entrepreneurship at the intersection of sports media and the social graph

Golden Footballs and the Economics of Groupon

By Evan Miller

May 30, 2009

UPDATE 9/28/2010 - There are other reasons for Groupon's success than the analysis described here. See also Is Groupon The Next Google?.

Why in the world do businesses like Groupon?

Customers, of course, love Groupon, and you don't need economic theory to figure out why. Groupon, if you haven't heard, is a website subtitled "Collective Buying Power." Every day, the site advertises a groupon—a coupon with a collectivist twist. A groupon can only be redeemed if a certain number of people agree to buy one. So one day Groupon might offer you a 78% discount on a hot stone massage one day, or 54% off a tennis lesson; but if not enough people sign up for that groupon, then you, poor customer, will be left with an aching back and a pathetic forehand.

Groupon seems like a gimmick, like those knives they sell on TV supposedly worth $155, yours for only $29.99 plus shipping and handling and sales tax. You might be thinking: if groupons actually offered a real discount—fifty, sixty, seventy, eighty percent off—and not just off of soda pop, Subway sandwiches, or the usual coupon fare, we're talking about fancy haircuts and Cubs games and teeth whitenings—why in the world would businesses agree to it?

If you have studied some economics or marketing, you might come up with a few answers. Perhaps Groupon users are more financially constrained than the average (say) Cubs fan, and Groupon enables price discrimination; or perhaps Groupon is a way to reach out to first-time customers who will then become regular customers and pay the full price.

A year ago, I would have been happy with either explanation. But after hearing Kevin Murphy pontificate on a similar subject, I am convinced that other forces pull beneath the surface of Groupon. I believe that Groupon represents a profound economic innovation. I have been trying to find an article on the phenomenon I am about to describe, but it might reside only in Kevin Murphy's lecture notes. In any event, allow me to paraphrase his ideas, however imperfectly.

I am going to assume that you took an introductory microeconomics course one or more decades ago, and bring back a few diagrams from the foggy mists of college.

Let's say we have a seller who vends hot dogs. It costs him a dollar to make a hot dog, but he can charge whatever he wants. The cost is the supply curve:

Now let's draw in a demand curve. We'll suppose people like hot dogs to varying degrees, and are willing to pay anywhere from $10 down to $0 for a hot dog. If we arrange these individual demands from top to bottom, we get the demand curve:

Suppose we're inside a baseball stadium and there is no other place to buy hot dogs. The seller can choose any price. If he picks a high price, very few people will buy and he makes very little profit. Everyone else will be sad they couldn't buy a hot dog:

If he chooses a price down close to the cost, a lot of people buy and are happy that it only cost a dollar or two. But, he still makes little profit:

So, the seller chooses a price somewhere in the middle, to make the profit box as big as possible. Some people are sad that they can't buy a hot dog for a dollar, but other people are more than happy to pay the price of convenience there in the baseball stadium:

This is the standard diagram of a monopolist. Higher prices than the monopoly price make everyone worse off. Lower prices make the consumers better off but the business worse off.

But let's try something a little subversive. What if we picked a combination of prices and quantities over on the right hand side of the diagram?

Consumers, it turns out, are happier on net:

And profits are bigger for the hot dog vendor:

Normally, the right side of the diagram is off-limits because given a price, customers choose how much to buy, and choose an amount along the demand curve. But what if we said you can only get this price if you agree to buy a certain quantity?

That is where Groupon comes in. Groupon provides the mechanism to move businesses and customers over to a part of the diagram previously regarded as unreachable. It only works because customers can collectively commit to buying more than they would with a run-of-the-mill coupon.

We can work with the diagram to find out exactly what kind of discounts—and crucially, what kind of participation requirements—Groupon can offer. First consider the customers' perspective. We can draw an indifference curve that shows groupons that make the customers just as happy as without a groupon. Customers like everything below the curve (because that means lower prices):

Now consider the business. They want a profit box just as big as before. That can be achieved anywhere along a hyperbola that looks like this. Businesses like everything above the curve, because that means bigger profits:

Taking these two curves together, we find that there is a whole region that is preferable to the business and preferable to the customers. After Kevin Murphy, I like to call it the golden football:

That sliver is the raison d'etre of Groupon. It pulls everyone off the demand curve and makes them—against all the economics you learned in undergrad—better off. It works even if Groupon customers never return. It works even if they could afford the regular price. Price discrimination and the gimmick theory are completely unnecessary for explaining the success of Groupon. Groupon opens up the golden football.

