Why Does Groupon Work?

Last week, Felix Salmon had a long blog piece titled "Grouponomics" which was pretty bullish on the targeted web coupon.  I've been mulling this for a week, trying to determine whether I think that this has long-term revolutionary potential, or whether it will end up being a flash in the pan.


To start with, I'm hazy about what function Groupon serves.  Is it a traditional coupon service, which simply allows businesses to price discriminate--selling their product expensively to the people who are pressed for time, and cheaply for those who can afford to spend their Sunday mornings clipping modest savings out of the local paper?  I think the answer is obviously not: Groupons offer fairly substantial savings for virtually no effort. 

Yet the discounting is fairly expensive for the Groupon offerer.  Take a typical $20-for-$40 worth of food restaurant deal.  As I understand it, the restaurant splits that $20 equally with Groupon, which means that they're now providing $40 worth of food for $10.  Sure, we might order drinks and dessert, adding $40 to that $10 you already got.  But keep in mind that even though this isn't a classic price discrimination strategy, a significant number of your customers are going to be price constrained--the sort of people who can't really afford to go to your restaurant unless they get a coupon.  Those people are going to nurse one drink and skip dessert, giving you a net loss.  Unless your restaurant has some abnormally fat margins, or your average Groupon buyer is a raging alcoholic, you're not likely to make very much money off such a deal, even if you're just filling surplus seats.  One study found that 32% of Groupon merchants lost money (with restaurants faring worst) and 40% said they wouldn't do it again; even people who made money had staff problems due to high volume and, er, cheap tippers:

"Because the Groupon customer base is made up of deal-seekers and bargain shoppers, they might not tip as well as an average customer or be willing to purchase beyond the deal," Dholakia said. "So employees need to be prepared for this type of customer and the sheer volume of customers that might come through."
So why do it?  If I'm already a regular at the restaurant, this is terrible business; I'm going to go in and pay less for a meal I would already have eaten.  Maybe you encourage me to eat an extra meal there, but as we discussed, is that a profitable extra meal?  

Maybe, if you have empty tables.  But it's not likely to be a very profitable meal, and it has costs: extra strain on the kitchen, extra product to the tables. The sheer volumes that Groupon drives may alienate either existing or new customers, as crowds make the place less pleasant and service slows.

Evan Miller channels Kevin Murphy to argue that Groupon is essentially creating extra consumer surplus by allowing vendors to sell at a lower price only if multiple people sign on.  I completely see the logic with something like hotel rooms or booze cruise seats, where you've essentially got a wasting asset: filling it at almost any price is better than not selling it.  But that doesn't describe businesses like restaurants, which do have significant marginal cost.  And in fact we've already seen businesses complaining that the Groupons didn't make them money, or that Groupon sales people suggested they raise their prices substantially just before the Groupon "discount".  

It's also worth pointing out that the model Evan Miller is looking at seems to be a monopoly.  It's relatively easy to produce extra consumer surplus from a monopoly situation.  In the competitive universe that most businesses operate in, it seems fairly likely that Groupon is simply re-allocating money between restaurants.  Essentially, they're competing to offer extremely low-cost meals.  In businesses like this, what's the benefit of getting 2,000 people to commit to taking up your tables and server time serving substantially less profitable meals?

Which makes me think that Groupon is just advertising, and fairly expensive advertising.  It has some virtues: you only pay for people who actually commit to come to your business.  But of course, it also has some drawbacks, both for the vendors and for Groupon.  It's hard to restrict to new customers--and the people who already like your product are probably the most likely to use the coupon.  (Propane Taxi, a propane delivery service we already use, recently had a Groupon which they limited, to our great disappointment, to new customers.  But they can check whether we're already in their database; most restaurants and bars can't.) And the business model is clearly extremely easy to emulate, since lots of companies are, many of them offering better deals for the customers, such as getting your coupon free if you recruit three people.  Felix argues that Groupon will benefit from superior targeting capabilities as its network grows, but if it's network and targeting capabilities are so great, how come it just targeted me with a groupon (limit 25) for a pool membership in Southwest DC? (I live in Northeast). 

