Network Effects Are Overrated

When the model shifted toward streaming starting in 2008, the sources of advantage remained the same although the fixed costs of the physical distribution were now replaced with the fixed costs of digital storage and distribution. Conventional wisdom, however, is that the Netflix streaming model has unleashed a variety of supernatural powers flowing from A.I. and network effects. The result, the Deutsche Bank analyst Bryan Kraft wrote in a 2019 research report, has been to bestow upon Netflix a mystical “platform status,” implying stronger entry barriers and supporting higher valuations. Such true believers think for instance that the streaming model not only allows Netflix to refine its already excellent recommendation engine, which it does, but actually bestows on Netflix a magical ability to algorithmically pick hits, which it does not.

This particular canard begins with the origin story behind Netflix’s first big hit, “House of Cards.” As The Times columnist David Carr described it, Netflix was able to prudently outbid all other comers for two seasons of the series — 26 episodes in total for a reported $100 million — without so much as a pilot because of structural advantages bestowed by big data and artificial intelligence. In this telling, competitors were not privy to three key bits of data that together made “House of Cards” a surefire hit: the popularity of films directed by David Fincher, films starring Kevin Spacey, and the original BBC “House of Cards” series with Netflix viewers. “With those three circles of interest,” Mr. Carr wrote, “Netflix was able to find a Venn diagram intersection that suggested buying the series would be a very good bet.”

Such ex-post explanations for the selection of successful creative projects suggest a false level of predictability. They inevitably follow hits just as deafening silence follows flops. Soon after the triumph of “House of Cards,” Netflix committed to an even more expensive series — “Marco Polo.” Dropped by the original buyer, Starz, because of the prohibitive expense and complications of filming in China, the first two 10-episode seasons had an estimated budget of $180 million. When the show was canceled, no suggestion of an algorithmic glitch was provided.

Increased original content spending has been the most significant change since then in the Netflix business model, and this reflects not a better business but increased competition from companies like Disney, WarnerMedia, ViacomCBS and NBCUniversal upon whom Netflix relied for its licensed content. “Reading a script and guessing who might be good to cast in it — it’s not something that fundamentally as a tech company … we’re likely to build a distinctive organizational competence in,” the Netflix C.E.O., Reed Hastings, told Fast Company around the time of the original “House of Cards” investment. His conclusion could not have been clearer: “We think that we’re better off letting other people take creative risks.”

Netflix’s unleashing the Kraken of content investment reflects competitive necessity not newly discovered competitive advantages. Of course, the easiest way to check whether barriers to entry have gone up or down is to see how much entry has occurred since. Just between the beginning of 2019 and the end of 2020, Netflix went from representing almost half of U.S. subscriptions for on-demand video services to around a quarter, according to data compiled by The Wall Street Journal.

For almost 20 years, Netflix has repeatedly tried to incorporate network effects into its core business model. But it has failed consistently, and ultimately given up.

Even going back to the days of DVD by mail, Netflix tried to create its own form of social networking by establishing Netflix Friends in 2004. Despite never gaining traction, the company held on to the service until 2010 before shutting it down. A number of subsequent programs with Facebook, one of which Mark Zuckerberg personally had a hand in designing, were also discontinued for lack of user interest. Netflix even eliminated user reviews altogether in 2018. Hastings himself ultimately described his futile quest for network effects to me as a “competitive fantasy.”