The latest quarter results for Netflix, a service website that enables its users with access to television shows and movies via online streaming and in the mail, saw its membership increase by 610,000. According to CEO Reed Hastings, this marked the biggest surge in the number of users, a sharp rebound from a debacle last summer when 800,000 members quit the service following an unexpected price hike and Netflix’s decision, which has since been reversed, to separate the company’s streaming and mail-order DVD rental businesses.

In an industry once dominated by firms like Blockbuster and Hollywood Video, Netflix has since taken over the competition by revolutionizing the video rental process. First, it pioneered the movie-by-mail business that put many video rental stores out of business. Instead of having customers travel to the stores, Netflix essentially reversed this relationship by directly reaching out to the customers themselves.

The company also made highlight in making a smooth transition from “old technology” (delivering movies via mail) to “new technology” (having an online database that streams movies and shows online). Since then, Netflix has transformed the way people watch television shows and films. Currently, it boasts over 75 thousand selections for its 24.4 million subscribers in the US, Canada, and even parts of Central America.

Critics of the company are quick to posit that the success of Netflix is an ephemeral phenomenon. They claim that just as Netflix was able to overtake its competitors in a short span of time, it too will be a victim of technological innovations in the near future. All businesses rise and fall. People believed MySpace would last for a long time, given the great level of innovation in networking it brought to the market at the time… until companies like Facebook emerged. Perhaps there will be a time when a new innovative high- flier shuts down Netflix’s business. However, current conditions indicate that it won’t happen for any time soon.

In the midst of heightened public sensitivity over Internet piracy due to H.R.3261 (Stop Online Piracy Act) and S.968 (Protect Intellectual Property Act), Netflix is one of the few that is insulated from the consequences of these legislations. Although Representative Lamar Smith (R-TX) has withdrawn the House bill, the Senate legislation is still up for debate. However, regardless of whether PIPA is passed into law or vetoed, Netflix will be in good standing.

If the bill passes, Netflix would become the most financially viable option to watching shows and movies for many consumers. Besides the computer gurus who might be able to work around the regulations and download from illegal websites or networks, most consumers are left to seek legal alternatives. Having to pay ten dollars for a movie ticket versus paying eight dollars for a monthly Netflix membership fee, the consumers would much rather choose the latter because consumers can access many more shows while paying less per shows that they watch. By having a Netflix account, subscribers can view thousands of television shows and movies provided by the website. Rather than being able to watch the one movie from buying the movie ticket, consumers can watch many more shows for the same price.

Furthermore, having the ability to stream for shows online eliminates the implicit costs of time and money to travel to video stores or the movie theaters. Therefore, consumers who may otherwise not have subscribed to Netflix will have even more incentives to subscribe if online piracy regulations are passed into law.

This may give Netflix a near monopoly power over the industry, which they can leverage to hike up membership fees. However as long as they can adjust their monthly charges at a reasonable rate, it seems hard to doubt the continuity of Netflix’s high- flying success. Even if the bill is not passed, Netflix can still potentially benefit from this result, as some consumers worried about the legitimacy of their pirated contents may end up switching to the legally viewable sites like Netflix.

Additionally, in a high-piracy environment, Netflix can profit from favorable contracts with media companies. As content owners become more disheartened to see their content being shared without them receiving any revenue, they will offer more favorable negotiating terms to Netflix, which can help them monetize beyond box-office tickets, pay-per-view or DVD sales.

Internet piracy will never completely go away, but the ebb and flow is something that Netflix can capitalize on. Perhaps Netflix is the true winner of this ongoing battle over online piracy. was initially launched in 2007 as a defensive move by television networks to address the growing unlicensed television content being shared illegally over the internet. Television network executives at NBC Universal, Fox Entertainment and ABC created the website as a joint venture with the intention of avoiding the outcome of the music industry, in which third party applications, such as iTunes, became the ultimate profiteers of web-delivered content. By hosting high-quality, full-length television episodes, Hulu successfully ensured networks compensation for their content. The challenge currently facing the website lies in outlining a sustainable business model that can support its content and interface while still generating profit. Kim Joar Bekkelund’s analysis of the “freemium” business model provides the perfect platform to analyze the impact of Hulu’s newest feature, Hulu Plus, a subscription service that charges users for access to increased content on a wider range of platforms. This analysis shows us that, given Hulu’s costs and pricing options, the website is currently a poor candidate for the freemium model.

