Undressing Groupon

The following paper is my analysis of the Groupon business model in which I present a novel economic framework for understanding Groupon. I've dubbed it price discrimination degree transformation. I demonstrate the power of the framework by describing a strategy for Google to compete with Groupon.

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Google's Groupon Strategy: Algorithmic Price-Sensitivity Quotients

Note: This blog post is a section from my full paper on the Groupon business model in which I describe a strategy for Google to compete with Groupon. The strategy rests on a novel economic framework for understanding Groupon, as explained in my previous blog post. The full paper is available at this link - “Undressing Groupon”.


The Equivalence of Advertising and Price Discrimination

Product and price are two sides of the same coin. The worth of a product to a consumer – its utility – is subjective and depends on how much a consumer desires the product. Price, on the other hand, is an objective measure – the cost of the product in the real world.

The two are intimately connected in that they both determine the value of a product – the spread between the subjective worth of a product and the real world price. Value increases not only when a product is desired more but also when the price is lowered. Consider a silver necklace at a bargain price of ten dollars. It is actually more valuable than an identical gold one at a million dollars.

In the same way, advertising and price discrimination are intimately connected. Both have an equivalent objective: increasing a consumer’s perception of value. Advertising does it by raising a consumer’s subjective perception of the utility of the product. Price discrimination does it by lowering the price.

The Google

The equivalence of advertising and price discrimination means that Google and Groupon are essentially in the same business – a surprising realization since the business models are so different. Both companies provide a service to influence consumers’ perception of product value – Google via advertising and Groupon via price discrimination. And both aim to deliver customers – one virtually, the other in the physical world.

It begs the question: can Google compete with Groupon? If so, how?

The short answer is that they can. Moreover, they can do it well because they possess all the necessary tools and resources to innovate and create a superior business model.

Two potential scenarios are presented here. The first is an evolved version of the Groupon business model. The second is a more profound integration of price discrimination into the existing Google Adsense and Adwords platforms.

A next generation business model

The Groupon price discrimination degree transformation model has two sides – the merchant facing side and subscriber facing side. The merchant facing side is the “real world” and involves the merchant sales and service functions. The subscriber facing side is “data” oriented and involves the fundamental task of identifying price-sensitivity.

On the “data” side of the equation, Groupon’s two-tier 2nd degree price discrimination function is a relatively crude way of identifying price sensitivity, relying on self-selection and several hurdles. It works in a binary way and cannot measure the magnitude of price-sensitivity.

Google, on the other hand, has access to vast amounts of data, including Gmail user data, search queries, click-through data, and all manner of other information from their vast constellation of services. On top of that, they are experts at computational algorithms. They can easily implement sophisticated analysis to identify price-sensitive users and to measure the magnitude of the price-sensitivity as a quotient assigned to each user. For example, if a user frequents websites with information on how to save money then Google would know that the user is price sensitive. But if a Gmail user receives a reservation confirmation email from a very expensive restaurant then Google would conclude that the user is price insensitive.

The Google system would be much closer to the ideal of 1st degree price discrimination and far superior to Groupon’s two-tier 2nd degree price discrimination function. It would give Google a competitive advantage in their ability to target users and to maximize profits for merchants.

All that would remain is to grow a subscriber base. Google could imitate Groupon by advertising on its own search platform. More effecively, they could get permission from Gmail users to message them - easily done with a prominent “Turn on daily local deals” button in Gmail. A massive subscriber base would instantly spring to life.

On the merchant side of the equation, Google could easily imitate the Groupon model. They possess the financial resources to build their own sales and customer service organization in the same way as Groupon. But they have a much more powerful option: to externalize the merchant facing sales and service functions to independent locally based affiliates.

The “we provide the platform only” model would be superior for two reasons:

First, a distributed collection of local affiliates would hold an information and relational advantage over a centralized army of non-local sales and service employees (i.e. Groupon’s Chicago office). Native folk know their communities better and are more effective in cultivating merchant relationships than outsiders.

Secondly, an externalized model would have a financial and scalability advantage. Internal sales and customer support employees need care and feeding and require a huge amount of working capital to support their operations (look at the funding that Groupon is soaking up). An externalized model would be more capital efficient and therefore more scalable, absent the investment requirements of growing a sales and service organization. External independent local affiliates – properly incentivized with a profit motive – would be far more effective and cost efficient in covering the many small local areas that are currently being ignored by the Groupon model.

To illustrate this, imagine a local newspaper with a restaurant review column. They could become a Google affiliate and begin to offer a deal a day for a featured restaurant. They would handle the sales, customer service, and promotional email design – all the functions performed by the merchant facing side of Groupon. They would then use the Google platform to offer a deal. The platform would take care of all the necessary technology functions, including sending emails, running the website, and payment processing. And because of lower overhead, the affiliate would share in the revenue for much less than the onerous 50% Groupon fee.

