10/31/2011

Pricing Decision of Redbox

Redbox recently announced that it would raise its nightly DVD rental fee from $1 to $1.20 due to increased costs, specifically the increase in charges for processing debit card transactions. In an article by Matt Brownell (http://www.thestreet.com/story/11293833/1/redbox-price-hike-could-dodge-netflix-outrage.html), Redbox's interchange fees are going to increase from $.06 to $.23 on average. In the days following the announcement, Coinstar, owner of Redbox, saw their share price drop by %10. This may have been worse, but Redox eased the new, higher price into the market by first testing it in different markets. However, despite the drop in the share price, the price increase on DVD rentals will pay off in the end. Some articles cite that after Netflix raised their prices 810,000 customers cancelled their subscriptions looking for a cheaper alternative (http://seekingalpha.com/article/302037-netflix-disaster-shifts-focus-to-redbox). Redbox in a prime position to win over those 800,000+ customers with their cheaper prices. The pricing decision must also have economic reasons backing it. In chapter 9 of the text teaches that "To maximize profits...management should take into account both the demand and the costs" (pg. 229). Specifically mentioned in making a pricing decision that will maximize profits are the marginal costs, the price elasticity of demand, and the incremental margin percentage. The authors explain that "...when marginal revenue equals marginal cost, then the incremental margin percentage equals the reciprocal of the absolute value of the price elasticity of demand" (pg. 228). Using the numbers from Matt Brownell's article, we know that Redbox's marginal costs are $.23 , with a price of $1.20 the incremental margin percentage will decrease to from .94 to .808. With an incremental margin percentage of .94, that would mean that the price elasticity of demand would have to be -1.237 so a 1% increase in price will lead to decline in demand of 1.237%.
It will be interesting given the recent price increase of Netflix and the number of cancelled subscriptions to see if the price increase will actually lower the demand for Redbox rentals.

12 comments:

sjenn said...

Redbox has been charging one dollar per rental for several years now with no increase in price. I have been waiting to see a price change as it is inevitable. With rising prices in nearly every sector of the economy, there no doubt has been much economic pressure on Redbox to change its pricing structure. A twenty percent increase, however, is much easier to stomach than a much more significant increase made by Netflix. I don't think this increase will lead to a decrease in demand by consumers.

Brandon said...

I think Redbox has established a good example of how to handle a price increase. Even though they announced that they are going to raise their DVD rental fee to cover increased costs, they have eased the idea of charging a higher price to customers by implementing this new price in a few different markets to try and gauge how customers will respond when they increased price is fully implemented. According to last week's Bloomberg Businessweek issue (Oct. 24 - Oct. 30), when Netflix decided to split their DVD mail order service from their online movie streaming service and increase the prices of both, they never ran any focus groups or interviewed any customers to see how they would react to such a change. Instead, Netflix simply relied on data they had collected that showed that over 75% of new subscribers preferred online streaming service over the DVD mail order service. Nevertheless, this data didn't account for Netflix raising their prices or splitting their services. By implementing their increased prices in to different test markets, I believe that Redbox has put themselves in a prime position to continue to maximize their profits, as well as pick up some of the customers that Netflix has lost. I also agree with Mitchell that it will be interesting to see how the decline in demand for Redbox is affected by the price increases of Netflix.

Dr. Tufte said...

-1 on Mitchell for grammatical errors.

But, what a great application of Chapter 9 Mitchell. It seems like Redbox should not go in this direction, but we'll see.

I don't have much more to add, but it's going to be fun going back and reading this stuff in Fall 2012 when I know how it turns out.

Papa Smurf said...

I understand why as we have read, and as Mitchell pointed out so clearly, this increase in price should hurt the overall demand of Redbox. However, I do not think that Redbox will see the same decline that Netflix saw. I see two reasons why Redbox will not suffer the same decline in demand that Netflix experienced. The first reason is because Redbox faces very limited competition. There simply are not many places that a consumer can go and rent a movie now. Competition such as Blockbuster and Hollywood Video are non-existent in the St. George market, there simply are not other substitutes for renting a video other than Redbox. One problem that Netflix has is that there are a considerable amount of substitutes in their industry. The second reason that I don’t believe that Redbox will see such a huge drop in demand is for the simple reason that it is only an increase of 20 cents. True that the overall rise in price the price of a DVD rental is 20%, I just don’t see consumers quitting their use of Redbox over 20 cents.

Dr. Tufte said...

Interesting. I agree with Papa Smurf, but I feel odd about it.

He's saying that the demand for DVD's from Redbox is inelastic. That may be so, and I'm inclined to agree with it ... but I don't think that many would have predicted that the market would turn out like this a few years ago.

It seems to me that people flocked to Redbox, in part, because their demand for, say, Blockbuster was very elastic. Now we shift forward, and it seems that demand for Redbox might be inelastic. I'm not sure how that happens in practice, but it seems plausible to me right now.

Sam said...

I think Redbox’s demand is currently inelastic because their prices are so low compared to other alternatives. If you recall, renting a new release video at blockbuster cost about $5.00. This is a 400% increase over the cost over what Redbox is now charging. Blockbuster justified this price by giving you the video for a full 5 days; however this rental period was excessively long. I never rented a video that I wanted to watch 4 days after I picked it up. Blockbuster currently offers an online and offline movie service called Blockbuster Movie Pass that costs $20 per month. Netflix seems like an inexpensive alternative at $8 a month but if you want the newest releases you will need to increase your subscription to $16 a month and wait for the video to arrive in the mail. I think due to its relatively very low price the increase of $.20 will not affect consumer behavior. It would take a considerably higher price increase to cause consumers to even look at the alternatives.

Dr. Tufte said...

-1 on Sam for poor capitalization.

Sam's agreeing with us (which is fine). But I'm still not getting how demand could be inelastic. Demand for low ticket items tends to be elastic.

Locke said...

It may be true that Redbox has no real competitors, with Blockbuster and Hollywood videos going out of business, but the effects of a price increase may depend on the strategy.
When Netflix increased their prices they expected to lose subscribers. But they also planned on expanding at the same time. According to Bloomberg Businessweek (Oct 31-Nov 6 p.32) Netflix wanted to expand into the UK and Ireland. The price increase elicited a loss in over 800,000 subscribers, and a drop of 27% in stocks. Expansion will have to wait until the numbers look better.
If Redbox has a head on its shoulders (a strategic plan at corporate levels), it will continue forward through this price increase.

Unknown said...

It really is a shame that Redbox had to raise their prices, but they did a really good job at doing so. They tested it out with a few states and then did it throughout the U.S. I think it won’t affect them too much. I went with Blockbuster through my provider/employer DISH Network and I love it! I get so much for only $10 a month. I get streaming, mail-in DVDs, in-store exchanges, 20 premium HD channels, Blu-rays and games at no extra charge and new releases 28 days before Netflix or Redbox. I couldn’t be happier with my choice.

Joe said...
This comment has been removed by the author.
Joe said...

Has anyone considered Redbox's strategy of blaming the increase in price on the interchange fee? It has been a few years since I worked in the industry but it used to be rare that a transaction fee would increase that much. I'm suspicious: obviously I don't know for sure but I'll bet Redbox is receiving a deeper discount on the equipment used in the transaction in exchange for the increased fee. Shrewd, effective, and certainly light-years ahead of Netflix's PR skills.

Dr. Tufte said...

Ooh Joe, now that is a neat idea. Thanks for adding it!