Stanford Business magazine

Netflix Erases the Deadline Rule

By Bill Snyder

It isn’t often that a business model becomes the subject of a patent violation suit. But that’s exactly what happened in 2006 when Netflix, the pioneer in online video rental, sued Blockbuster, the giant of the brick-and-mortar video rental companies.

In 2003, Netflix patented a 31-page business model that allows customers to pay a fixed monthly fee, create an online wish list for future rentals, and order them over the internet for postal delivery. There are no late fees, as customers can keep as many as four DVDs at a time but cannot rent new movies until the previous ones are returned.

The novelty of the model and the possibility that it might be applicable to other businesses intrigued Sunil Kumar, the Fred H. Merrill Professor of Operations, Information, and Technology, whose research focuses on analyzing mathematical models of operations, particularly congestion phenomena. Along with colleagues Achal Bassamboo, PhD ’05, of Northwestern University and Ramandeep Singh Randhawa of the University of Texas, Austin, he studied the Netflix model with the goal of determining what effect the lack of deadlines has on customers and identifying the smallest amount of inventory Netflix could carry while still having enough movies on hand to satisfy customers.

The answers were straightforward: “Netflix got it right by not imposing deadlines,” Kumar said. The company needs to stock only a small fraction of the total demand for any one video to still provide good service. The Netflix business model contains an interesting set of trade-offs. When a customer keeps a movie for an extended period of time, Netflix is deprived of its use, which is a negative. Deadlines help ensure prompt return and thus reduce the number of copies that Netflix needs to stock. But because the customer can’t rent another movie until one is returned (this is known as “max out” and is included in the patent), deadlines speed up demand for other movies and trigger costs of fulfillment, such as postage, which Netflix pays. Kumar and his coauthors show that there is no trade-off here at all—not having deadlines is a win-win.

Netflix isn’t flying blind because customer wish lists give insight into what movies customers want. So the question remains: How many copies of a given movie should the company stock, and is it really better to eschew return deadlines? Customer behavior is pretty random, with some holding movies for a week, others three. The timing of new movie releases is also random. It turns out that those two facts are key to resolving the questions, according to the GSB research paper “Dynamics of New Product Introduction in Closed Rental Systems.”

To demonstrate why, Kumar uses an analogy familiar to many business students—“the inspection paradox.” Here’s how it works:

Suppose we note that taxi cabs pass a given corner on the average of one every ten minutes. Then assume I show up at a random time, and I’m told that a taxi left the corner eight minutes ago. At first glance, one would assume the next taxi will arrive in two minutes on average. But that’s incorrect; the real answer is much longer, and depends on the degree of randomness. 

The release of a new movie is like the arrival of the taxi, and the customer’s readiness to rent another DVD is analogous to showing up at the corner. Imposing deadlines would remove some of the randomness from the equation and push customers to rent faster, resulting in higher costs. Removing deadlines creates a better balance of supply and demand, the researchers conclude.

If the no-deadline model works for Netflix, would it work for another type of business? The answer is maybe, Kumar said. It would not work for a car rental business, since people tend to rent a car and return it without renting another. But consider the customers of an equipment rental business. One might rent, say, an air compressor at the beginning of a job and then return it and rent a backhoe, which could mean that a no-deadline policy would work. “It’s worth examining,” Kumar says.

And the suit? It was settled out of court in 2007, with the terms kept under wraps.

 

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