To Groupon or Not to Groupon: The Profitability of Deep Discounts

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To Groupon or Not to Groupon: The Profitability of Deep Discounts Benjamin Edelman Sonia Jaffe Scott Duke Kominers Working Paper 11-063To Groupon or Not to Groupon: The Protability of Deep Discounts Benjamin Edelman y Sonia Jae z Scott Duke Kominers x June 16, 2011 Abstract We examine the protability and implications of online discount vouchers, a new marketing tool that oers consumers large discounts when they prepay for participating merchants' goods and services. Within a model of repeat experience good purchase, we examine two mechanisms by which a discount voucher service can benet aliated merchants: price discrimination and advertising. For vouchers to provide successful price discrimination, the valuations of consumers who have access to vouchers must systematically dier from|and typically be lower than|those of consumers who do not have access to vouchers. Oering vouchers is more protable for merchants which are patient or relatively unknown, and for merchants with low marginal costs. Extensions to our model accommodate the possibilities of multiple voucher purchases and merchant price re-optimization. Keywords: voucher discounts, Groupon, experience goods, repeat purchase. The authors appreciate the helpful comments and suggestions of Peter Coles, Clayton Featherstone, Alvin Roth, and participants in the Harvard Workshop on Research in Behavior in Games and Markets. Kominers gratefully acknowledges the support of a National Science Foundation Graduate Research Fel- lowship, a Yahoo! Key Scientic Challenges Program Fellowship, and a Terence M. Considine Fellowship in Law and Economics funded by the John M. Olin Center. yHarvard Business School; bedelman@hbs.edu. zDepartment of Economics, Harvard University; sjae@fas.harvard.edu. xDepartment of Economics, Harvard University, and Harvard Business School; skominers@hbs.edu. 11 Introduction A variety of web sites now sell discount vouchers for services as diverse as restaurants, skydiving, and museum visits. To consumers, discount vouchers promise substantial savings|often 50% or more. To merchants, discount vouchers oer opportunities for price discrimination as well as exposure to new customers and online \buzz." Best known among voucher vendors is Chicago-based Groupon, a two-year-old startup that purport- edly rejected a $6 billion acquisition oer from Google (Surowiecki (2010)) in favor of an IPO at yet-higher valuation. Meanwhile, hundreds of websites oer discount schemes similar to that of Groupon. 1 The rise of discount vouchers presents many intriguing questions: Who is liable if a merchant goes bankrupt after issuing vouchers but before performing its service? What happens if a merchant simply refuses to provide the promised service? Since vouchers entail prepayment of funds by consumers, do buyers enjoy the consumer protections many states provide for gift certicates (such as delayed expiration and the right to a cash refund when value is substantially used)? Must consumers using vouchers remit tax on merchants' ordinary menu prices, or is tax due only on the voucher-adjusted prices consumers actually pay? What prevents consumers from printing multiple copies of a discount voucher and redeeming those copies repeatedly? To merchants considering whether to oer discount vouchers, the most important question is the basic economics of the oer: Can providing large voucher discounts actu- ally be protable? Voucher discounts are worthwhile if they predominantly attract new customers who regularly return, paying full price on future visits. But if vouchers prompt many long-time customers to use discounts, oering vouchers could reduce prots. For most merchants, the eects of oering vouchers lie between these extremes: vouchers bring in some new customers, but also provide discounts to some regular customers. In this paper, we oer a model to explore how consumer demographics and oer details interact to shape the protability of voucher discounts. We illustrate two mechanisms by which a discount voucher service can benet al- iated merchants. First, discount vouchers can facilitate price discrimination, allowing merchants to oer distinct prices to dierent consumer populations. In order for voucher oers to yield protable price discrimination, the consumers who are oered the voucher discounts must be more price-sensitive (with regards to participating merchants' goods or services) than the population as a whole. Second, discount vouchers can benet merchants through advertising, by informing consumers of a merchant's existence. For these adver- tising eects to be important, a merchant must begin with suciently low recognition among prospective consumers. The remainder of this paper is organized as follows. We review the related literature in Section 2. We present our model of voucher discounts in Section 3, exploring price discrimination and advertising eects. In Section 4, we extend our model to consider the possibility of consumers purchasing multiple vouchers and of merchants adjusting prices 1 Seeing these many sites, several companies now oer voucher aggregation. Yipit, one such company, tracked over 400 dierent discount voucher services as of June 2011. 