Prior to mid-2010, Hulu’s sole source of revenue was from the short fifteen-second to two-minute advertisements shown before and throughout videos. Although episodes streaming on Hulu have significantly fewer minutes of commercial than traditional television episodes, the website brings in considerable revenue because of its high traffic. Hulu presumably also charges advertisers a premium for the controlled quality of its content library, the interactiveness of its commercials, and its interface’s ability to tailor advertising to specific audiences. In 2009, Hulu’s revenue from its then entirely advertisement supported site was $108 million and the site’s annual advertising revenue has only grown since. Its costs are also significant, however. Although the company’s general administrative costs and the cost of supporting the website’s bandwidth should be relatively insignificant, Hulu must pay television network “content partners” 50 to 70 percent of its advertising revenue for permission to stream their video content.

Hulu added its second revenue stream in June 2010. Hulu Plus charges users a monthly fee of $9.99 for access to full seasons of television shows and the ability to use Hulu on select non-computer platforms, including iPads, iPhones, Blu-ray players, and certain Samsung televisions. (The price of the service has since been lowered to $7.99.) Notably, Hulu Plus is also ad-supported, suggesting that the company does not see subscription fees as a replacement for advertising revenue. The paid service is instead being positioned as an upgrade to the free version of Hulu. With this second revenue stream in place, Hulu has essentially transitioned itself into a variation of what is known as the freemium business model.

In his paper Succeeding with Freemium, Bekkelund outlines eight preconditions necessary for a freemium model to be effective.  Hulu meets most conditions: the site has a large addressable market, its interface makes the benefits of Hulu Plus clear to nonpaying users, and initial advertising for the free product was primarily driven by word of mouth. Hulu, however, fails to meet one key precondition—a low marginal cost. In theory, a freemium company uses its free product as a marketing tool to convert general users into paying customers and revenue from paying customers to finance the free product. Thus, it is in a freemium company’s interest to attract as many free users as possible to widen its pool of potential paying premium users. For the revenue from premium users to cover the costs of a high number of free users, marginal cost must be low. Hulu’s high content cost prevents it from meeting this condition.

It may seem that, because Hulu brings in advertising revenue from videos streamed, its high marginal cost should not be an issue; this is unfortunately not the case. If profit margins from Hulu Plus users were significantly higher than those from free users, Hulu Plus subscription fees could cover the majority of Hulu’s business costs and profit expectations. Advertising revenue from free users would then be supplementary and Hulu would essentially operate under an adapted freemium model. However, because Hulu Plus offers much more content than the free version of Hulu, streaming full seasons of shows rather than four or five recent episodes, Hulu Plus’ content costs are also higher. As a result, the profit margins of Hulu Plus are likely similar to those of Hulu. If Hulu was unable to sustain itself with only advertising revenue from its free service (which seems the case given that adding a pay wall on a previously entirely free website runs the risk of alienating existing users), the addition of Hulu Plus is unlikely to help the situation.

Bolstering Hulu’s profitability by adjusting the price or product mix of Hulu Plus is also not an option. In fact, given the company’s unique constraints, there is in fact no possible price point or product mix combination at which Hulu Plus would be profitable. Media feedback and the company’s decision to reduce Hulu Plus’ price shortly after its launch indicate that users are reluctant to pay for the service. Because Hulu needs permission from television networks to provide content, it does not have the option of improving Hulu Plus’ content offer and driving up the subscription fee. Furthermore, since television networks are accustomed to higher compensation for their content from other distribution channels (network television, DVD sales), Hulu is unlikely to negotiate its content costs down.

Adjusting free and premium product mixes is often used as a method of encouraging premium service sales. By reducing the quality of their free service, companies can make their premium service more desirable in comparison. However, because Hulu faces stiff competition from other video providers in the market, artificially decreasing video content or increasing the amount of advertising on the free service, would drive users away from the website completely. Besides online pay-per-view service websites (iTunes, Amazon) and other subscription based video services (Netflix), Hulu competes against illegal video sharing and file sharing sites that offer video content for free. Such sites have nonmonetary costs for users, such as a risk of computer viruses, risk of prosecution, and a level inconvenience. Even still, if the quality of Hulu’s free service declines excessively, users may nonetheless return to these options for their online video needs.

Thus, as the service currently stands, Hulu Plus is a poor application of the freemium model and not a viable long term business plan. In fact, content partners may actually be the main beneficiaries of Hulu Plus. Television networks have long complained about the compensation they receive for their content from Hulu and Hulu Plus could very well have been intended as an addition revenue stream designed to appease them. Hulu was founded as a joint venture between television networks but, as an independent company, its current priority should be to establish a business model that optimizes its long term profitability. This version of “freemium” is clearly not the answer.