Friday, December 03, 2010

How Groupon is nailing it (because you suck at evaluating prices)

It's easy to look at Groupon's success and shrug with "who knew people wanted coupons?" But that misses a big part of the magic. Groupon has figured out a way to present their coupons that manages to double their perceived value, and not in a way that misleads anyone.

To understand how they do this you first have to acknowledge that you suck evaluating prices. So do I. So do experts. You can read about all the reasons why you suck at prices in Dan Ariely's Predictably Irrational or William Poundsone's Priceless. They'll talk about a range of reasons like anchoring and default choice and comparable items. But what Groupon takes advantage of is that when it comes to price we're all about ratios.

The classic example of this is consider you are shopping for a pair of jeans. You find a pair you like at the beginning of the day for $80 but you decide to keep looking because you've just started shopping and you may find a better price. At the end of the day you're in another store, across town and they have the exact same pair of jeans for $130. You're now 30minutes away from the original store, and you're tired, and there's traffic. Would you go back for the better deal? Most people would say they would.

But lets say instead you are shopping for a laptop. Now the last store you are in is selling it for $1,550 and the original store is selling it for $1,500. Now do you go back? Most people would say they wouldn't. But the weird thing is the $50 savings has nothing to do with the product. On the one hand the deal is:

1. Get the thing you want
2. Pay out the lower price
3. Spend 30minutes in traffic

and in the other case the deal is:

1. Get the thing you want
2. Pay out the lower price
3. Pay an extra $50.

Really in both cases the question is would you spend 30minutes in traffic to save $50. (The response would be different still if it were framed as spend 30minutes in traffic to be paid $50. But that's neither here nor there.) But we instead fall into the trap of thinking about ratio savings.

So how does this apply to Groupon? Let's consider the deal I was offered today. Get a $125 coupon for for $50. That's great, right? $125 value for $50; that's 60% off. Pretty good. But you haven't actually got anything yet. So what can you get for $125 from Indochino? Well their specialty is custom suits that start at $299. So $125 is about 40% off. Still pretty good.

But really, your entire savings is never more than $75. Which means your savings off that suit is only around 25%. By splitting up the purchase of buying a suit from Indochino into buying a coupon from Groupon and then paying the rest at Indochino, Groupon has managed to leverage the savings rate from 25% up to 60%.

So you would figure if they are using leverage to make the first half of the transaction feel like a good deal then the second half of the transaction must feel like a terrible deal. Not quite. Remember that 40% number we arrived at? When we are actually buying the suit, which is a second transaction that doesn't occur on Groupon, that $50 we paid is out of mind. It's sunk cost. And we ignore sunk costs. (Actually sometimes we're really good at ignoring sunk costs, and sometimes we're terrible at it. For example, even if Indochino were to suddenly jack up their prices we would have a hard time not spending that coupon because it cost us $50 which we are resistant to ignoring.)

So the result is after the second transaction you've saved 40% thanks to Groupon. Feels pretty good. Feels like brand loyalty. Maybe you'll buy another coupon.

So Groupon has managed to transform 25% savings into a 40% savings and a 60% savings? Did I start out by saying they doubled the perceived value?

(40%+60%)/25% = 4X

Turns out they actually quadrupled the perceived value. Pretty clever.


Lorenz said...

Pretty interesting analysis and especially true in this example! I run a blog on Indochino and I always found it funny that people jump on those Groupon coupons like crazy while there is another coupon around that gives you 20% and some free shirts. Actually, the groupon coupon only makes "sense" if you go buy pants at 99$ plus a tie for 39$...

Anyway, Groupon is very interesting for sure, wish I had had that idea...

Steven H. Noble said...

Thanks Lorenz. Care to plug your blog?

Bob Garrish said...

Write a book, Steve, please write a book. I feel like you could pump out a Freakonomics level of awesome.