2in anticipation of voucher usage. Finally, in Section 5, we discuss implications of our results for merchants and voucher services. 2 Related Literature The recent proliferation of voucher discount services has garnered substantial press: a multitude of newspaper articles and blog posts, and even a short feature in The New Yorker (Surowiecki (2010)). However, voucher discounts have received little attention in the academic literature. The limited academic work on online voucher discounts is predominantly empirical. Dholakia (2011) surveys businesses that oered Groupon discounts. 2 Echoing sentiments expressed in the popular press, 3 Dholakia (2011) nds mixed empirical results: some business owners speak glowingly of Groupon, while others regret their voucher promo- tions. Byers et al. (2011) develop a data set of Groupon deal purchases, and use this data to estimate Groupon's deal-provision strategy. To the best of our knowledge, the only other theoretical work on voucher discounting is that of Arabshahi (2011), which considers vouchers from the perspective of the voucher service, whereas we operate from the perspective of participating merchants. Unlike the other academic work on voucher discounting, we (1) seek to understand voucher discount economics on a theoretical level, and (2) focus on the decision problem of the merchant, rather than that of the voucher service provider. Our results indicate that voucher discounts are naturally good ts for certain types of merchants, and poor ts for others; these theoretical observations can help us interpret the range of reactions to Groupon and similar services. Although there is little academic work on voucher discounts, a well-established liter- ature explores the advertising and pricing of experience goods, i.e. goods for which some characteristics cannot be observed prior to consumption (Nelson (1970, 1974)). The parsimonious framework of Bils (1989), upon which we base our model, studies how prices of experience goods respond to shifts in demand. Bils (1989) assumes that consumers know their conditional valuations for a rm's goods, but do not know whether that rm's goods \t" until they have tried them. 4 Analyzing overlapping consumer gen- erations, Bils (1989) measures the tradeo between attracting more rst-time consumers and extracting surplus from returning consumers. Meanwhile, much of the work on experience goods concerns issues of information asym- metry: if a merchant's quality is unknown to consumers but known to the merchant, then advertising (Nelson (1974); Milgrom and Roberts (1986)), introductory oers (Shapiro (1983); Milgrom and Roberts (1986); Bagwell (1990)), or high initial pricing (Bagwell and Riordan (1991); Judd and Riordan (1994)) can provide signals of quality. Of this lit- erature, the closest to our subject is the work on introductory oers. Voucher discounts, a 2 In a related case study, Dholakia and Tsabar (2011) track a startup's Groupon experience in detail. 3 For example, Overly (2010) reports on Washington merchants' mixed reactions to the LivingSocial voucher service. 4 Firms know the distribution of consumer valuations and the (common) probability of t. 3form of discounted initial pricing, may encourage consumers to try experience goods they otherwise would have ignored. However, we identify this eect in a setting without asym- metric information regarding merchant quality; consumer heterogeneity, not information asymmetries, drives our main results. 5 Additionally, our work diers from the classical literature on the advertisement of experience goods, as advertising in our setting serves the purpose of awareness, rather than signaling. 6 A substantial literature has observed that selective discounting provides opportunities for price discrimination. In the settings of Varian (1980), Jeuland and Narasimhan (1985), and Narasimhan (1988), for example, merchants engage in promotional pricing in order to attract larger market segments. 