Whither Groupon?

Groupon, or a commitment mechanism like it, has something to offer any business that sells a unique product above the cost of production: that is, businesses that are monopolists, or price-setters. So far Groupon has proven suitable to small businesses that offer one-of-a-kind services (for example, a downtown restaurant), but the economics hold for large businesses selling patented or highly branded products. All that is needed is a simple trade with a group of customers: a lower unit price in exchange for an agreement to buy a larger quantity than they would actually like to have at that unit price. Like the best economics, the golden football is a simple idea—but a powerful one.

All graphics in this article were created with the excellent OmniGraphSketcher.

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In the current issue of the New Yorker, columnist James Surowiecki, who I generally admire, gets it exactly wrong when it comes to Groupon.

He writes:

" But it seems unlikely that it’s going to become a revolutionary company, along the lines of YouTube, Facebook, Twitter, and Google. ....Groupon, by contrast, is a much more old-school business. It doesn’t have any obvious technological advantage. Its users don’t really do anything other than hit the “buy” button. And its business requires lots of hands-on attention..."

Well, that's a defensible opinion, but after visiting CEO Andrew Mason this week in Chicago, and thinking about it a bit, I must say that I wholeheartedly diasagree.

Many folks think of Groupon as a relatively simple idea. A daily deal, a large sales force, and that's about it. Too easy to copy (there are scores of "Groupon clones"), and too labor intensive (the more small businesses you want to work with, the more sales and service people you need).

All this is true. But it fails to understand the power of Groupon's model. To sum it up: Groupon has built a new channel into the heart of the the world's economic activity: Small businesses. And it is that channel where the true power lies.

First, the economic math: Small businesses create more than 50% of US GDP and create more than 75% of net new jobs each year. But small businesses represent a fragmented, maddeningly difficult sector of our economy - 23 million small pieces loosely joined. Any platform that has connected them and added value to their bottom line has turned into a massive new business.

Over the past century, there have been two such new platforms. The most recent is Google, a proxy for the rise of the web as a platform for small business lead generation. Before that, it was the Yellow Pages, a proxy for the rise of the telephone as a platform for lead generation.

Groupon, I believe, has the potential to be a new proxy - one that subsumes the platforms of both the Internet and the telephone, and adds multiple dimensions beyond them.

I know that's a stretch, but hear me out.

First, let's review the Yellow Pages. What is it? Well, for the most part, it's a paper-based publishing platform that combines a curated local business phone directory with advertising listings. Nearly every single small business with a phone number is listed in the Yellow Pages, and a large percentage of them also buy advertising to promote their wares as well.

In short, the Yellow Pages is a platform that connects every single consumer with a phone to every single local business with a phone.

As a business, the Yellow Pages consists of folks who manage the listings and produce the books, as well as a very large sales force which calls on local businesses. Once a year, the product turns over, and a new book is made.

That's it. Simple (and certainly not technologically defensible), and while it's clearly in decline, the Yellow Pages is currently a $15 billion revenue business in the US alone. Now, the Yellow Pages is also an online business, but they were late the party, and have pretty much lost to Google when it comes to the platform play.

Google represents a second new platform which connects consumers and small businesses. Many forget that it was small business that drove early adoption of AdWords (as well as Overture, its early competition). And while not every small business is yet online - 36% of US small businesses still don't have a web site - a the clear majority of them do, and milllions of them use AdWords, as well as organic search, to drive leads to their business. Google makes billions of dollars leveraging its platform, which, by the way, has subsumed the Yellow Pages business and grown well past it into any number of other markets, including most major international regions.

Google alone is on a $30 billion revenue run rate, and it's only ten years old. That's twice the US revenues of the Yellow Pages, which were built up over more than 50 years.

So to review, the Yellow Pages leveraged the telephone to create a massively scaled and profitable platform connecting consumers and businesses. Google did the same, but leveraged the Internet (and subsumed the telephone as well).

And Groupon is doing it again, subsuming the telephone, the Internet, and leveraging an entirely new platform: the mobile web.

