Groupon's big discounts: how its coupon business could eventually cripple the merchants that rely on it.

Commentaries on economics and technology.
March 23 2011 7:09 AM

The Groupon Paradox

How its coupon business could eventually cripple the merchants that rely on it.

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Will coupons drive the price of services down? Click image to expand.
Will group coupons drive the price of services down?

Internet firms are supposed to be all about the cutting edge, but reality and buzz sometimes conflict. Consider Groupon: Its focus is the power of groups, but its actual business is the old standby of direct-mail marketing and coupons. Groupon is spreading that model to a much wider audience—not so much to coupon users, but instead to merchants offering coupons. Groupon is doing for e-mail marketing what other Internet companies are doing for the Yellow Pages or classified ads: encouraging merchants to use modern technology to reach their customers.

Groupon now has more than 50 million subscribers and aims for 150 million by year-end. Its revenues—about half the value of total transactions—were an estimated $760 million last year and should hit $2 billion or more this year. Unlike most Internet companies, it has a lot of employees relative to its revenues—about 5,000.

Thousands of companies have used Groupon to sell their wares, though Groupon does not disclose its rate of repeat sellers.

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In theory, Groupon's business model is "group coupons": If enough people sign up, the deal "tips" into action (because Groupon is so large, almost all deals now tip). In practice, Groupon's original idea—to encourage users to form groups to negotiate with merchants—seems to have disappeared. The notion of user empowerment has likewise vanished amid intense competition for the direct-to-consumer e-mail marketing business.

And Groupon is good at it. While privacy is a big issue in the online consumer business, it is a moot point in the Groupon world, because customers voluntarily and explicitly sign up to be targets (otherwise known as "opt-in"). While some brave start-ups are trying to create "you-own-your-own-data" businesses, Groupon and its many clones/competitors simply appeal to the consumers' lust for deals and discounts. They don't talk about privacy at all—either pro or con.

This model is likely to spread, but it is unlikely to be as centralized as search, whether for Groupon or some other competitor. Just as users indicate their interests when searching the Internet, they sign up for deals that interest them.

So, you could say that Groupon is opening up e-mail marketing just as Yahoo opened up search. Yes, I said Yahoo on purpose: There is no guarantee that Groupon will be the long-term winner. Other players, including Facebook (which can mine a 500-million-plus customer base), could give it strong competition, using newsfeeds or its evolving messaging functions rather than e-mail.

Groupon's emergence is another step in the Internet's move toward ever-greater efficiency and transparency. That is good news for the strong players, but not so good for the weak.

Consider the airline business in the United States. Long ago, the online aggregators Expedia and Travelocity opened up the market. In response, the leading airlines united to create Orbitz in an effort to control the distribution of their services to consumers. But Orbitz became too powerful for them. Now American Airlines is at war with Orbitz for control of its customers.

Increased transparency has made the airline business more "efficient," but now airplane seats are hard to sell on any basis other than price. In an effort to keep their headline prices low, airlines are tacking on surcharges for baggage, drinks, pillows, and other items that once were free.

Thanks to Groupon, merchants may face a similar, but perhaps even more damaging, fate. Prices are likely to erode as consumers come to expect deals. They will wait for sales to buy, and merchants will find themselves competing ever more fiercely. Meanwhile, merchants' brand power will be eroded as consumers look to Groupon (as they do to Orbitz), rather than to the merchants themselves, for the best deals.

The logic is simple: Merchants are encouraged to use the deals to attract new customers, who in theory will return at full price. But, in what seems to be an increasing number of cases, customers come for the deals and then leave for deals offered by other merchants through Groupon. So the number of "new" customers attracted by cheap prices increases, and the number of loyal customers decreases as shoppers prefer to become "new" again for whoever offers the best deal.

Over time, merchants are likely to lower the level of their discounts (they can't afford to do otherwise). But Groupon and its ilk will continue to offer an effective way for new merchants to enter the market and attract new customers. Overall, this newly efficient market will be tough on both incumbents and new entrants.

All to the good, most people will say: More consumers get good deals, and bad companies have a tough time staying around or getting established in the first place.

But that same trend is likely to affect Groupon itself. As the market becomes more efficient, Groupon will have to work harder to keep its edge. Its sales force is training thousands and perhaps millions of merchants to use e-mail marketing and coupons. In the long run, they will figure out how to do it for themselves, and Groupon and its competitors are likely to offer self-service, just as Google does for search ads. Merchants may well use intermediaries to reach consumers, but they are unlikely to continue to hand over such a huge share of the revenues.

In other words, the market is working faster and faster, and it's getting harder for anyone to stay ahead for long, whether it's Groupon's merchant-customers or Groupon itself. For my money, Facebook has a stronger position than anyone in the market. If it can extend its power to daily deals, its competitors had better watch out.

This article comes from Project Syndicate.

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