7 Similar work illustrates how promotions may draw new customers (Blattberg and Neslin (1990); Lewis (2006)), and lead those customers to become relational customers (Dholakia (2006)). These results have been found to motivate the use of coupons (Neslin (1990)), especially cents-o coupons (Cremer (1984); Narasimhan (1984)). We harness the insights of the literature on sale-driven price discrim- ination to analyze voucher discounting|a new \sale" technology. Like the price-theoretic literature which precedes our work, we nd that price discrimination depends crucially upon the presence of signicant consumer heterogeneity. Our work also importantly diers from antecedents in that the prior literature, in- cluding the articles discussed above, has considered only marginal pricing decisions. In particular, the previous work on experience goods and price discrimination does not con- sider deep discounts of the magnitudes now oered by voucher services. 3 Model Oering a voucher through Groupon has two potential advantages: price discrimination and advertising. We present a simple model in which a continuum of consumers have the opportunity to buy products from a single rm. The consumers are drawn from two populations, one of which can be targeted by voucher discount oers. First, in Section 3.1, we consider the case in which all consumers are aware of the rm and vouchers serve only to facilitate price discrimination. Then, in Section 3.2, we introduce advertising eects. 5Of course, our treatment of advertising includes a very coarse informational asymmetry: some con- sumers are simply not aware of the merchant's existence. However, conditional upon learning of the merchant, consumers in our model receive more information than the merchant does about their valua- tions. This is in sharp contrast to much of the previous work on experience goods, in which merchants can in principle exploit private quality information in order to lead consumers to purchase undesirable (or undesirably costly) products (e.g., Shapiro (1983); Bagwell (1987)). 6 In the classical theory of experience goods, advertising serves a \burning money" role. Merchants with high-quality products can aord to advertise more than those with low-quality products can, as consumers recognize this fact in equilibrium and ock to merchants who advertise heavily (Nelson (1974); Milgrom and Roberts (1986)). In our model, advertising instead serves to inform consumers of a merchant's existence; these announcements are a central feature of the service voucher vendors promise. 7 In other models, heterogeneity in consumer search costs (e.g., Salop and Stiglitz (1977)) or reservation values (e.g., Sobel (1984)) motivate sales. Bergemann and Valimaki (2006) study the pricing paths of \mass-market" and \niche" experience goods, nding that initial sales are essential in niche markets to guarantee trac from new buyers. 4We present comparative statics in Section 3.3. Our model has two periods, and the rm ex ante commits to a price p for both periods. The rm and consumers share a common discount factor . Following the setup of Bils (1989), consumers share a common probability r that the rm's product is a \t." Conditional on t, the valuation of a consumer i for the rm's oering is vi . A consumer i purchases in the rst period if either the single-period value, rvi p, or the expected discounted future value, rvi p + r(vi p), is positive, i.e. if maxfrvi p; rvi p + r(vi p)g 0: For > 0, there is an informational value to visiting in the rst period: if a consumer learns that the rm's product is a t, then the consumer knows to return. As a result, all consumers with values at least v(p) 1 + r r + r p purchase in the rst period. To consider the eects of oering discounts to a subset of consumers, we assume there are two distinct consumer populations. Proportion of consumers have valuations drawn from a distribution with cumulative distribution function G, while proportion 1 have valuations drawn from a distribution with cumulative distribution function F . We denote by V supp(F ) [ supp(G) the set of possible consumer valuations. We assume that G(v) F (v) for all v 2 V , i.e. that the valuations of consumers in the G population are systematically lower than those of consumers in the F population. The rm faces demand (1 G(v(p))) + (1 )(1 F (v(p))) in the rst period, and fraction r of those consumers return in the second period. The rm maximizes prots given by (p) (1 + r)((1 G(v(p))) + (1 )(1 F (v(p))))(p c); where c is the rm's marginal cost. The rst-order condition of the rm's optimization problem is (1 G(v )) + (1 )(1 F (v )) 1 + r r + r ((p c)(g(v ) + (1 )f(v )) = 0 (1) where p is the optimal price and v v(p ). We assume that the distribution of con- sumers is such that prots are single-peaked, so that p is uniquely dened. 3.1 Discount Vouchers After setting its optimal price p , the rm is given the opportunity to oer a discount voucher. 8 Only fraction of consumers in the G population have access to the discount 8 For now, we assume the rm did not consider the possibility of a voucher when setting its price. In Section 4.2, we consider the possibility of re-optimization. 5