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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