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Groupon: Another Market Success

Mises Daily: Monday, September 27, 2010 by

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I am always about 18 months behind a new trend. In high school, I refused to roll up the cuffs of my jeans, because I thought it was dumb. More recently, I resisted getting a "smart phone" until I lost my phone in a cab. Since I had to buy a new phone anyway, I opted for the cheapest Blackberry available. And even then I didn't get around to setting up its ability to get my email for a good 6 months (no exaggeration).

Given this aspect of my personality, I managed to ignore the term "Groupon" the first dozen times I heard it. I assumed I had misheard, or that a blogger had misspelled "coupon." But when my wife nonchalantly used the word the other day in conversation, I finally broke down and asked her what it was.

As most readers have probably known for a long time, Groupon is a brilliant concept that uses social networking to mobilize shoppers and bring down prices. In contrast to all the mainstream economic models of "market failure," Groupon is yet another example of market success.

How Groupon Works

At the risk of sounding like a commercial, I should briefly explain how Groupon works: Every day the website posts an "amazing deal" in each participating city. That's no hyperbole; my wife says that a Groupon for a hair salon might cost $55 for a service that would normally cost $200.

The hitch is that customers sign up for the day's deal on a conditional basis — the deal only works if a sufficient number of people apply for it. If that happens, then everybody who signed up has his or her credit card billed and can then print out the Groupon to bring to the merchant in question.

On the other hand, if not enough people apply for a particular day's deal, then it is canceled. The people who signed up don't get billed, and they just check the website (or get email notifications) for the next day's amazing deal. (Scroll to the bottom right of this page for a short video explaining the Groupon process.)

Why Groupon Works

Now that we see how Groupon works, the next question is, why does it work? The simple answer is volume. In general, businesses are willing to cut their unit prices for bulk purchases. That's why toilet paper is cheaper per roll if you buy the 24-pack rather than the 12-pack.

To see why a merchant could benefit from Groupon, consider a new, upscale restaurant opening in the downtown of a major city. Because of the high rent and other fixed costs (such as keeping a world-class chef on staff), the new restaurant can only survive if it very quickly establishes a constant stream of diners flowing through it every meal.

Obviously, the way to do this is to run an aggressive promotional campaign early on. It's well worth it even to lose money on the meals, so long as the restaurant is packed and everybody has a great experience.

However, there are some logistical problems. The restaurant owner probably doesn't want to charge low prices for the first month and then jack them up once he builds up a customer base; that would irritate his customers, and he also might attract the wrong crowd, given his long-run objective.

So he'll want his menus to reflect the actual, long-run prices he wants to charge when the business is in full swing. In order to give a special inducement for people to come in the beginning, the price discounts will have to be temporary.

Now, the owner could simply write up "Today's Special" on a marker board and place it on the sidewalk. If the deal is really good, plenty of passersby just might walk in and try it.

Yet depending on the numbers, that might not be good enough; there might not be enough walk-in business to justify the huge discount. So the owner could turn to traditional advertisements. He could run ads in the local papers, radio, and TV, or he could buy billboard space. That way, many thousands of people would learn about the special promotion, and he might draw enough business to make it worthwhile in the long run.

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There are problems with this strategy too. No matter how hard he tries to isolate his target audience, the owner can't really control how many people show up. Or, the numbers might turn out such that (conventional) advertising is too expensive.

We now see the beauty of Groupon. The restaurant owner might say to himself, "If I could be guaranteed to have a full restaurant for lunch, then I would be comfortable scheduling all of my top waiters and waitresses, and I could even give our best lunch special at half price. But if it's just going to be a few customers coming that day, I'll stick to my lighter rotation of wait staff and I'll charge full price for the lunch special."

Groupon takes the uncertainty out of this decision. The Groupon promotion can target a particular day, with people pledging to pay the half-price amount for the lunch special. If enough people sign up to fill the restaurant, the deal is activated, the people are charged (and the restaurant gets paid), and then the people show up on the specified date (which can be in the future). The restaurant owner knows how many people are coming, so he can be totally prepared.

Of course, if an insufficient number of people sign up, the only real downside is the owner's possible embarrassment and loss of reputation to the restaurant. The owner isn't locked in to losing money on each meal, served in a half-empty restaurant.

The Point: Solving Collective-Action Problems

Readers who have studied mainstream economics may have recognized that Groupon solves what would typically be described as a "market failure": In a standard model where the restaurant owner can only charge a fixed unit price for meals, depending on the numbers, the market could be stuck in an inefficient equilibrium. If everybody goes to the restaurant, everybody is better off, but if people are restricted to self-interested decisions, then the collective outcome can be inferior. Why, we need the government to levy a tax on everyone living in the city, and then give a subsidy to everyone who goes to new restaurants!

Although I'm exaggerating, it's not by much; a large portion of my graduate work was spent studying all the different ways that decentralized markets could fail to achieve a "Pareto optimum," and where "the social planner" — yes, that is the actual term they used in the classroom — could make everyone in society happier.

As Groupon so wonderfully shows, the market is capable of solving these thorny problems without relying on coercion. Specifically, Groupon motivates people to use emails, tweets, Facebook posts, etc. in order to spread the word about a particular deal they want to get. Our hypothetical restaurant owner can effectively purchase a giant advertising campaign at no additional cost.

There are other examples of the real-world market sidestepping the "market failures" that exist only in crude models. For example, Michael Kinsley once fretted about the "problem" of marginal-cost curves that didn't rise. (Yes that's right, Kinsley was worried that business costs sometimes stayed low as output expanded.) The ostensible problem is that if marginal cost stays below average cost, then a business can't charge a "fair" price — where the consumer pays the marginal cost on each unit — and stay in business.

As I pointed out in my response, entrepreneurs solve this type of problem by deviating from the mainstream model of markets. For example, airlines charge different prices for "the same" seats, depending on when the customer purchases them. For a different example, clubs like Sam's Club and Costco charge a membership fee, and then allow customers to buy at wholesale prices. This practice helps to isolate the various components of the overall service, so that the company can cover its overhead (lights, property taxes, etc.) while passing on (much of) the unit price discount available at wholesale.

As I was investigating the website for Groupon, I discovered that it was a specific application of the more general website, The Point. As the short video at the link explains, The Point exists to solve collective-action problems. Whether it's something trivial like raising money from coworkers to buy a ping-pong table for the break room, or something grand like raising a million dollars to fund a long-shot political candidate, The Point offers a convenient way for people to conditionally pledge to give money (or perform some other action) if enough other people sign on.

What's especially intriguing is that The Point offers members the option of joining a cause anonymously, with their identity being revealed only if the "tipping point" (hence the name) has been reached.

Conclusion

Groupon is an extremely clever idea with an equally catchy name. It is just one example of the solutions that free entrepreneurs can dream up to solve social problems. Libertarian dreamers should familiarize themselves with the campaigns at The Point to see if there are applications to achieving their ends, such as adopting alternate currencies or developing a Friedrich Hayek Super Bowl commercial.