Economics behind Groupon and LivingSocial

Groupon and LivingSocial are two of the fastest growing social media companies in 2010. Together they are expected to gross about $2 billion in revenues in 2011. Groupon recently rejected an offer to be bought by Google for $6 billion. Groupon is also in talks with Meryl Lynch and other investment bankers to do an IPO for an estimated $ 15 billion.

Have you wondered what's the secret behind the success of these companies ? The reason these coupon companies are popular is because they are able to provide services like house cleaning, massages, sushi, rock climbing, sky diving etc from local business to consumers at discounts anywhere from 50% to 90%!!!

How do they provide these discounts ? How can companies afford these levels of discounting ? Is the high levels of discounting sustainable ? Here's my theory on how the Groupon / living social / social coupons work. There are several benefits of social coupons.

Social coupons provide a direct marketing and advertisement for many new and small companies. Instead of spending the money in media buys and promotional events new companies can promote themselves by selling their product / service to customers at a steep discount and they are guaranteed to get a certain amount of customers.

Social coupons are acting as advanced resource management systems for many small firms and thereby reduces the slack in their system and improves productivity of smaller firms and their resources. This is the biggest invention / contribution to the economies of small firms by social coupons. A spa or tanning salon will have to employ certain number of employees to address walk in customers. The span owner do not usually have a very accurate method of estimating how many customers they will get on a given day therefore they will have some employees who will be waiting for customers and this means employees will have to be paid while they wait for customers to show up at the firm and hence the average price of the service goes up because it includes both the actual cost of service and also the cost of employees who are waiting. By using social coupons these small firms can plan their resources in advance sometimes even for couple of months so that they can reduce the time wasted by their employees in waiting for customers and as a result the cost of the service will come closer to the actual cost of hiring employees who perform the services.

Then there's the economies of scale, A small firm which knows in advance how much raw material it needs for the next month or year can manage to get better prices from their suppliers by getting into long term contracts thereby pushing the cycle of efficiency one step back into the supply chain / economy