This hypothetical Google platform would require considerable thought and design. All the important issues discussed in this paper would have to be addressed. But it could be a game changer. There is tremendous room for innovation. One possibility is the integration of an auction model, in the same way as the current Adwords program. Third-party affiliates would compete for access to the Google platform. The competitive dynamics would ensure that only the best deal affiliates would continue to thrive.

Groupon-google
The integration of price discrimination into Adwords and Adsense

A potentially more profound application of the principles of price discrimination is integration into the existing flagship Google Adwords and Adsense platforms.

The entire basis of Google’s advertising business is relevance. Advertisements are primarily targeted on the basis of search and context relevance as well as location, language and other parameters. As described already, Google possesses the resources to algorithmically identify price-sensitivity on an individual basis. Consider if this parameter is added to Google’s advertising platform as a targeting option. In addition to relevance, advertisers would be able to tailor their messages based on the price-sensitivity of the viewer. A price-sensitive user might be shown an advertisement that highlights a discount whereas a price-insensitive user might be targeted with a message that highlights the high-end features of a product. The platform could also be used to distribute daily deals but with even greater flexibility.

If Groupon’s power is derived from the scale of its target audience, one can only marvel at the possibilities with Google in this scenario.

 

The Essence of Groupon: Price Discrimination Degree Transformation

Note: This blog post is a section from my full paper on the Groupon business model in which I describe a novel economic framework for understanding Groupon. In my next blog post, also a section from the paper, I demonstrate the power of the framework by describing a strategy for Google to beat Groupon. The full paper is available at this link - “Undressing Groupon”.


An Engine for Price Discrimination Degree Transformation

Groupon’s core business is price discrimination – for now, a fancy word for discounted deals.

First a quick and simplified overview of the microeconomic theory:

In a typical market with one price, a merchant can increase customer demand by lowering price. But the benefit comes at a cost – the original customers who were willing to buy at the original price also receive the lower price and consequently provide less revenue as a group.

The answer: price discrimination – the practice of distinguishing and separating potential customers on the basis of price-sensitivity and offering a different price to each group. The revenue from the original customers is protected – by continuing to show them the original price, while additional revenue is generated from new price-sensitive customers who would otherwise stay away – because of the targeted lower price. The merchant gains as long as the lower price is higher than the marginal cost of producing their product or service.

The challenge lies in identifying price-sensitive potential customers, commonly addressed in two ways:

In 3rd degree price discrimination, an observable characteristic is used as a proxy for the price sensitivity of a customer. The observable characteristic forms the basis of segmentation and defines a coherent group for targeting. One example is the practice of offering student discounts. Students are presumably non-employed and consequently more price-sensitive as a result of the financial constraint.

In 2nd degree price discrimination, customers are categorized based on actions that reveal their price sensitivity, used when observable characteristics are lacking or impractical as a basis for segmentation. Customers are typically lured into signaling their price sensitivity based on their response to a set of choices crafted by the business. Coupons are a well-known example as users who go to the trouble of collecting them are taking an action that signals their price sensitivity.

A 3rd Degree Price Discrimination Service to Merchants

The primary Groupon service to merchants is a 3rd degree price discrimination service. From the perspective of merchants, Groupon subscribers are a readily identifiable group. The observable characteristic is that they are Groupon subscribers. The service provides a way to target the market segment directly with a promotional message and offer. All a merchant has to do is to sign a contract for the service.

It can be tempting to think of the service as block pricing - a form of 2nd degree price discrimination - because of the “deal activation threshold” requirement of a minimum number of customers. Block pricing, however, is designed to identify price sensitivity at the individual level by presenting potential customers with a quantity-based choice. With Groupon, the job of identifying price-sensitive customers is already done. Furthermore, the group is targeted with a single price, not a selection designed to elucidate price-sensitivity.

One way to appreciate the service is to contrast it with an alternative. A comparable method would have to include advertising on a grand scale – perhaps a half page advertisement in the New York Times. And the advertisement would have to include a price discrimination couponing mechanism to filter consumers based on the inconvenience of clipping them. Can you imagine coupons in the NYT? It would look terribly odd even if the editors were to allow it!

Two Tiers of 2nd Degree Price Discrimination

Groupon provides merchants with access to a unique targetable market segment of price-sensitive consumers. But how does Groupon identify price-sensitivity at the individual level in order to build the group in the first place?

As discussed previously, 2nd degree price discrimination is the method of identifying price-sensitive customers on the basis of their choices or actions. When a consumer subscribes to Groupon, they are essentially making a choice that signals their price sensitivity. If the process were a conversation, it would look like this:

Groupon: Hey, I have super duper deals, but you must give me your name.
Consumer: Oh yeah! Put me down because I’m price sensitive.

Groupon is therefore a self-selection mechanism for price-sensitive consumers to reveal themselves. Price-sensitive consumers cannot resist the bait – it is catnip for them. Subscribers provide their email address, which conveniently serves as a pipeline for continued messages.

But there is more. There is also a second tier of 2nd Degree Price Discrimination!

