by Benjamin G. Edelman, Sonia Jaffe, and Scott Duke Kominers

[Reprinted for our readers, from HBR Blogs with author's permission.]

Hundreds of websites like Groupon, LivingSocial, Eversave, and BuyWithMe sell discount vouchers for services ranging from restaurant meals and museum visits to spa treatments and skydiving. Best known is Chicago-based Groupon: although only two years old, Groupon touts a ten-digit valuation and purportedly rejected a $6 billion acquisition offer from Google.

To consumers, discount vouchers promise substantial savings — often 50% or more. To merchants, discount vouchers offer possible opportunities for price discrimination, exposure to new customers, online marketing, and “buzz.”

To merchants considering whether to offer discount vouchers, the most important question is the basic economics of the offer: Can providing large voucher discounts actually be profitable?

Attracting new customers through voucher discounts can boost profits when those customers later return and pay full price. But vouchers can reduce profits if they prompt many long-time customers to use discounts.

Our recent paper “To Groupon or Not to Groupon: The Profitability of Deep Discounts” (link PDF) develops a model to explore how consumer demographics and offer details interact to shape the value of voucher discounting.

We illustrate two mechanisms by which a discount voucher service can benefit affiliated merchants:

First, discount vouchers can facilitate price discrimination, allowing merchants to offer discounts to customers who value the merchant’s product less than ordinary customers do.

Second, discount vouchers can benefit merchants through advertising, by announcing a merchant’s existence to thousands of consumers en masse.

Our analysis shows that merchants will find discount vouchers most profitable when the population claiming vouchers differs greatly from the merchant’s typical clientele. We explore two areas of difference: either voucher users must be more price-sensitive than the population as a whole, or they must be particularly unfamiliar with a participating merchant’s services.

Regardless of consumer demographics, vouchers are more likely to be profitable for merchants with low marginal costs (who can better accommodate a large discount) and for patient merchants (who place higher value on consumers’ possible future return visits).

Looking at merchants’ recent use of discount vouchers, we are struck by how few merchants measure the effects of discount vouchers. If a merchant intends its discount vouchers to attract consumers who return for future visits (paying full price forevermore), then that merchant should have a plan for assessing whether voucher customers return — if not a customer loyalty program, then cross-checking of credit card receipts. Likewise, merchants intending discount vouchers to bring in entirely new customers need to check whether that is actually happening — again, credit card data makes such analysis possible. We are working with merchants on implementing these analyses, and would love to hear from anyone who has tried these tactics or would like to do so.

The authors are:

Benjamin G. Edelman is an Assistant Professor at Harvard Business School. Sonia Jaffe is a PhD candidate in economics at Harvard University. Scott Duke Kominers is a PhD candidate at Harvard University’s joint program of Business Economics.

Comments and interaction directed to the Harvard team can be via the HBR Blog Comments page.