Netflix recently announced that they were going to offer, for the first time, their streaming video subscription service separately from their DVD-by-mail subscription service. Streaming-only will be the default for new customers, DVD-by-mail is an optional add-on. Much of the discussion, verging on outrage, about this move centered on a price increase for the popular one-at-a-time DVD plus streaming option, which is the one my family uses. Price increases are rare and this was a large one, at least on a percentage basis; the new price is nearly double the old one. You can see by this pricing choice that Netflix is positioning itself differently, a positioning that is part of its long term strategy.

One of the functions of price is as a signalling mechanism. You can make all sorts of signals with price. For instance, you can with your prices signal to customers that you are a premium provider, or you can make price changes ahead of a market shift to signal to competitors that you are moving aggressively.

Netflix, with this price increase, is signalling that they are not focused on the DVD-by-mail business and with their prices they will try to drive customers away from that offering.

Netflix is playing a long game here. They entered the market with an innovative product, DVD-by-mail, and a very innovative pricing structure based on a flat subscription fee rather than the penalty pricing that Blockbuster, the former market leader, used. Blockbuster’s pricing signalled, at least to me, that they despised their customers.

But Netflix is named Netflix, not “Mailflix.” They have always been focused on creating an Internet based video delivery service. The technology to do this — broadband, fast-enough video codecs, high bandwidth content delivery networks and the rest — has only been widely available in the US for a few years but Netflix has been around for fourteen years.  And that’s without considering any of the infinitely complex legal issues around licensing content (hello, knucklehead music industry!)  Their CEO, Reed Hastings, is a Bowdoin grad, so its obviously well-run.

The pricing decision has to be seen in the context of this long game that they’re playing, and winning at. Pricing decisions are always serious because they flow almost directly to the bottom line, so Hastings must have concluded that the short-term loss of income from cancelled subscriptions will be outweighed by the longer term gain in new subscribers who do not take the DVD-by-mail option. Netflix is signalling to these customers that streaming is a better option; DVD-by-mail becomes a niche offering for them.

I don’t know what their costs are, and too many pricing decisions are based disproportionately on cost, but their scale is very large. Their DVD-by-mail business is one of the US Post Office’s largest customers (Netflix spent an estimated $600m on postage alone in 2010, 1.7% of all first-class mail revenue) and their video delivery business is responsible for 30% of peak downstream Internet traffic. My guess is that although the cost of the DVD-by-mail service is high — running all those fulfillment centers, dealing with lost DVDs — the more important factor is the scale of the business and the potential for distraction from what they see as a bigger opportunity, video delivery over the Internet. Remember, they’re called Netflix; that’s their business.

They’re used smart pricing to bring their customers along with them. When streaming was first offered as an option, it didn’t cost extra. As long as you had one of their DVD-by-mail subscriptions, you could get streaming video for free. That’s a great offer. I think we immediately moved from a three DVD subscription to a cheaper one DVD subscription, because the streaming option gave us so many options. We watch Netflix movies on our big television with a Roku box, but also on an iPad and on our computers. This range of options is really impressive: I can start watching a movie on our big screen and continue it — in bed with headphones — on an iPad. In a pinch, I’ve even watched movies on my iPhone.

Netflix used the time from the launch of their streaming business until now as, essentially, a testbed to see if the pieces worked and if they could build up enough of an ecosystem of hardware partners — televisions, game consoles, set-top boxes, even DVD players — to make them comfortable that streaming Netflix was widely enough available as an option. It might have been a very different scenario if they had launched streaming video as a separately priced offering. But now that we’re accustomed to it, we know that its a viable delivery mechanism and I won’t mind giving up the DVD option. We hardly use it anymore anyway. So the price change, from the customer’s point of view, is nil.

By instituting such a large price increase, Netflix forcing a very clear segmentation in their customer base. Most customers, like me, will gladly give up the DVD-by-mail option. The customers that value the DVD-by-mail will stay, pay more, and grumble. Some of them will leave entirely. My prediction is that Netflix has not only built this into their model: they have a price-based response to it. After a few months, once the main base has been successfully shifted, they will offer some intermediate option — perhaps an occasional DVD-by-mail offering — which will placate the objections. Maybe they’re offering it quietly already.