Price promotions are perhaps as old as the markets. The main objective of discounts is to attract customers in the hope that they will return and pay the full price for subsequent purchases. Let’s say that every business has product/service quality that is unobservable to customers without trying the product once. After the first use, however, the customers can determine the true quality. The customers are not aware of all the businesses either. Therefore, some businesses create this awareness by advertising while others do it by offering lower prices for trials. As a special case when all the businesses have the same quality, they will select their marketing strategy that results in the least possible costs.
Several marketing and economics models are built around this simple notion (see this excellent summary of the literature). In practice many businesses use some combination of different strategies. For example, they advertise their price promotions on local TV channels or radio stations. Although price promotions draw customers, it is perceived as an inferior marketing strategy. Marketing researchers have found that it actually erodes brand equity in the long term (e.g., see here, here, and here).
However, we now have an entire business in Groupon that is based purely on price promotions. There is nothing path-breaking about the business model for the small businesses. I think at Techcrunch Rocky Agarwal has done a great deal of analysis of Groupon’s ponzi scheme and how it is harming small businesses. In this post I am not going in those details. My objective is to highlight a rarely discussed issue about Groupon which small businesses are perhaps overlooking.
A major objection about Groupon model is that it brings in customers that are just looking for the deals and they will not repeat the purchases at full price. This is a very valid argument and I don’t think Groupon or any of its supporters have presented any rigorous data refuting this claim. In this discussion, however, most of us tend to forget the impact of these deep discounts on the existing customers of the small businesses.
Imagine that you are a loyal customer of a diner. You eat 3-4 breakfasts at this diner every week and really enjoy the experience. The diner decides to run a Groupon deal to attract more customers like you. There is a very good chance that you—the existing loyal customer—will use that coupon, which is a waste from the diner’s point of view because you are already a loyal customer. However, more importantly, now you may start thinking that your breakfast at the diner is worth only that discounted price! This actually changes how you perceive the diner. In marketer’s language, the positioning of the diner in your mind changes because the diner is offering deep discounts. The shift in positioning may harm the diner more than anything because now the diner is perceived as a cheap eatery that is using discounts. There is also a real possibility of changes in the food or service quality at the diner because you and other loyal customers may force the diner to reduce the prices or offer frequent discounts thereby cutting the profit margins.
I strongly believe that price discounting is a horrible strategy which alienates existing customers. The empirical research in marketing supports this notion. I urge small businesses to stay away from Groupon and its likes such as Living Social and Facebook Deals, etc. They will suck the blood out of your businesses and leave you for dead. I understand the pressure is enormous when business owners see the competitors joining hands with Groupon. Groupon salespeople can also be very persistent and convincing. However, in the end it doesn’t make sense that every business offers a price discount and somehow snatches away customers from competitors. It is impossible. It is prudent to avoid that temptation and focus on building your businesses in traditional fashion, i.e., by identifying your customers’ needs and finding a unique way of satisfying them. That is the only way you can keep those customer with you.
Micro-Positioning 
Not sure, Ashwin…if the reading is entirely correct!. Yes, discounting, by its very principle is bad for a seller; but that isnt to condemn discounting as a wholly wasteful exercise.
As humans in the world we live in, we are always looking for deals- someone actively, some passively. Even a connoiseur who doesnt mind spending extra wouldnt mind spending a little less on what he is passionate about, if there is a possibility.
My personal view is that discounting works very well if you offer it only on trial/abridged versions of anything that you want to people to get hooked to. The tough thing though is to make the trial version/sample tantalizing enough for the customer to enjoy it, but crave for the full product ultimately.
In one of the 3 areas that I have worked on, for eg: Sewing threads: providing deep discounts on a small bobbin of a premium thread gets the customer to maybe use it for one part of an apparel; customer loves the thread quality but to make it fully convenient/usable for stitching many apparels/garments, he will need to buy the larger unit at full price. Using another small unit only adds to the inconenience & he would prefer the larger standard unit.
Thanks for the comment Rajeev. The type of discounting you mentioned is similar to what many software companies do whereby limited features are available to the user at a lower price. My view is that it is not the price promotions Groupon is doing. What you mentioned is more for reducing the information asymmetry between the buyer and seller by way of giving a “sample” to try. This is common where the relationship is going to be long term. However, we have seen this in FMCG too. Sam’s Club, for example, gives away samples of food items all the time. That’s not price promotion, it is sampling.
In most Groupon deals the price is discounted by at least 50%….there is no profit there at all. On top of it, Groupon takes 50% of the revenue, which means the seller gets only 25% of the revenue at most. In many cases the deals are open for a long time and several people use the Groupons. This means that the business is literally pouring in money at the customers, without even covering the variable cost all in the hope that those people will return.
Totally agree. You have demand, which is a relationship between buy/seller; and, the Groupon’s become a third party that siphons an outsized proportion of the revenue. Nevermind whether the customer comes back or what have you. This is the sucking sound of smart people (Groupon) taking something off the table that wasn’t really there to begin with! Net result? More small business bankruptcy – guaranteed.