[CognitiveLens]

The increasingly profitable examples of Netflix, iTunes, and other online digital media stores have clearly demonstrated the viability of digital distribution, and it's still a very young industry with room for refinement. Yes, making movies is far more costly than hosting them, but paying distributors to be the middle man in getting the media to consumers is even more expensive, and creates the kind of problems discussed by the OP.

[SoftwareMaven]

Those are distribution based profits. It's questionable whether those could cover production based activities. Hopefully Netflix' venture into production will prove you can profitably make content at streaming prices (though even their experiment with Arrested Development will be on the cheap side, since all the sets and the initial story were already there and purchased on the cheap).

[CognitiveLens]

Netflix pays studios for their content, which compensates them for production (as determined by their own contract negotiators). Netflix then makes a profit beyond that contract cost, which means that digital distribution is covering both the costs of production and distribution. Ultimately, production costs must be covered in order for distribution to be profitable, and that's exactly what we're seeing.

[SoftwareMaven]

Except we are rarely seeing the best content being distributed through Netflix because the studios believe that distribution mechanism will eat the profits from theaters and DVDs.

Do you believe Marvel could make up the entire cost of the new Spiderman movie if they distributed solely on Netflix? Could Netflix remain profitable if they had to pay enough to Marvel to cover that (e.g. would people be willing to pay that much more for Netflix)?

I really believe the studios see Netflix as a way to get a little more milk out of the bottom of the bucket. If they believe there is some other way to get more milk, it doesn't show up on Netflix.

[CognitiveLens]

Sorry for the slow reply.

Studios might believe that digital distribution will eat the profits from theaters and DVDs, but that doesn't appear to be happening - at least, the "lost" profits appear to be recouped as part of digital distribution deals, and there is definitely room for improvement in this business model.

I should also clarify that I am not at all advocating digital-only distribution, I am advocating a model that is not physical-media-only. It must be possible to have a happy medium that allows consumers to get their hands on the media they are willing to pay for without having to decide between waiting for regional distribution deals or piracy.

Studios are shooting themselves in the foot by not implementing a more effective way of getting in-demand products to consumers using available digital distribution technology.