When subscribers are presented with a deal, there are strings attached. First, subscribers must prepay. Groupon provides the platform to do so. Secondly, they must agree to be bound by the limitations of the deal (e.g. admission after 7pm only). Lastly, subscribers must take action within the one-day limit of the deal offering. In combination, the actions are a set of choices that constitute another tier of 2nd degree price discrimination. Subscribers are signaling their price-sensitivity by agreeing to the hurdles placed in front of them.

So in totality, Groupon is a highly effective two-tier 2nd degree price discrimination mechanism that filters subscribers in a way that credibly demonstrates a price-sensitive group.

Price Discrimination Degree Transformation / Arbitrage

We can now begin to appreciate the beauty of the Groupon business model.

On the merchant side, Groupon provides a convenient 3rd degree price discrimination service in the form of a coherent targetable market segment. On the subscriber side, Groupon identifies price-sensitive consumers with a two-tier 2nd degree price-discrimination mechanism comprised of a self-selection filter and a set of hurdles consisting of prepayment, acceptance of limitations, and required action within the time limit. And Groupon sits in the middle.

The business model transforms the more powerful but difficult method of 2nd degree price discrimination to a more convenient and palatable 3rd degree price discrimination service. The arrangement is essentially an arbitrage platform. In the process, Groupon extracts a premium. One way to visualize it is from the perspective of the financial flow. Groupon sells a product or a service to individual consumers at a discounted price but then effectively buys it from a merchant at an even lower price. The difference is revenue to Groupon. The notion of arbitrage stems from the fact that Groupon risks nothing in terms of having to accumulate inventory or assume any obligations. Conventional wisdom states that arbitrage should not persist in the long-term. The increase in competition from Groupon clones makes complete sense when seen in this light. Groupon’s margins - the arbitrage spread – will likely erode over time.

Groupon-arb

 


Explaining the NYC Startup Scene

Recently, I experienced NYC’s vibrant startup scene first hand at Startup Weekend NYC, a unique weekend event held at New Work City in downtown Manhattan. If the energy at the event was any indication, all the talk of a NYC startup blossoming is true.

But why NYC and why now?

I was chatting with Jeremy Mims, one of the panelists at the event, about the differences between San Francisco and New York City and he was essentially saying that New York has more “real world” stuff going on – real world businesses, commerce, etc.

It reminded me of an article on Techcrunch – ‘Why Online2Offline Commerce is a Trillion Dollar Opportunity’ – about O2O commerce: local transactions that are initiated online but physically consummated offline in the “real world”. The article gave two examples as vanguards of the trend: Groupon and Opentable.

I started wondering if the O2O trend could explain the boom in NYC startups. It would make sense since O2O is about bridging the online and “real worlds” and NYC has the most “real world” stuff. So I looked up a list of well-known NYC startups. But it was a bust. Most of them did not fit the strict O2O profile.

Yet, the same list showed a definite pattern. Most of the startups were intersecting with the “real world” in more interesting and diverse ways than startups in other places. One example was Square, a company that provides a small plastic thing-a-ma-jig that allows an iPhone to process credit card transactions. Another was Stickybits, a company that provides a way to “attach digital content to real world objects”.

So perhaps the “real world” aspect of NYC has something to do with the startup boom after all. It would make sense in the larger context of the evolution of the Internet as it continues to permeate life in new ways, from the social to the commercial and from the mundane to the uncommon.

One possible explanation stems from the nature of innovation, which does not happen in a vacuum. In any particular field of work, innovation usually happens in places with the highest concentration of activity and people engaged in the field. Indeed, NYC, with its diversity of sectors and concentration of educated workers, fosters a lot of innovation in those sectors. A good example is SecondMarket, a startup providing a marketplace for illiquid financial assets - hardly surprising given the status of NYC as the mecca of finance.

Another possible explanation is business strategy. Consider the perspective of a startup company that must gain initial traction to survive. Locating close to a large pool of potential customers can maximize the chanced of acquiring the critical first few. In NYC, this is especially relevant to startups involving advertising, media, fashion and finance. True, online business models often reduce the importance of geographic boundaries, but that assumes the survival of the business past the embryonic stage. Being located in NYC affords a survival advantage.

The last possible explanation for the link between the “real world” aspect of NYC and the startup boom is greater access to capital. New York has the greatest concentration of wealth of any place. It also has a lively VC and angel scene. Investors, especially at the early stage, often prefer to invest close to home. It gives them more credibility in their claims of adding value beyond the capital allocation decision. The benefit for NYC startups is that they have greater access to capital – and therefore another survival advantage.

In the final analysis, there are plenty of good reasons why NYC should be a happening place for startups. But in the long run, the passion New Yorkers feel for their city might turn out to be the most significant. It is a passion that was most evident at the Startup Weekend event in the pitch made by Jonathan Wegener for Adopt a Hacker, a project to attract more developers to the city.

 

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Hi, I'm Ahmadali Arabshahi. Welcome to my blog.

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