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.