Now, before you yell at me and claim that Groupon is anything BUT a mobile-driven company (the company sends email to 40mm US subscribers, for example), recall my definition of mobile is a bit more complicated than most.

Remember MOLRS? As I said in that post: "if you are going to think about mobile, you have to think about social, local, and real time." In short, mobile is meaningless without context: Where someone is (or is about to go), who someone is with (or about to go meet), and why someone is where they are (or with who they are with). And, of course, when someone is where they are (and with whomever they are there with...).

Whew. Sorry, but you get the picture.

Now, let's think about MOLRS in relation to small business. First, small business owners (SBOs) care deeply about location. Are they in a good location? Will customers be able to find them? Is there parking? A good neighborhood? Strong foot traffic?

Second, SBOs care deeply about relationships and word of mouth (or what we will call social). Do people refer their friends and family to the business? Are people happy with the service? Will they say nice things?

Third, SBOs care very much about timing (what I call "real time" in my MOLRS breakdown). What are the best hours for foot traffic? What are the best times to run promotions? How can I bring in more business during slow times? How does seasonality effect my business? When should I have a sale?

In short, SBOs are driven by local, social, and real time.

Turns out, so is Groupon.

Now, ask any small business owner what they wish for more of, and they'll give you a resounding answer: More customers. It's why they pay for the Yellow Pages ad, and it's why they buy AdWords from Google.

And it's why they are starting to buy Groupon's product, at a breakneck pace. Sure, some of them buy too much of it, or fail to do the math and lose money on the come. They'll adjust, and if they don't, smarter SBOs will eat their lunch, and the world will move on.

To my mind, the proof is in Groupon's growth rate. I've never seen anything like it - well, since Google. And just as Google lapped the Yellow Pages in a fraction of the time, Groupon seems to be on track to do the same to Google.

Good sources have told me that Groupon is growing at 50 percent a month, with a revenue run rate of nearly $2 billion a year (based on last month's revenues). By next month, that run rate may well hit $2.7 billion. The month after that, should the growth continue, the run rate would clear $4 billion.

Google's run rate, when revealed in its IPO filing six years ago, was staggering - it grew from under $200 million to $1.6 billion in less than three years. Groupon is on track to do the same - but in less than one year.

That's pretty extraordinary. But remember, Groupon has figured out a way to deliver what SBOs want most: more customers in their stores. And unlike Google or the Yellow Pages, Groupon doesn't sell advertising. Instead, it takes 50% of the actual revenue driven by its platform. Trust me, that's potentially a much bigger number.

Actually, it's pretty interesting to see how the business model of driving leads to business has shifted as each platform has risen to dominance. The Yellow Pages charge a set price for a display ad, with no guarantee that the ad would drive any leads. Google turned the model upside down, and charged only when people clicked on the ad. Groupon doesn't charge anything at all: It simply takes half the revenue generated when a deal is fulfilled by its platform.

So to summarize, I think those who claim Groupon's business is too simple are focused on the wrong things. Sure, there are other deal sites. But none have Groupon's scale. Sure, Groupon's model of one deal in one city on one day is limited, but it's easy to see how the product scales against category, zip code, time of day, and many other variables. And sure, Groupon has a lot of people who have to touch a lot of businesses and a lot of customers every day. But to me, that's the company's strength: SBOs are in the people business, and therefore, so must Groupon be.

And this, to my mind, is why Facebook or Google can't compete with Groupon. Imagine Facebook or Google with 1,000 people who do nothing but talk to customers all day long? Yep, I can hear the laughter from here....

While I was visiting earlier this week, CEO Mason told me that a significant percentage of Groupon's customer service reps are members of Chicago's vibrant improv scene. That makes sense to me - if you are going to deal with possibly upset people all day, it helps to have a culture of humor and thinking on your feet.

That culture will serve Groupon well as it attempts to deal with world record-breaking growth. While there is no certainty the company won't blow its lead, it's already a major international player. And while Mason would not comment on the rampant speculation over a $6 billion offer from Google that reportedly fell apart last week, in the end, it may be that the idea of Groupon being purchased by Google is as silly as the idea that the Regional Bell Operating Companies, who originally had the monopoly on the Yellow Pages market, could or should have bought Google.

In the end, it wouldn't have been a fit.