Grouponomics, and the power of counterfactual thinking

Felix Salmon wrote thousands of words to convince himself that Groupon has a viable business model. I have a lot of respect for Felix and love his blog, but he missed a key issue here. Maybe he drank the Koolaid, or perhaps I am an even bigger skeptic than Felix is. I don't have a rebuttal as much as an alternative narrative.

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Let's start with his neighborhood restaurant example:

At Giorgio's, for instance, diners paid $15 for their Groupon -- which gave them $30 of food. But dinner for two at Giorgio's, with some kind of alcohol, can easily run to $100 or more. So even after knocking $22.50 off the bill (remember that Giorgio's kept $7.50 of the proceeds of Groupon), the restaurant would often still make money.

This is a bit complicated. We can trace how the cash flows. For Groupon, diners pay them $15, and they keep half of that, $7.50. For the diners, they paid Groupon $15 (now worth $30 spending), and so they pay Giorgio's $70; in other words, they paid $85 out of pocket for a meal worth $100 without Groupon. Giorgio's take in $70 from the diners plus $7.50 coming from Groupon for a meal worth $100.

Where I think Felix missed the mark is when he reasoned:

If you're already a regular somewhere, of course, then buying its Groupon is a no-brainer. And the restaurateur won't begrudge you the savings, either: all restaurant owners want to treat their regulars as well as they can.

I violently agree with the first sentence -- that Groupon-type deals are a gold mine for regular customers. The second sentence, however, doesn't make sense. Go back to the example. For a new customer, Giorgio's makes $77.50 that it would otherwise not make without Groupon. For a regular customer, Giorgio gives up $22.50 that it would otherwise have taken in without Groupon. So, for every 3.4 regulars who use the coupon, Groupon has to generate at least 1 new customer for Giorgio's to break even.

If Giorgio's does not achieve that ratio of new to regular Groupon-wielding customers, then Giorgio's could end up earning less total revenues despite having served more diners/meals.

So, I don't think the Groupon model is the kind of slam dunk Felix seems to think it is. Only if certain conditions are met will the merchants gain anything from Groupon:

• the value of the coupon has to be a fraction of the total spending at the merchant; in this example, the diners spent more than 3 times the face value of the coupon. What if the diners spend exactly $30? Then Giorgio’s loses $22.50 on each regular customer and earns $7.50 on each new customer, meaning that every 3 new customers pay for each regular’s discount. Not very attractive numbers at all.
• the lifetime value of the new customer must be high. Felix also mentions this. The business case is better if the new customers keep coming back, and pay undiscounted rates.
• the coupons are available in limited quantities and at limited times. The more times regulars use these coupons, the bigger the revenue hole the merchant finds itself facing.
• the merchant has no other means of attracting new customers. Our computation assumed that the new customer would never contribute any revenues unless Groupon is in the picture.

This analysis deals with the business model of a merchant using Groupon; even when the merchant loses, Groupon will still make money.

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How is this related to statistical thinking, you might ask? Why am I wasting ink talking about this?

What is missing in the typical narrative about Groupon – the one promoted by the company – is the “counterfactual”. The counterfactual is a powerful concept embedded in statistical theory. In order to evaluate the data in front of us, we must imagine an alternative world (the counterfactual) in which we allow the data to present themselves differently. To understand how medicine X might affect you, you can't just measure what happened after you took medicine X; you must also consider what might have happened if you took medicine Y and/or nothing at all.

So, instead of just thinking about the new customers brought in by Groupon, we must also consider the world without Groupon.  In the world without Groupon, the regulars pay $100 for their meals, and the new customers pay $0 or some other amount (if Giorgio’s has other ways to attract them). This allows us to realize that the insertion of Groupon into that world would lower the intake from regulars while simultaneously raising the intake from new customers. For the merchant, whether Groupon is a net benefit depends on the balance between those two numbers.

This is related to the concept of opportunity cost in economics. When evaluating the value of an investment, we can’t just tally up the returns of said investment; we have to compare those returns to the returns of doing something else such as keeping the money in the bank.

 

Comments

[Jon Peltier]

Of course, if the regular customer comes in more frequently because of Groupon, it still is $77.50 the restaurant gains for each extra time that customer comes in. Your analysis assumes the regular customer comes in with the same frequency with or without the discount.

[Michael Crotty]

Does the restaurant keep the original $7.50 regardless of whether the Groupon is redeemed or not? If so, this income should be taken into account as well. (For those that are not redeemed (new or regular customers), the restaurant is getting $7.50 and providing $0 of food/service.)

[Ken]

The question is how likely are regular customers to obtain a coupon. At the time the coupons are offered only a small proportion of the people offered to will be regular customers. Even if they have a higher take-up rate it is likely there numbers will be smaller than new customers. My understanding (I'm in Australia so I can't try it out) is that it is only one coupon per customer.

[Rick Wicklin]

I'm reminded of the "toy" problems in calculus classes: If Giorgio's offers a coupon worth x dollars, it's profit changes by f(x). Find the value of x that maximizes the profit." As you correctly point out, if a meal at Giorgio's costs $30, then a $30 coupon is foolish (unless used as a "loss leader").

I think the conclusion is that the businesses that use Groupon need to be smart about how they use it. A well-designed statistical experiment wouldn't hurt: try offering several coupons, measure the results, and use statistics to find an optimal value. In fact, this seems like a valuable extra service that Groupon could offer it's customers...for a fee, of course.

[Aaron]

I've seen Groupon deals or other similar ventures that require the individual to be a "new customer" to redeem the coupon. That type of stipulation would help safeguard the business, although I have no idea of how many businesses actually make this rule.

[D R]

Even this is optimistic, no? Is the provision of the meal free to the restaurant? Can the marginal customer really so immensely profitable?

The restaurant preps and serves the regular diners regardless, so the Groupon costs the restaurant $22.50 for each regular regardless.

New diners spending $100 generates $77.50 in revenue. Suppose that the $100 meal costs the restaurant as little as $50, implying $22.50 in profit for each new customer. Then breaking even requires one new customer for each regular.

Diners spending $30 generates $7.50 in revenue, which assuming the same 100% mark-up of $15, implies a $7.50 loss of profit. In this case, the restaurant loses money on every customer.

If diners spend $30, the restaurant must spend less than $7.50 on the actual provision of food in order to break even just on the new customers. That implies that if the restaurant is marking up costs only 200% on those $30 meals then it still loses money no matter how many new customers show up.

The restaurant presumably expects to profit from the Groupon by generating new regulars who then pay back the restaurant in the long run.