Why customers – and investors – are overreacting to Netflix’s new prices

July 27, 2011, 9:00 AM UTC

Netflix CEO Reed Hastings.

FORTUNE — Netflix (NFLX) on Monday reported a 57% increase in profits. Its stock on Tuesday plummeted by more than 10% during trading before recovering to a level 5% below the previous day’s close. The plunge, at least according to reports, came because of Netflix’s recent price increases. Executives told analysts on Monday that in the near term, subscriber growth would slow due to the pricing change at Netflix. Not stall, mind you, but slow.

Did investors not know that price increases tend to decrease demand? When Netflix earlier this month announced its pricing changes – people who want both DVDs and access to streaming will see monthly bills rise from $10 to $16 – investors didn’t react at all.

In any case, while it’s somewhat understandable that customers complained about higher prices, Netflix is only doing the inevitable. Its prices were, and still are, artificially low. Insanely low, even. But they have drawn in millions of customers to sign up for what was basically the only service that offered lots of movies streamed over the Internet. The price “hike,” in fact, is actually just the expiration of a discount Netflix offered by giving DVD subscribers access to streaming video. The ill effects from this particular price hike will likely not be felt for more than a quarter.

As the company notes, the video-rental business is moving inexorably away from DVDs and toward streaming. As this happens, rivals such as Google (GOOG) and Amazon (AMZN) are stepping up their game, positioning themselves to compete directly with Netflix. Even Walmart (WMT) is getting into the streaming market. Meanwhile, the prices Netflix pays for rights to movies and TV shows are about to soar. One analyst estimates that next year, when its agreements with content providers expire, those costs will rise from $180 million in 2010 to $1.98 billion.

But competitors will be paying the same kinds of rates. Netflix, though, has already established itself as the leader through its insanely low prices and first-mover advantage, and they are scrambling to catch up.

Now comes the part where Netflix has to compete on price and service with a bunch of well-financed competitors.

CEO Reed Hastings told analysts on Monday that he expected lots of complaints from customers, but the “noise level was actually less than we expected.”

Three-quarters of the company’s new customers in the second quarter signed up for streaming-only plans. That’s no surprise: the “increase” affects only people who want both DVDs mailed to them and access to streamed videos. For people who want streaming only, the price is still ridiculously low — $7.99 a month for as many videos as you want to watch. The other option – DVD viewing with no access to streaming – is also $7.99 a month, though it’s more cumbersome because you get just one DVD at a time. Still, remember what you were paying, and how much hassle you went through, when you were renting videos from Blockbuster?

The irony is that prices will almost certainly have to increase next year, perhaps by a lot – that’s what happens when costs rise as much as tenfold all at once. But there will probably be fewer complaints because competitors will be charging similar amounts.