An awful lot of pixels have been burned on the dramatic price increase that Netflix announced last week. The popular phrasing described a “social media firestorm” of complaints from angry customers who vow to switch to Blockbuster rather than pay $16/mo for the service they’re getting today for $10. It’s not surprising that people would complain; a 60% price increase tends to get people’s attention. But complaining is one thing, and taking your business elsewhere is another. If you’re upset with the price hike, where are you going to find a service that gives you both unlimited streaming as well as DVD rental for $10 a month?

There isn’t a competitive service, of course. Blockbuster doesn’t do streaming, Amazon’s streaming service is extremely poor and limited, and Hulu’s streaming service isn’t competitive in terms of quality with Netflix. I suspect that those of Netflix’ customers who aren’t happy about the price increase will survey their options and decide to stick around. For most of them (myself included) the choice will come down to Netflix streaming or Netflix DVD. $10/month is about the right price, so I don’t expect a lot of people choosing both. I’m personally leaning toward the streaming-only service, despite the fact that the choice is pretty thin. If I find myself hankering for DVDs, there’s a Blockbuster close by that offers that service for a low-enough price without the postal delay.

A media analyst has finally broken the code regarding Netflix’ motivation, CNet’s Greg Sandoval. Sandoval’s article, Is Netflix killing DVDs like Apple killed floppies? explains how the customer rage will ultimately benefit Netflix:

This dissatisfaction is going to provide Netflix with tremendous leverage in their content licensing going forward. The question for Hollywood will be do you or don’t you want to sell premium entertainment to the largest and most active subscribed base of young film and TV customers in the country.

The complaint about the Netflix streaming library is the dearth of content, but that’s not really the fault of Netflix so much as it’s the fault of Hollywood for not making the content available. Netflix is banking on customers realizing that before the price increase takes effect on current customers in September, and sticking around with a streaming-only plan. Netflix is the biggest buyer of DVDs in the world, effectively a “monopsony” with the power to set prices for DVDs and shape the market in significant ways. If Netflix stops buying DVDs on a large scale, Hollywood is going to feel the pain.

Netflix has a business model that’s largely immune to fixed overhead. They rent the facilities they use to encode movies for streaming, and they rent Content Delivery Network services to stream movies. Most of their costs on the DVD side are postal fees and DVD purchases, and these scale with demand for the most part. The only fixed overhead is the labor to process DVDs on the way in and the way out, and people can be fired and contracts can be terminated without much impact on the bottom line. Netflix makes a lot more money per customer from streaming than they do from mailing DVDs, so they’d obviously like to focus on the streaming side even if that means a smaller company in terms of revenue, because it’s much more automated and much more profitable.

The bet actually comes down to a judgment that video consumers will prefer to stream three star movies and old TV series than to watch four star movies on DVD. Netflix has the customer preference data to take the risk out of this bet, and if they’re wrong they can always lower prices in the future and reinstate DVDs. I suspect they’re right.

So what we have here is a showdown between Netflix and Hollywood. Netflix has a secret weapon in this fight: Piracy. Some large number of the people who drop the Netflix DVD service will turn to unlawful sources for the four star content that Netflix doesn’t stream. They know this and Hollywood knows this, and both of them know that a little revenue from legal streaming is better for Hollywood than no revenue from piracy. There has been a decline in piracy recently, but it coincides with more content availability from legal sources. It also coincides with increased enforcement measures, and which is the more significant is one of the areas of dispute between Hollywood and Netflix.

If Netflix is right, video consumers care more about convenience than about content quality and choice. If they’re wrong, content is king. It seems that Netflix is hoping that their angry customers will shift their rage to Hollywood, and the content lords will lower prices and make more content available at lower prices. Hollywood has a few tricks up their sleeve, so it’s not obvious that Netflix is going to win this battle. Hollywood could also increase the quality and scope of its own content streaming services, replacing Hulu or substantially upgrading it. They have the expertise to do this, and considerable marketing skill of their own.

The DVD is an unappealing format, and a one-DVD-at-a-time rental plan is not at all suitable for many, many customers. But DVDs are nice for viewing on the road and in the air, where streaming is just not practical yet, so the question of timing is all-important.

It’s going to be interesting to see how this plays out, but in the short term Netflix has created an opportunity for a nimble competitor to enter the fray with a more mobility-friendly video service.

[Cross-posted at High Tech Forum]