Elasticity and Discounted Pricing

The common trend among startups nowadays is to give away their product for a low price (or no price), and often below what it costs them to make it. The reasoning is that this helps them build traction, and marketshare, quickly. And that once the market has taken to the product, and the product has become a significant part of the customer’s life, prices can be raised and money can be made.

The problem with this approach is the beast known as elasticity. Elasticity means that when you increase your price, quantity demanded falls. Some products are highly elastic – a small increase in price can result in a large drop in quantity. Others are less so. Yet, it is extremely rare to find a product whose elasticity is zero, that is, whose quantity demanded does not vary with price. And even if such products exist, it is extremely unlikely that a product produced by a startup will fall in that category.

A good example of elasticity hitting is the shutting down of this American company called HomeJoy. As this piece in Forbes explains, the chief reason for HomeJoy shutting down is that it couldn’t hold on to its customers when it started charging market rates:

Not only did that kind of discounting make Homejoy lose significant money, it also brought in the wrong kind of customer. Many never booked again because they weren’t willing or able to pay the full price, which ranged from $25 to $35 an hour. Homejoy changed its pricing last year to make recurring cleanings cheaper and encourage repeat business. In response, some customers simply booked at the cheaper price and cancelled future appointments.

Based on the above explanation, it seems like subsidising customers to gain traction is a bad idea, and that a business should not be willing to make losses in the initial days in order to gain market. Yet, that would be like throwing out the baby with the bathwater, for subsidising at the “right level” can help ramp up significantly without elasticity hitting later. The question is what the right level is.

A feature of many businesses, and especially marketplace kind of businesses that startups nowadays are getting into, is economies of scale. This means that as the number of units “sold” increases, the cost per unit falls drastically. In other words, such businesses work well when they have built up sufficient scale, but collapse at lower levels. For such businesses, the thinking goes, it is impossible to bootstrap, and the solution is to subsidise customers until the requisite scale can be built up, at which point in time you can start making money.

The question is regarding the “sweet spot” of subsidy that should be given to the customer in order to build up the business. If you subsidise the customer too much in the initial days, there is the risk of elasticity hitting you at steady state, and things rapidly unravelling. If you subsidise too little, you may never build the scale.

The answer is rather straightforward, and possibly intuitive – start out by charging the price to the customer at which the business will be profitable and sustainable in the steady state. This will imply losses in the initial days, since your unit costs will be significantly higher (due to lack of scale). Yet, as you ramp up and hit steady state, you don’t have the problem of raising the price which might result in elasticity hitting your business.

What if, on the other hand, the subsidy you are giving out is not enough, and you are not willing to build traction? That is answered with the “Queen of Hearts” paradigm. The paradigm says that if the only way you can make your contract is if West holds the Queen of Hearts (talking about contract bridge here), you simply assume that West holds the card and play on. If he held the card, you would win. If not, you would have never won anyway!

Similarly, the only way your business might be long-run-sustainable is if you can generate sufficient traction at your long-run-sustainable price. If you need to drop the price below this in order to gain initial traction, it means that you will have the risk of losing customers when you eventually raise the price to the long-run-sustainable-price, which means that your business is perhaps not long-run-sustainable, and it is best for you to cut your losses and move on.

 

Now think of all the heavily-discounted startups out there and tabulate who are the ones who are charging what you think is a long-run-sustainable price, and who runs the risk of getting hit by elasticity.

Grofers, BigBasket and the Lack of Systems Thinking

Last week I wrote this post about why Grofers is not a sustainable and scalable business. The basic point was that goods they sell undergo both high inventory cost (having been stored in a retail store) and high transport cost (delivery).

The most common response to the post was that my claim was wrong because “Grofers doesn’t store any inventory but only delivers”. And it was not unintelligent people who said this – I counted at least three IIM graduates who made this claim on Twitter (ok if that statement gives the impression that I think that all IIM graduates are intelligent, so be it. I don’t disagree).

While their claim is correct, that Grofers doesn’t store any inventory but only delivers, the problem with their line of attack is that they are looking at it from a very localised perspective and not looking at the bigger picture.

