Monday, August 5, 2013

Operational Advantages and Optimal Design of Threshold Discounting Offers

Read the working paper
INSEAD Working Paper 2013/90/TOM

We study the use of threshold discounting, the practice of o ering a discounted price service only if at least a given number of customers show interest in it. Recently, firms like GroupOn and others in the newly created multi-billion-dollar online deals industry have popularized this approach. We model a capacity-constrained service firm servicing a random-sized population of strategic customers in two representative time periods, a desirable hot period and a less desirable slow period. A comparison with the more traditional approaches typically employed in these circumstances (slow period discounting and closure) reveals that threshold discounting boosts the firm's operational performance on account of two advantages. First, the contingent discount incentivizes slow period consumption when the market for the service is large and reduces supply of the service when the market is small, in effect allowing the firm to respond to the service's unobserved market potential. Second, activation of the threshold discount signals the market state to strategic customers, supplying them with additional information on service availability, and inducing them into self-selecting the consumption period to one that improves the firm's capacity utilization and profit. Unlike in a typical setting with strategic customers, strategic behavior in our setting helps the firm, and a higher fraction of strategic customers in the population increases the firm's profits. When threshold discounts are offered through an intermediary, we find that the arrangements most used in practice distort the incentives of the intermediary, which can diminish the advantages of threshold discounting. We consider alternate deal designs, and we nd that the best designs compromise the service provider's exibility in order to provide strategic customers with clear offer terms. We conclude with a numerical study calibrated on data from the opera house Teatro Regio in Torino, Italy, where we consider a number of market and customer behavior scenarios to estimate that threshold discounting improves firm profits by as much as 29% (6.1% on average) and makes the rm's profits more resilient to increasing levels of market uncertainty.