The Birth and Infancy of Netflix

Netflix became an idea when founder Reed Hastings was furious over owing $40 in late fees to his local Blockbuster. Hastings had forgotten to return a copy of the 1995 film, Apollo 13, of which he could have purchased 3 copies for the same amount he paid in late fees.

Despite being motivated to remedy late fee frustration, Netflix started out charging late fees on their mail-order DVDs (yes, remember when they’d mail you your movies?). This was because late fees served an important operational purpose: late fees ensured that movies would be returned to Netflix distribution centres on time, thus the company was able to manage an inventory of DVD selections with more certainty than if the late fees did not exist. Instead of solving the problem that inspired the birth of Netflix, the only consumer problem that Netflix may have solved was accessibility because it allowed customers to browse movie titles from their own homes, and then receive them and return them via mail, which arguably had more local drop-boxes than Blockbuster had accessible locations. In fact, in 2001, Blockbuster claimed that 60% of the American population lived within three miles from a Blockbuster (Gupta, 2005). Netflix’s mail-order movies made home entertainment more accessible to the remaining 40% of Americans, but they still had not solved their late-fee problem.

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Netflix’s Core Competencies

Right from the company’s inception, Netflix’s probability of success was enhanced by their consumer responsiveness as well as their ability to adapt to their changing business environment. I would argue that those two qualities – responsiveness to demand and adaptability – are some of the most important markers of a sustainable business model.

Late Fees

Netflix listened to customers and addressed late fee resentment by researching alternative pricing models that existed outside of their industry. Their research settled them on a subscription pricing model which was popular with the growing internet and cellphone providers at the time. Looking to extra-industry models and successfully implementing them within their own industry is an indicator of their second core competency: adaptability.

By 2000, Netflix was adapting and solving new problems that arose from their subscription model. Their subscription model eliminated late fees but created the problem of inventory uncertainty; no late fees meant that customers could keep DVDs without consequences, and unreturned DVDs meant Netflix would not have DVDs to rent.

Netflix solved this by making people want to return their movies on time. This was thanks to an incentive system that was built into their new subscription pricing model. No more late fees, but customers had to return a movie if they wanted to rent another one. The limit on simultaneous rentals helped Netflix to predict inventory needs in a more efficient way than late fees could. This new pricing model also gave customers more control over their rentals; instead of punishing customers for returning a movie late, Netflix was rewarding customers for returning movies. On a side note, this is psychology at work within business, specifically, B.F. Skinner’s operant conditioning theory that describes positive and negative reinforcement.

Shipping and Delivery Times

Netflix was very attentive to the inconsistent customer experience that resulted from DVD shipping times across the continental US. Inconsistencies were dependant on where customers lived in relation to its central distribution centre in California. By June 2002, Netflix resolved this by opening 10 new distribution centres which brought shipping times to the east cost and Midwest from 5 days down to the conventional 1-2 days happily experienced by west coast customers (Gupta, 2005).

The new distribution centres were not only very capital intensive, but they also increased their fixed and variable operating costs significantly, depending on volume of customers.  However, the lost opportunity cost of not opening those distribution costs would have been greater. If Netflix had not opened new distribution centres, they will have left a niche ready for occupation by an east coast or Midwest competitor, a risk that Netflix did not want to take. Opening these centres was worth the investment since it maintained Netflix’s large market share, and with time, the distribution centres in their original form were no longer needed after the company moved to an online streaming platform. This presents another learning point where because Netflix was adaptable to its changing business environment and new technologies, the short-term costs of opening distribution centres paid off in long-term gains by growing market share before transitioning to online streaming.

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Business Model Sustainability

All business models are only sustainable provided that the conditions that made that business model successful remain unchanged. That is why Netflix’s industry competition, Blockbuster, felt safe saying that “online rental services are serving a niche market…. We have not seen a business model that’s financially viable long-term” (Gupta, 2005). However, the business environment is always changing, so what makes Netflix’s business models sustainable is the ability to pivot and adapt. As the Greek philosopher Heraclitus said, “The only constant in life is change”, so Netflix changed with the times.

We see Netflix continue to adapt even today by using subscription pricing to access a fully online streaming service. Introduced in 2007, Netflix streaming solved many of the problems that Netflix previously experienced: accessibility, shipping times, and inventory control to name a few. Now that streaming has become a new industry standard, Netflix now needs to compete by offering competitive content. So, once again Netflix adapted by producing their own entertainment content using their subsidiary movie production company, Netflix Studios LLC. Both streaming and producing content has allowed Netflix to grow as a company.

Even now, the challenges that Netflix faces are brought about by the way they have responded to previous business problems, and their new opportunities result from how they resolved previous business problems. This is the cycle of innovation that pushes businesses and industries forward.


Gupta, S. (2005). Netflix, Inc. (A). Michigan Ross School of Business.