The Prisoner’s Dilemma Wedge: Netflix’s strategy for startup traction

A case study in disruption and scaling

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Disney’s recent overture to acquire Fox seems to have prolonged a trend toward ever larger media consolidations, which is as good of a time as any to reflect on the genesis of that groundswell. Part and parcel, the disruption of so many media businesses at the hands of Netflix is a well-documented phenomenon: Netflix shook-up the entire landscape, both vertical and horizontal, from Blockbuster to movie studios to network TV to cable providers.

But, in all of that coverage, I’ve never heard anyone mention a specific prisoner’s dilemma that’s inherent in all highly competitive industries. It’s a dynamic that Netflix leveraged to coax content suppliers into giving them a foothold. Furthermore, any new entrant can use it to wedge itself into a crowded supply chain. It’s a fundamental, strategic hack that can help a lot of startups gain initial traction.

The supply chain and game theory

In 2008, Netflix signed a seminal distribution contract with Starz, gaining the upstart its first access to a content library that it could stream on-demand. While it was a breakthrough for Netflix, it’s important to note that it was inevitable, because the entertainment industry had essentially reached a state of perfect competition: A ton of competitors with highly substitutable content chasing scarce consumer demand.

As a consequence, for content producers positioned upstream in the supply chain, access to the end-user had always been a bottleneck. But, control of that bottleneck was spread out among a lot of midstream distributors — including movie theaters, DVD sellers, and cable networks like Starz. Even though producers were fighting for limited “shelf-space” and finite attention, the fragmentation of that distribution choke-point always assured that power was, well, distributed.

The media supply chain pre and post-internet (*oversimplified and not even close to scale)

Enter Netflix.

Back in 2008, Netflix wasn’t selling something that could augment the core business of Starz and its ilk. On the contrary, a deal with Netflix seemed more likely to cannibalize that core — at least at first blush. After all, Starz’s lifeblood was the affiliate fees paid by cable providers, who valued networks based upon the subscriber headcount they could bring to the table. Said another way, Starz’s core business lived and died by how many eyeballs it could deliver to cable companies, and the eyeballs won by Netflix not only wouldn’t count towards that sum, but could potentially subtract from it.

But when you think about the nuts-and-bolts, such churn wasn’t a realistic risk, because consumers still got a lot more value out of their cable bundle than the Netflix/Starz combination. At that time, a full Starz subscription cost under $2 per month as an itemized part of the cable bundle — compared to Netflix’s equivalent at $8.99. So, Starz at least had the security of that low-cost provider price arbitrage in its partnership agreement with Netflix.

More importantly, consider what Netflix was offering Starz (and any other takers) from a bottom-up perspective:

1. Starz was not just commoditized, but an also-ran compared to the likes of HBO and Showtime, so it had no negotiating leverage over the cable companies upon whom it was dependent, which made Netflix’s new revenue stream alluring as both a hedge and bargaining power come time for cable contract renegotiations;
2. Netflix’s licensing fee was incremental revenue at zero marginal cost

That first item is self-explanatory, but the importance of the second can’t be overstated. Starz didn’t have to incur any tangible expenses to stream its content via Netflix — no additional production costs, no additional content licensing costs, nor distribution costs, customer acquisition costs, not even forgone opportunity costs. In fact, Netflix paid Starz for the rights! All Starz had to do was sign on the dotted line, then Netflix merely flicked-a-switch. (To be clear, there were associated costs and marginal costs borne by Netflix, the intrinsic value of which was likely imputed in the bilateral contract, but Starz itself bore little more than its own legal and administrative expenses.) Who in that position would refuse that opportunity — free revenue, pure profit, no heavy lifting!?

Given that risk/reward, plus all of the undifferentiated competitors in the fray along with Starz, it was only a matter of time before one upstream or midstream supply-sider dissented to sign-on with Netflix. It was a prisoner’s dilemma, entrapping every one of those contemporaries in a false-choice among:

1. If everyone rejects the Netflix deal, you all maintain the status quo;
2. If you alone reject the deal and your competitors accept it, you alone get obsoleted;
3. If everyone accepts the deal, everyone gets modularized;
4. If you alone accept the deal and your competitors reject it, you alone get handsomely rewarded

Objectively, the dominant strategy given a prisoner’s dilemma is to accept the deal, because accepting has a higher expected value than rejecting. This is essentially “Nash Equilibrium”. Since collusion is illegal, we can only assume that nobody knows what anyone else is doing, so we’d expect at least one person to accept the deal, because accepting has the highest risk-adjusted payout.

That’s our first critical insight: If you’re an upstart, occupy a bottleneck in a competitive market with commoditized suppliers or distributors, then present the supply chain with a prisoner’s dilemma.

