Netflix disruptive innovation is a textbook example of the rise of a startup and the fall of a giant due to technology discontinuity. The underlying reason has been the discontinuities created by two technologies: DVD and digitization of video content. Although incumbent rental service providers managed to withstand the effect of the reinvention wave created by the DVD mailing service, they failed to survive with the impact of video as a streaming service. With the rise of the digitization wave, a late entrant Netflix has become a poster child of disruptive innovation, whereas once market leader Blockbuster disappeared.
In the 1980s, the growing adoption of video recorders and players at home started creating the market of rental service of VHS videotapes. Among others, Blockbuster was a pioneer. It grew like a giant with 9,094 stores and 84,300 employees at its peak in 2004. However, the video products experienced reinvention in the late 1990s due to the emergence of the optical disk as DVD. Unlike VHS tape, DVDs were far lighter, opening the option of a DVD mailing service. During the same time, a new reinvention wave in the form of digitization of content and delivery over the net started to pop up. However, despite the potential, it kept struggling for multiple reasons. Some of them were the necessity of set-top boxes, slow downloading speed, and high bandwidth cost.
However, in the 2010s, this reinvention wave started gathering momentum due to positive externalities. Like many other examples, late entrant Netflix exploited unfolding positive externalities. The company got into video streaming services, but video rental service providing giants like Blockbuster were slow to respond. Subsequently, streaming services took over both rental and mailing services, and the market tipped, making Netflix disruptive innovation poster child.
Defining disruptive innovation: setting the context for comprehending Netflix disruptive innovation
Upon birth, products evolve with incremental advancement, forming an S-curve-like innovation lifecycle. The declining rate of progress at maturity starts encouraging innovators to explore alternative technology cores for reinvention. In many instances, innovators succeed in finding suitable emerging technology cores. Hence, they embark on reinvention by changing the matured technology core. However, perpetually, alternatives around reinvention appear in primitive form, producing loss-making revenue. Therefore, invariably, dominant producers busy profiting from mature products show reluctance to lead or make an early switch to the new waves. Despite the promise of unleashing radical or revolutionary innovation, for sure, new waves are fraught with pervasive uncertainties. Hence, incumbent firms suffer from innovators’ dilemma syndrome.
However, those new waves sometimes grow and become a better alternative to matured ones, turning inferior alternatives into creative destruction. Hence, due to timely switching failure, incumbent producers of matured products suffer from disruptive business, as creative destruction waves turn into disruptive innovations. Therefore, disruptive innovation is the disruptive effect on the business of incumbent firms due to switching failure to creative destruction wave formed out of reinvention.
For example, RCA suffered from disruptive innovation due to the rise of transistor radios and TVs. Similarly, the disruptive innovation effect of the digital camera made Kodak bankrupt. Other examples include cell phone, iPod, music streaming, PC, word processor, and many more. Like all those disruptive innovations, video streaming is a notable one—that grew out of the reinvention of tangible video products. The formation of video as digital content and its delivery over the internet has become a radical innovation, as it destroyed the demand for video rental and DVD mailing services. It has become a disruptive innovation due to the disappearance of incumbents and the rise of a late entrant–Netflix.
Rise of VHS tape video rental service:
The invention of the video cassette recorder (VCR) in 1956 opened the door to revolutionizing the movie industry. It seeded the changing television-watching habits. However, still the 1970s, its adoption did not pick up due to high costs; there was the need to change the costly rotating head. For example, in 1956, the price tag of Ampex’s VRX-1000 was US$50,000 (equivalent to some US$325,000 today). It also needed a highly-skilled operator.
Miniaturization of electronics and adoption of VHS standards led to the rapid adoption of VCR at home. It also contributed to the growing availability of movies on VHS tapes. Hence, a demand got created for renting movies as VHS cassette tapes. The world’s first video rental store renting out copies of films for private use started in 1975. The ease of getting movies to watch with VCR at home positively affected the adoption and creation of demand for rental services. Hence, due to the advancement and price reduction of VCR and the positive externality effect, the rental service market started growing rapidly. Furthermore, scale advantage fueled monopolization leading to the formation of dominant rental service provider Blockbuster, founded in the USA in 1985.
The emergence of DVD mail delivery service—could not Netflix disruptive innovation
To overcome the deteriorating quality of video recorded on magnetic tape, innovators were after the reinvention of video recording and playback means. It led to the emergence of DVD—digital video disk. The compactness of DVD created the window of reinventing video rental service, making it a DVD mailing service. Hence, among others, a startup, Netflix got into renting DVDs by mail in1997. As opposed to driving or walking to video rental stores, customers started finding the option of browsing catalogs on websites, placing an order, and getting delivery through the mail more preferable.
