaming services, the large providers should keep getting stronger. This makes it difficult for the smaller services to catch up. Thus, I believe the mature industry will result in winner-take-most dynamics. This was not the case for media companies before the internet. Historically, TV stations only had to produce enough content to fill their limited number of time slots. And for the most part, media companies were not global businesses because scaling was too expensive.

But Netflix, by distributing its content over the internet, has flipped this on its head. There is no limit to the amount of content Netflix can put on its platform. They are trying to be ABC, CBS, Fox, HBO, History Channel, Comedy Central, Cartoon Network, Family Channel, and more all rolled into one. Netflix can satisfy all of a customer’s attention like one TV network never could. The result of this should be that viewing time will consolidate into a handful of providers that have the most content.

I also believe the streaming industry will be winner-take-most because there are more switching costs now than in the traditional TV world. Historically, there was almost friction to go from one media provider to another. A consumer paid $100 per month for 300 channels and all they needed to do to view a different company’s content was to change the channel.

Now, signing up for an additional streaming service like Hulu, HBO Now, or the soon-to-be Disney+ involves much more friction. It requires signing up for a new service, inputting your credit card information, and paying an additional amount each month. And even though streaming services are much cheaper than the cable bundle, I think each service being a separate purchase decision will be a hurdle for Netflix’s smaller competitors. Consumers are financially incentivized to concentrate their viewing time into as few services as possible.

Because there’s no limit to the amount and breadth of content one streaming service can provide, I believe most people will be satisfied with 1-3 streaming services. Those handful of services that win will be the ones with the most content that can satisfy the most viewing time. Currently, Netflix is winning in that regard. And getting households to stay on Netflix is a much easier proposition than convincing them to add an additional monthly expense for another streaming service that has less content.

Netflix has been able to gain their scale advantage because its business model benefits from several strong network effects—all of which are interrelated. Most importantly, as more users join the site and more content is added, the value of Netflix increases for all users. Getting more subscribers gives Netflix more money to spend on content, which results in a more valuable content library that will attract more subscribers.

Next, content creators are attracted to the service that has the most members. Artists who create shows want their pieces of art to be viewed by as many people as possible. Currently, that is Netflix. Having the most users attracts content creators to Netflix, which will result in more content and more users.

NFLX user flywheel

Netflix also benefits from network effects on the technology side. Having the most users in the streaming industry gives Netflix the best data and the ability to invest the most money in better technology. This results in better recommendations, more accurate ratings, and better decisions on when to continue or cancel a show. All of this combines to make Netflix a better service, which will attract more users.

NFLX tech flywheel

The combination of Netflix’s scale advantages and their network effects results in them being able to outspend their competitors for content, while still getting a healthy return on their investment (i.e. economically outspending their competitors). Netflix can spend more than HBO for a new TV series, but still pay less on a per hour watched per user basis. That’s the benefit of scale. And because of their strong network effects, Netflix can be confident they will continue to grow and add users. This means their cost on a per unit basis will be even cheaper in the future—encouraging them to spend more in the present.

This scale and network effects combination should also result in the value of a Netflix subscription increasing over time. This makes it very difficult for smaller competitors to catch up. As the other streaming companies will also benefit from many of these same advantages (but on a smaller scale), it makes sense that the industry will be consolidated down to a small number of large players.

Finally, I believe Netflix benefits from two other small competitive advantages that, while not nearly as important as scale and network effects, are still worth mentioning. It doesn’t get said very often, but Netflix’s culture is a customer-first, tech company. To say that is the opposite of many of their traditional competitors is probably an understatement. Amazon is the only other streaming service that is tech-first and obsesses over pleasing consumers. Beyond Amazon, the other streaming services are coming from companies with very different cultures.

On top of that is Netflix’s brand name. Netflix is synonymous with streaming shows and movies on the internet, similar to how Google is with search and Uber is with getting a ride. The saying is Netflix and chill, not Hulu and chill. And it’ll never be Disney+ and chill.