The approach reminds me of Steve Jobs launching iPhone in every country by approaching the #2 (or even lower-ranked) telecom companies, like the US’s AT&T and Japan’s Softbank, for whom the proposition of iPhone exclusivity promised enough incremental marketshare that it was worth the risk/reward of surrendering to Apple’s terms.

The challenge for demand aggregators

Thus far, we’ve ignored a fundamental challenge to upstarts like Netflix on the demand-side: Following academic business strategy is one thing, but developing a winning product/service is another. In other words, demand aggregators actually need a way to aggregate demand, right?

Well, perhaps that challenge is overstated: Netflix didn’t even need to aggregate a critical mass of users; all it needed was to lure someone on the supply-side with a fat check. (Perhaps the bigger challenge was that capital doesn’t grow on trees, although that’s what robust funding and liquid capital markets are for!)

That’s our second critical insight: If a prisoner’s dilemma is the stick, then something-for-nothing (e.g. free revenue) is the carrot.

I don’t want to minimize the product challenge, but a good product is merely the ante and I’m here to talk strategy. More importantly, consider product within context of this prisoner’s dilemma. Building a two-sided marketplace like Netflix’s can present a chicken-or-the-egg paradox when trying to gain initial traction. How can you attract consumer demand without content supply — and vice versa? Well, Netflix cut straight to the chase by licensing Starz’s catalog, instantly scaling the supply-side and betting that the demand would follow.

That was a huge bet, to be sure, especially considering that Netflix had to upsell its own, new subscribers, who could access this same content (and a whole lot more) for cheaper elsewhere. In fact, we can roughly quantify the magnitude of that bet: Since the Starz license was worth ~$25M, Netflix was betting that they could attract ~230k subscribers¹ who valued their product (streaming video) highly enough to justify the premium over preexisting solutions (cable).

That might sound like a lot, but it’s not entirely unrealistic. To cover the licensing fee, Netflix only needed to sign-up at most 0.2% of US households who subscribed to pay TV² (or grow-the-pie by tapping unmet demand).

That’s our third critical insight: You have to upsell the supply you’ve acquired, so focus on a tiny niche of buyers for whom the problem you solve is so acute that they’re willing to pay a premium over preexisting solutions.

Position and integration/disintegration

Whether bestowed by academics like Clayton Christensen or analysts like Ben Thompson, new strategic dicta are starting to pervade mainstream consciousness. They talk about how market opportunity — whether horizontal or vertical — continually shifts between integration and disintegration.³ At the same time, every successive epoch’s monopoly is created by occupying a choke-point in the supply chain.

Netflix exemplifies both of these dynamics, integration and modularization. While it looked like just another distributor in 2008, Netflix had actually positioned itself at a bottleneck even further downstream — in a void between these distribution networks and the audience.

Being closer to the customer than their competition also gave Netflix insight into usage trends, which they could then use to fuel the industry’s fastest product iteration cycles. (This is one of modern direct-to-consumer business’ most massive, transformative revelations.) At the start, they were able to aggregate end-user demand thanks a 10x value proposition that a few niche consumers highly valued, then compound that initial interest via an accelerating flywheel that continuously made the product better. As a consequence, Netflix eventually both integrated content from modular distributors (vertical integration), and modularized the bundle from integrated cable providers (horizontal integration).

The “Population vs Sample Parlay”

Simplistically, all of Netflix’s contemporaries started with a similar value proposition — let’s call it the the “Population vs Sample Parlay”: Most of our latter-day tech darlings disrupted incumbents by providing consumers with (effectively or comparatively) the entire population of supply, whereas incumbents were structurally constrained to merely providing a sample. For example…

• Google: The entire population of information vs Yahoo’s sample (which was constrained by manual curation);
• Facebook: The entire population of your classmates’s info (easy to find in a single medium) vs a sample (hard to find across fragmented mediums with unknown phone numbers and email addresses);
• Amazon: The entire population of books vs Barnes & Nobles’ sample (which was constrained by inventory capacity);
• Netflix: The entire population of titles vs Blockbuster’s sample (which was constrained by inventory capacity)

The intuition of the Population vs Sample Parlay is perhaps implicit in the definition of “Aggregators”, but it’s a tidy distillation of the concept that traces all of these disruptors back to a common thread. (Although, of those four FANGs listed as examples above, Netflix is least likely to qualify as an Aggregator per the academic definition. Perhaps more on that another time.)

Had it been for the unconstrained potential of Netflix’s on-demand population vs linear TV’s sample alone, nobody would have given Netflix an in. But, in reality, nobody in that part of the supply chain could have foreseen Netflix as a rival.

