Discriminatory Pricing

So in my last post, I used the phrase "price discrimination" without defining what it was, and a number of readers either professed confusion at the term, or painstakingly explained to me that I'd missed the real point of coupons, which is . . . followed by a lengthy description of price discrimination.  Clearly, my jargonmeter needs to be recalibrated.

So: what is price discrimination?  It is not the sort of discrimination that gets you investigated by the EEOC.  Rather, it's a way for companies to maximize revenue by charging high prices to people who are relatively price insensitive, and low prices to everyone else.  

The famous example of this is airlines, which is why fares have so many restrictions, and vary according to the length of stay and how close to departure you book.  Based on cost alone, there's no reason to pay extra for booking one week out, or for having 2 days between your flights instead of ten.  In practice, these restrictions allow them to weed out the business travelers, who are price insensitive because they have to get to Tulsa for that meeting, from the leisure travelers who will decide to stay home if the airfare is too high.

This is also the way couponing works for all the brands in your grocery store.  There's some residual advertising effect (people try your fantastic new cherimoya-flavored Greek yogurt because there was a coupon), but as a group, coupon clippers display little brand loyalty:  they're looking for a deal, and the minute you stop offering one, they move onto the next discount.  

No, mostly what coupons allow you to do is sell a product at a high price point to people who are brand loyal and can't be bothered to clip coupons, while selling at a lower price point to people who care more about price, and place a lower value on their own time. Done properly, it allows you to make extra profits by charging price sensitive consumers something below your average cost, but above your marginal cost.

Most businesses do not want to charge below average cost if they can only charge one price, because that would mean they were losing money.  In the graph above, the darker, downward sloping line is demand, while the upward-sloping line represents supply.  The red dotted line at P=AC represents the point where the business starts being profitable*. 

But marginal cost (the cost of producing and selling an extra unit) is usually lower than the average cost, because companies have fixed overhead costs like rent and equipment that have to be paid somehow.  So there's a lost profit opportunity: there are customers who are not willing to pay as much as your average cost, but would be quite willing to pay something closer to your marginal cost.  Since this is still more than the marginal cost of the extra units, this would be a good deal for both producer and consumer.  But if you can only charge one price for your product, you can't make that deal; you'd be losing money on your total sales volume.

In less industrial economies, they solve this problem by haggling.  In modern economies, where one price is the rule for all but the biggest ticket items, we solve this problem with coupons.  Voila!  As long as most people are too lazy to clip coupons, the manufacturers can increase their profits while making price-sensitive consumers better off, and other consumers no worse off.  The pink triangle shows the added benefit that comes from a two-tiered pricing strategy.

Is this what's happening with Groupon?  Sort of.  Anecdotally, the Grouponers look a lot like other couponers:  little brand loyalty, and a fierce propensity to spend as little money as possible.  But the service businesses that Groupon attracts are very different from the retail food industry.  The marginal cost of an extra few cans of Diet Coke is pretty low, even when you factor in shipping; it makes sense for those brands to discount heavily in order to attract price sensitive consumers, because most of those customers will be additive, rather than cannibalizing full-price sales.  And it's a fair amount of work, relative to the savings, to clip coupons; that's why so few people do it regularly.

Restaurant meals and spa days are a little trickier.  Groupon is much more convenient than clipping coupons, and the potential savings are much larger, which means that more of your existing full-price customer are likely to simply get a discount on a meal they would have eaten anyway. And Grouponers are likely to want to consume these things on the same weekends and evenings that everyone else does, meaning that unless you restrict the Groupon to near-uselessness, there's a risk that they will be replacing full-price customers, instead of giving you extra revenue.  Given how deeply Groupons are discounted, this makes me think that Groupons are mostly supposed to be advertising, not a price discrimination strategy.  

But if Groupon is really bringing in a crowd that looks like coupon-clippers, merchants will not get much joy out of this advertising--not unless they, too, are selling a product with a very high markup.  Advertising to people who shop almost entirely on price is wasted effort.  Advertising exclusively to those people seems borderline crazy, especially for businesses like restaurants, where the real money is in the high margin extras like booze and dessert.

Of course, we don't really know that that's the case, or that it will always be the case; the market is still evolving.  But it does suggest some reasons to be cautious about predictions that Groupon is getting ready to take over the world.  Over the long haul, Groupons need to be a good deal for both merchants and consumers.  Price discrimination creates just such positive-sum deals.  Advertising, less so.

* Yes, this is dramatically simplified, because AC will fall, with discontinuities for capacity expansion, as you sell more units. But in many/most cases, it remains true that AC > MC, which is sufficient for our purposes.