Consider the marginal cost associated with one additional booked room at the hotel; it’s close to zero. Essentially, you just need housekeeping to clean the room – an hour of work, tops, at little more than minimum wage. Given those numbers, the hotel can still earn a marginal profit on a $250 room (or even a $150 room), even when it pockets just 25% of the standard room rate (after the 50% discount and the 50:50 revenue share with the deal site.)
Now consider the case of the upscale restaurant. In fine dining, the cost of the food to the restaurant represents, on average, 40% of the menu price. That cost alone would eat up nearly the entire price the customer pays for the meal under a 50%-off deal, wiping away any hope of a marginal profit once revenue is shared. As such, the restaurant can only justify the transaction as a form of advertising that is expected to generate recurring revenue beyond the initial deal.
Survivors of another meltdown
That’s a textbook discussion. In the real world, when it comes to some of the businesses that generate the highest marginal profit on every additional unit sold (including hotel rooms or airline seats), the marketplace is already pretty efficient. Also, the opportunity is well covered by companies that survived the collapse of the first Internet bubble in 2000, including Priceline.com Inc (NASDAQ:PCLN) and Expedia Inc (NASDAQ:EXPE).
Priceline, which arguably came up with the most disruptive model with its “name your price” offer, earns very high margins and terrific returns on capital. It doesn’t position itself as an advertiser because the hotel rooms and airplane seats it fills are profitable for the hotels and airlines it does business with.
Outside of the sectors that share this property, group couponing can only be analyzed as a form of advertising, rather than distribution. Unfortunately, the evidence that consumers who participate in a deal are willing to return to a merchant and pay full retail prices is underwhelming. Manta, a small-business online community and service provider, recently surveyed 1,080 such companies, with only 3% of respondents reporting that daily deals produce repeat patrons.
Big wow, half-price
Here again, a basic economic concept helps to explain that figure. The price elasticity of demand is the percentage change in demand for a good or service in response to a 1% change in price. Demand for a good or service is said to be elastic when the change in price has a relatively large effect on demand, and inelastic when the change has a small effect.
Logically, demand for discretionary items tends to be elastic, while demand for necessities, such as consumer staples or health care, is inelastic. When it comes to the type of offers deal sites put together, you’re combining huge changes in price (a 50% discount) with goods and services with highly elastic demand. Indeed, deal sites like to entice their users with offers on unusual leisure products, services or experiences, as there is no “wow factor” in staple goods (for example, LivingSocial advertised a deal that combined a horseback ride with a wine tasting). Put huge discounts together with high elasticity and presto! it’s no wonder these deals generate explosive demand.
