Question

PART 2 - Short Answer, 7 points overall, point values are indicated for each part of the question. You need to show your work and/or explain your reasoning to receive full credit. 1. Suppose Netflix currently offers two plans to stream television shows and movies. The Basic plan normally costs $11 per month, while the Premium plan normally costs $18 per month. The Premium plan includes the ability to watch on multiple screens at the same time and the ability to watch in high definition (HD) and ultra-high definition (UHD). Both packages allow for the option to chill while watching. In a bold strategic move, Netflix decides to lower the prices to $9 per month for Basic and $14 per month for Premium. When they do this, the number of subscribers for the Basic service rises from 75 to 85 million, while the number of premium subscribers increases from 25 to 35 million. a. (3 points) Calculate the price elasticity of demand for each of the packages offered by Netflix. This should be two separate elasticity calculations. NOTE: you can use 75 rather than 75,000,000 (and so on) when you calculate percentage changes. b. (2 points) Based on part a, how would you characterize demand for each type of service? Explain why the price elasticities might differ across the two plans, and whether or not you think the results here make sense. C. (2 points) Discuss whether the decision to lower prices was a good one. Then explain (briefly) how Netflix could use the information from these calculations to maximize revenue.

Answer 1

a. The table below shows the calculations for price elasticity of demand for the two plans. Price elasticity of demand for Basic plan is -0.73 meaning that for each 1% change in price, quantity demanded changes by -0.7%. Similarly price elasticity of demand for Premium plan is -1.8 meaning that for each 1% change in price, quantity demanded changes by -1.8%

	Price	Quantity	Revenue
Basic T	11	75	825
Basic T+1	9	85	765
% change	-18%	13%	-7%
Price elasticity of demand		-0.73
(% change in quantity / % change in price)
Premium T	18	25	450
Premium T+1	14	35	490
% change	-22%	40%	9%
Price elasticity of demand		-1.80
(% change in quantity / % change in price)

b. The demand for Basic plan is less than unitary elastic, implying this to be more like a necessity. It is expected to behave in this manner since a Basic Netflix plan is essential for almost every household. It also reflects in the numbers (it has 3x the demand for Premium plan). On the other hand, the demand for Premium plan is more than unitary elastic, implying to be more like a comfort or luxury, which it is since people can live with just the Basic plan. They go for the Premium plan with a drop in its price.

c. If Netflix knew the nature of the two services (necessity versus luxury) and their price elasticity, they won't have dropped the prices for both. It made sense to drop the price for the Premium plan since it resulted in the total revenue going up (due to greater than unitary price elasticity). For the Basic plan, they should have either left the price unchanged or increased it. Dropping its price has led to total revenue from this plan going down. (the other real consideration, though, could be that dropping Premium plan's price while increasing the price of Basic plan (or keeping it unchanged) may not help the perception of the difference between the two plans, which is very important for the consumers to buy Premium plan.