Therefore, DVD mailing services started to grow as a new wave, posing a threat to the video rental service of dominant players like Blockbuster. Among others, startup Netflix launched its DVD mailing service in 1998 through Netflix.com. However, the service was facing difficulty due to poor collection and limited adoption of DVD players. For example, Netflix debuted in 1998 with 925 titles—almost the entire catalog of DVDs at the time.
However, due to the superior quality of DVD content and decreasing price of players, demand for DVD subscriptions rapidly ramped up. In the USA and many other high-income countries, DVD players became a popular gift for holiday sales in late 2001. In addition to being a pioneer with DVD mailing services, Netflix also focused on attaining proprietary technologies, leading to getting a US patent covering its subscription rental service and several extensions.
As usual, successful high video rental service provider Blockbuster responded late to this new wave. Albeit late, Blockbuster launched its DVD mailing service in 2004, reaching 2 million users by 2006.
Growing profit and record DVD mailing did not let Netflix to complacent: a key driver of leading disruptive innovation
Due to the rapid adoption of the DVD mailing service, Netflix posted its first profit in 2003, earning $6.5 million on revenues of $272 million. Its’ profit soared to $49 million on $500 million in revenues in 2004. Netflix’s collection also ramped to 35,000 different films in 2005. But, despite the record shipping of 1 million DVDs every day and soaring profit, Netflix did not rest on enjoying the success. Instead, it focused on destroying the success of the DVD mailing service. Hence, Netflix embarked on reinvention by making movies digital content and delivering them over the Internet. In retrospect, it was an essential requirement for the uprising of Netflix disruptive innovation.
Digitization of video content and delivery over the net: struggled to take off but finally made it
Ironically, video on demand (VOD) over the net started in the early 1990s. Despite its adoption in hotels, it did not take off in the home market, the majority segment. Many startups pursuing VOD for the home market over the Internet got burst in the late 1990s. Underlying factors stunting the growth of VOD at the infancy included low Internet penetration, muffled speed, high cost of bandwidth, and need for special purpose equipment. The bandwidth solution could have been overcome by sending low-resolution videos, but viewers were not used to it. But the same VOD as streaming service became a mega success story down the road—primarily due to positive externalities. Hence, the timing for synchronization with externalities highly matters for the rise of the reinvention wave as creative destruction.
To bring radical innovation in movie selection and viewing experience, Netflix embarked on reinvention. Hence, in January 2007, Netflix launched a streaming media service–introducing video on demand via the Internet. But it was inferior due to only 1,000 films available for streaming compared to 70,000 available on DVD. Besides, internet speed was still a barrier. But among other externalities, the growing habit of watching video steam through YouTube played a positive role. Subsequently, the rapid expansion of Internet penetration, the rapid growth of speed, and the quick adoption of smart TVs led to ramping up the diffusion of streaming services. However, to tip this new wave towards Netflix, the company undertook serval measures. Forming agreements with movie-making studios and producing premier content are among them.
Late entrant Netflix leads reinvention out of digitization and once-dominant Blockbuster suffers from disruptive innovation—making Netflix disruptive innovation
Reinvention waves out of digitizing movies and sending them to home viewers as streaming service has grown as creative destruction. It has destroyed the demand for video rental and mail delivery of DVDs. Although both Netflix and Blockbuster became strong in DVD mailing service, Netflix became far more aggressive than others to lead the next wave, video streaming service. Like in the past, Blockbuster was late. Unfortunately, the rapid scale-up of Netflix’s streaming services and tipping did not give time to Blockbuster to switch. Hence, unlike the past, in turning late move to DVD mailing an apparent success, Blockbuster suffered from the burn of the disruptive effect of streaming services.
Unlike Blockbuster, Netflix did not become content with its success. The rapid growth of DVD subscriptions and soaring profit could have been a reason for Netflix’s management to keep exploiting the current wave. If it did so, a new entrant could have driven the streaming service, making both Blockbuster and Netflix sufferers from the disruptive innovation. Surprisingly, being a dominant player in DVD mailing service wave, Netflix took the dive to reinvent—subsequently destroying its profitable business. Due to growing positive externalities, reinvention wave streaming services took off. Through additional measures, like partnership and premium content creation, Netflix successfully tipped the streaming wave towards it.
Consequentially, once valued at $8.4 billion (1994), Blockbuster is now bankrupt. On the other hand, late entrant Netflix through the self-inflicting creative destruction wave became a $203 billion company in 2020. The company witnessed $29.7 billion in revenue and $5.1 billion in net income in 2021. Hence, the fall of once giant Blockbuster and the rise of late entrant Netflix out of creative destruction is a typical example of the disruptive innovation effect of digitization. Indeed, Netflix disruptive innovation offers lessons to startups and incumbents.