Despite the hype, my subjective experience is that these realities are starting to be reflected in the quality of the deals available on Groupon.  Initially, there were a fair number of great deals that I eagerly snapped up.  But I'm buying fewer and fewer these days, because as merchants have gotten savvier about the costs, I'm finding that more and more of the deals aren't very good.  

Peter and I made the mistake of paying quite a lot of money for a scotch tasting--something I've enjoyed doing in the past--which, through the magic of Groupon, turned out to be an opportunity to stand in lengthy lines in a hotel lobby for the privilege of tasting mostly pretty ordinary bottles from a liquor store's stock.  They'd clearly allocated a very limited number of pricey bottles to a tasting for which they'd sold hundreds of tickets, so they quickly ran out of anything older or more interesting.  We did end up buying a couple of interesting blends, but the experience annoyed the hell out of both of us, which has not enamored us of either Groupon, or the liquor store.

Take a look at the other deals which are available to me on Groupon today:

  • $5 for $10 Worth of Pizza and Beverages at a local pizza chain
  • $35 for a Six Pack of Selected Wines or a Grey Goose and Cristallino Gift Set at the same liquor store in Maryland that sold us the horrible scotch tasting
  • $15 for $30 Worth of Personalized Gifts and Stationery from Tickle Bellies
  • $2,500 for LASIK Surgery for Both Eyes at LasikPro ($5,000 Value)
  • $15 for $30 Worth of Glassware, Bar Gear, and Luxury Home-Entertaining Items from CocktailVibe
  • $99 for an Initial Consultation and Two Hours of Interior Redesign and Planning from Decorating Den Interiors ($200 Value)
  • $79 for a Dryer-Vent Cleaning or Chimney Sweep from Mitchel's Chimney & Masonry Specialists Inc. (Up to $179 Value)
The first is a traditional Groupon, but on a low-cost product that makes it barely worth remembering to print out the coupon.  The second--well, I don't recommend them, that's all.  

The personalized stuff and glassware Groupons are maybe good deals, and presumably also good for the merchant--when you get to the store, I presume you discover that anything you really want costs way more than $30, and their cost of goods sold is pretty low.  But their uptake seems to be pretty small for an online offer.

The Lasik is almost certainly a "raise prices and discount" situation--you have no idea what their normal price is.  Even so, who wants discount eye surgery?  (11 people, apparently.  Good luck with that).

The last two are just using Groupon for a very traditional service business model: low-cost services or "consultations" that they use to upsell you more expensive services.  I can get equally good "deals" by going to their website, or finding a copy of the Yellow Pages.

But perhaps these deals just aren't targeted to me?  Maybe not, but to whom are they targeted?  How is Groupon's deal of the day a three month single-person pool membership that only 25 people can buy?  This is in a city with 600,000 residents.

Not all the deals are that specialized, obviously, but I do think there's been a real decrease in the quality of the deals available.  And I assume that this is due to two factors: competition from other sites, and the increasing sophistication of merchants themselves about the possibilities of these sites.  As they hear the complaints from other vendors, they're becoming more strategic about how they offer deals.  This will prevent problems like this, but also limit the value to consumers.

I'm not predicting gloom and doom for Groupon by any means.  But nor am I convinced that Groupon is the next Facebook/Google/insert website here.  Advertising is a profitable business.  But the kind of advertising that Groupon does has some limitations--it cannot simply grow indefinitely.  In a lot of local markets, I think that Groupon is going to bump up against that capacity fairly quickly, particularly as competitors like LivingSocial make inroads.
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Megan McArdle is a columnist at Bloomberg View and a former senior editor at The Atlantic. Her new book is The Up Side of Down.

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