To wit, even in 2008 Starz had a number of on-demand offerings of its own, and although every one of them had its own foibles, inertia would’ve likely allowed traditional distributors’ video on-demand (VOD) services to squelch Netflix’s offering. But, part of Netflix’s marketing genius was to comp itself not against its own suppliers’ VOD offerings, but rather against Blockbuster and other dinosaur movie rental chains, relative to whom its value proposition was strongest.⁴ By serving a different niche than its suppliers, Netflix might have even been viewed favorably by the integrated providers, since it was growing-the-pie for the entire entertainment industry. Relative to upstream providers, Netflix looked like just another distributor, at a head-to-head cost disadvantage, staying-in-its-lane — this little niche horizontal for consumers who are willing to pay an enormous premium for streaming video on-demand (SVOD). That made Netflix no more of a competitor to producers and distributors than movie theaters or rental chains.

That’s our fourth critical insight: Choose a direct competitor in your horizontal against whom your value proposition is strongest, which not only avoids channel conflict with your upstream suppliers, but also justifies your markup relative to their services.

Yet, again, even had all the players recognized Netflix’s potential (to integrate both horizontally and vertically), the prisoner’s dilemma still assured that someone would give-in.

“The prisoner’s dilemma wedge”: A canvas

Here’s the framework established by that Netflix case study, which anyone can apply via the following canvas:

1. Occupy the bottleneck between [commoditized/modularized/atomized upstream suppliers] and [end-users];
2. Present all of those substitutable suppliers with a prisoner’s dilemma, specifically [something] in exchange for [nothing], which will attract at least one bite and provide the supply your end-users want;
3. Cover the acquisition cost by upselling it to [a subset of niche end-users] who value [your unique solution] so highly that they’re willing to pay a premium price, which assures your suppliers that you won’t cannibalize their preexisting revenue;
4. To further avoid channel conflict with your upstream suppliers and justify your markup above their direct-to-consumer pricing, market yourself against [the direct competitor in your own horizontal] who makes [your value proposition] look the strongest by comparison.

To summarize, that canvas has these fill-in-the-blanks, arranged in proper order as follows:

The Prisoner’s Dilemma Wedge (a canvas)

1. What do you want from upstream suppliers in your industry that will cost these suppliers nothing?
2. Who are the commoditized/modularized/atomized upstream suppliers in your industry?
3. What’s something you can offer them in exchange for what you want?
4. Who are the end-users in your industry?
5. What is your unique solution?
6. Who are the subset of niche end-users that would pay a premium for your unique solution?
7. What is your value proposition for that subset?
8. Who is the direct competitor in your own horizontal who makes your value proposition look strongest in a head-to-head comparison?

For example, applying that, Netflix’s canvas before the Starz deal would’ve looked like this:

1. Occupy the bottleneck between linear movie channels (like Starz) and cable subscribers;
2. Present all of those modularized linear movie channels with a prisoner’s dilemma, specifically free revenue in exchange for turnkey access to their movie catalogs, which will attract at least one bite and provide the supply Netflix’s end-users want;
3. Cover the acquisition cost by upselling it to movie enthusiasts who value streaming video on-demand so highly that they’re willing to pay a premium price, which assures Starz that Netflix won’t cannibalize its preexisting revenue;
4. To further avoid channel conflict with Starz and justify its markup above Starz VOD pricing, market Netflix against Blockbuster who makes Netflix’s frictionless movie rentals with no late fees look the strongest by comparison.

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Footnotes

¹ Assumes an $8.99 monthly subscription and a conservative 12-month average life. So, Netflix’s customer lifetime value (LTV) was as follows: LTV = $8.99 * 12 = $108

² In 2010, 88% of US households subscribed to pay TV, and there were a total of 116.7M households nationwide. So, Netflix’s tangible addressable market (TAM) was as follows: TAM = 116.7M * 0.88 = 102.7M

³ The idea of industries constantly shifting between integration and disintegration echoes of a saw most commonly attributed to Jim Barksdale:

There are only two ways to make money in business: One is to bundle; the other is unbundle.

In some form, this concept of profit pools shifting up and down a supply chain or value chain manifests Clayton Christensen’s original “Law of Conservation of Modularity”, which he himself later renamed “The Law of Conservation of Attractive Profits” (COAP). Seeming to describe Netflix, Starz, and The Prisoner’s Dilemma Wedge rather presciently, Professor Christensen concluded a bit about COAP as follows, from his book “The Innovator’s Solution”:

Overshooting does not mean that customers will no longer pay for improvements. It just means that the type of improvement for which they will pay a premium price will change. Once their requirements for functionality and reliability have been met, customers begin to redefine what is not good enough. What becomes not good enough is that customers can’t get exactly what they want exactly when they need it, as conveniently as possible. Customers become willing to pay premium prices for improved performance along this new trajectory of innovation in speed, convenience, and customization. When this happens, we say that the basis of competition in a tier of the market has changed.

⁴ Truth be told, by 2008, Blockbuster had come-from-behind to meet and exceed Netflix’s competitive challenge. The rental chain would’ve genuinely overtaken Netflix had it not been for a shareholder activist, Carl Icahn, whose newly-appointed CEO, James Keyes, derailed Blockbuster’s turnaround train.