Question 2: What explains customers’ reactions to the pricing plan change announ
ID: 425240 • Letter: Q
Question
Question 2: What explains customers’ reactions to the pricing plan change announced by Netflix and the fee proposal announced by BankAm? Include in your discussion what role elasticity may have played. Identify the determinant of elasticity most applicable to the explanation you have provided.
ABSTRACT
This “compare & contrast” case study is based on two real-world examples of pricing strategy missteps dating back to 2011. In July 2011, Netflix, a popular online movie rental company, announced that it would split its popular $7.99 DVD and streaming combination plan into three separate plans. Despite massive negative subscriber reaction, loss of customer base, and a plunge in share price, Netflix went ahead and implemented its new pricing plans. In September 2011, Bank of America announced that, starting in early 2012, it would start charging some of its customers a $5 fee for making purchases using debit cards. In the face of severe customer reaction, in November 2011, Bank of America abandoned its plan to implement the fee. How does one explain the starkly different outcomes in the context of similar customer reaction? The very different elasticities of demand for the two services, attributable primarily to the degree of competition in the two business sectors, can be used to explain the contrasting final decisions. Students of economics at any level can apply their understanding of determinants of elasticity to analyze these two managerial decisions.
INTRODUCTION
Elasticity is a topic that students in a Principles of Microeconomics class learn right after they have learned about demand, supply, and equilibrium. Economics is purported to be “the study of mankind in the ordinary business of life” a la Alfred Marshall (1890). Students of economics, in their role as consumers, surely react differently to similar price changes of different goods and services. Yet, it has been the case author’s experience that students find the concept of elasticity hard to grasp. Using real-world examples is beneficial, however; it helps students apply the otherwise-abstract concepts to a situation they can relate to. This case study was originally designed as a discussion topic for undergraduate students in an online Principles of Microeconomics class. Students’ qualitative reasoning sufficed for the assignment at that level. Over time, the case has been developed to include additional questions, making it appropriate for an upper level undergraduate or even a graduate level Managerial Economics as well. The three fundamental determinants of elasticity of demand are: (i) the availability of substitutes, (ii) the importance of being unimportant (or, proportion of total budget spent on the product), and (iii) the time dimension. This case illustrates how these three determinants may have played a role in the companies’ final decisions.
THE CASE OF NETFLIX Brief History
Netflix, the popular online movie rental company, was founded in 1997 by Reed Hastings and Marc Randolph. In 1998, the Netflix.com website was launched; it was the first online DVD rental and sales site. The dominant brick-and-mortar DVD rental company at the time was Blockbuster. In 1999, Netflix debuted its subscription service, allowing subscribers to rent DVDs for monthly subscription fees. Netflix went public on May 23, 2002, listing on NASDAQ with an initial offer price of $15 per share and raising $77.2 million. Between October 2002 and January 2004, the stock price had appreciated by more than 1,500%. The company did a 2-for-1 stock split in February 2004 when the price reached $80 (Caplinger, 2016). At the time of its IPO in 2002, Netflix had about 600,000 subscribers. In 2007, it introduced online streaming, allowing subscribers to instantly watch TV shows and movies on their laptops or computers. Between 2007 and 2011, the number of subscribers in the U.S. grew from 7.48 million to 23.53 million (Dunn, 2017). On July 11, 2011, the stock closed at $41.53 (price adjusted for dividends).
The Pricing Misstep
On July 12, 2011, Netflix split up its existing one DVD at a time + unlimited streaming plan for $9.99 into 3 separate plans: (1) DVD only starting at $7.99, (2) streaming only for $7.99, and (3) DVD + streaming for $15.98 (Gilbert, 2012). The rate hike caused a loss of subscriber base from 24.8 million subscribers in end-June to 23.8 million subscribers in end-September (Pepitone, 2011). By July 29, the stock price had dropped to $37.99, a drop of 8.5% from July 11. By November 25, it had tumbled to $9.12, a plunge of almost 78% since the day of the announcement (closing prices from NASDAQ).
The Final Decision
Despite subscribers and investors voting with their feet, the company defended its decision – albeit apologetically - and implemented the new pricing plans.
THE CASE OF BANK OF AMERICA (BANKAM) Brief History
Bank of America was established in 1904 as Bank of America National Trust and Savings Association (Encyclopaedia Brittanica). Several decades, many acquisitions and mergers, and multiple name changes later, Bank of America (BankAm) was formed in 1998 when the erstwhile NationsBank acquired the former BankAmerica Corporation. From checking and savings accounts to debit cards, credit cards, loans, and asset management, BankAm provides a range of services for both households and businesses. In the words of CEO Brian Moynihan, “Bank of America has been helping connect people to what is most important to them for more than 200 years.” (the Bank of America website traces the bank’s roots back to 1804 and the Nantucket Pacific Bank). In 2010, BankAm had $916.11 billion in deposits. At 12% of market share, this ranked BankAm number one in terms of deposits. It was followed closely by JP Morgan Chase and Wells Fargo, each of which had about 10% market share (Comoreanu, 2017). BankAm stock is listed on the NYSE. On September 1, 2008, the stock closed at $35 (price adjusted for dividends). The bank suffered losses during the financial crisis, reaching a low of $3.95 on February 1, 2009. After recovering to $17.83 on March 1, 2010, the stock price started declining again. The downtrend continued in 2011, with a drop of almost 19 per cent between March 1 and June 1 (from $13.93 to $11.24), and another 29 per cent to $7.91 by September 1, 2011.
The Pricing Misstep
On September 29, 2011, Bank of America announced that, beginning in early 2012, it would start charging its customers $5 a month for using their debit cards (Rauch, 2011). The announcement was met with angry outrage by customers on social media. Reflecting the negative sentiment, stock price declined 7 per cent in the week following the announcement, from $6.35 on September 29 to $5.90 on October 6. It recovered about 8 per cent to $6.83 on October 31, 2011; however, this price was still almost 14 per cent lower compared to that on September 1.
The Final Decision
Following the tremendous backlash from its card holders, BankAm abandoned its plans. On November 1, 2011, it announced that it would not implement the debit card usage fee (Bernard, 2011).
Explanation / Answer
Elasticity of demand is essentially A measurement of change in demand resulting from a change in another economic factor, for example the cost. Most companies depend on calculation of demand elasticity to forecast the potential change in demand for a product upon implementation of change in price of the goods or services offered, other goods or services and also other important market factors. An accurate analysis of elasticity of demand helps companies to manage competition more effectively due to Awareness of available elasticity in pricing. The price elasticity of demand specifically is utilised for calculation of sensitiveness of the quantity of demand for a goods or services in relation to a change in its price. Price elasticity of demand historical data clearly indicates consumer response to change in demand. Cross elasticity of demand is another major factor to be considered for change in pricing, which reflects the percentage of change in quantity of demand of a goods or services divided by percentage change of price on Other goods or services. This indicates the impact of change in price of Other goods upon the demand for a particular product or service.
Whenever a service provider such as Netflix announces a change in pricing plan which is as aggressive in extreme as announced by Netflix it is bound to create a massive flashback by the users as it leads the users to reassess the value of the service for the user and weather the increase in price is justified by the intrinsic value of the service. This leads to them considering substitution of the utilise product or service by shopping for other available options. Most companies strategies increase in pricing in a manner so as to avoid consumers entering this phase of evaluation and subsequent substitution. Unprecedented hike in rates by Netflix cost extensive damage to the company by leading it to lose large customer base and also impact its growth, the company seems to have learnt from its mistake, and is careful to introduce price hikes in small and spread out doses. However, due to Netflix having a service which was not easily substitutable due to the quality offered by Netflix and lack of strong existential competition Netflix good implement the price hike and do damage control adequately, which is proved by its exponential growth globally and within America in successive years. Therefore it is clear that the demand was unelastic for Netflix, with the change in price not resulting in extensive change in demand.
In the case of Bank of America the proposal to implement AC on debit card usage was horse mate with angry outrage by all customers and show the massive impact on the share price of the bank immediately after its announcement. Bank of America however reversed its decision to impose the fee and put it down to consideration for the sentiments and views expressed by its customers. However, it is very obvious to every individual aware of dynamics that exist within the market that the bank was forced to back off due to all the competitors which had also planned to collectively impose such charges, reversing the decisions and leaving Bank of America standing alone facing the tough decisions of how much loss of customer base the decision would convert into. The bank issued a statement saying it would not be going ahead with this proposal to implement debit card usage fee due to recognition for the concern of the customers and understanding their views. They also cleared the intention of not levying the charges anytime in the near future. Bank of America faces serious competition from many major banks within the economy leading to easy substitution for the customer as the services offered are not in any way superior exclusive to those of other banks. Therefore we can say the demand is very elastic of the Bank of America and any change in pricing of the service will lead to substantial change in the demand due to the sensitivity of the demand to change in any economic factor. The service offered does not have exceptional value for the customer to consider paying for it as it has always been perceived as a fundamental service provided by the bank free of cost. Any attempt to charge for it psychologically feels like exploitation to the consumer. In the case of Netflix the service provided has essentially a great degree of value due to non availability of substitute and intrinsic quality of the services offered being extremely high as compared to the competitors. Also it is an important satisfying service for individuals for which we are willing to allocate sufficient proportion of total budget available by making necessary cuts another spain's which may not be providing as much satisfaction. Debit card usage does not in anyway provide satisfaction of any kind to an individual but is used more as a service which is the right of every customer of a bank.
The determinant of elasticity most applicable for these cases is price elasticity of demand showing the sensitivity of the quantity of goods or service demanded for a relative change in its price.
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