A similar problem can be seen in this post on TechCrunch announcing BigBasket’s latest round of funding. Relevant section here (hat tip: Rohin Dharmakumar):

Challenges faced by BigBasket include the grocery industry’s low margins, the cost of adding new delivery staff, and the fact that it carries its own inventory. This allows BigBasket to offer a large selection, but also means it has more overhead than hyperlocal services that partner with existing merchants and needs to more time to prepare before expanding into new cities. (emphasis added)

Catherine Shu, who wrote that piece, might be right in claiming that Bigbasket carries its own inventory. But she is wrong in claiming that it is a problem, for Bigbasket is in a completely different business compared to those hyperlocal services, and in my opinion in a superior business. The carrying of inventory is a feature rather than a bug.

What the twitter comments on my post on Grofers and this piece on BigBasket illustrate is the lack of “systems thinking”. People are great at looking at localised problems, and localised “point solutions” to these local problems. What is not so intuitive is to look at a particular problem as part of a bigger picture and in a more holistic fashion.

Grofers itself may not carry inventory, but the goods it ships would have been part of inventory of some retailer. So while Grofers may not directly incur this high inventory cost, someone along the chain (the retailer in this case) does, and that means there is less money for Grofers to play around with and make a margin.

BigBasket, on the other hand, carries its own inventory and this inventory is aggregated at a much higher than retail level. This implies that the inventory costs for BigBasket are significantly lower than any retailer (since aggregation leads to lower inventory costs). And this inventory cost thus saved can help BigBasket make higher margins. It also allows them to serve the “long tail” to the customer cheaply, something Grofers may not be able to do if no shops in the customer’s vicinity stock such products.

The problem with localised thinking is that it leads to localised solutions, and local optimisation. Optimising locally at different points in a chain makes it harder to optimise at a system level.

Why Grofers is not a sustainable business

When I meet acquaintances for “gencus” nowadays, one of the things we somehow end up talking about is the startup world and inflated valuations of some Indian tech-enabled startups. The favourite whipping boys in any such discussions are food delivery companies such as Swiggy or TinyOwl and grocery delivery startups such as Grofers.

All three aforementioned companies have raised insane amounts of money and are making use of these insane amounts of money to poach employees at inflated valuations. They are also launching significant “above-the-line” advertising campaigns making use of the funds they are flush with. Yet, there is one fundamental concept that indicates that these companies are not likely to go far.

The whole idea of e-commerce is that you trade inventory costs for transportation costs. In “traditional” offline retail, transportation costs are low, since everything is transported in bulk, up until the retail store. In exchange for this, there are significant inventory costs, since inventory needs to be stored in a disaggregated fashion (at each retail outlet) pushing up uncertainty, and thus costs.

E-commerce works on the premise inventory is held in an aggregated fashion thus pushing costs down significantly (especially for “long tail” goods). In exchange, the entire transportation supply chain happens in an expensive “retail” manner. Thus, you save on inventory costs but incur transportation costs.

The problem with businesses such as Grofers is that they incur both costs. First of all, since they rely on picking up goods from retail stores, the high inventory cost is incurred (the hope is that retailers will give Grofers bulk discounts, but that is capped at a fraction of the margin that retailers make). And then, since Grofers transports the item to the customer’s location, retail transportation cost is incurred (whether it is directly paid for by the customer or by Grofers is moot here, since it has the same effect on prices and volumes). Thus, Grofers incurs costs of inefficiencies of both online and offline retail, and is thus a fundamentally unsustainable business.

It can be argued that Grofers offers a degree of convenience that you pay Grofers rather than incurring the cost yourself of getting the goods from the shop. This has two problems, though – firstly, a large number of small and medium retailers in India anyway offer free home delivery (and take orders by phone). Secondly, the cost incurred by Grofers for delivery is a transaction cost and irrespective of who bears it, it results in a reduction of total volume of transactions.

In its last round, Grofers raised $35M. Given the above fundamental inefficiency in its model, it is hard to see the business being worth that much in the long term.

Vistara and Indigo

Earlier today the Air Traffic Controller of Bangalore tweeted that Air Vistara had a 100% on time performance in Bangalore.

My immediate reaction was that this was because Air Vistara is positioned as a premium service, and hence their schedule is more “sparse” and has greater “slack”. That, I mentioned, has a direct consequence on their on-time performance.

The Directorate General of Civil Aviation puts out monthly reports on the performance of airlines in India. The data they dispense is very interesting, but the format is horrible. It’s a PDF embedded into a 20th century web page. If you can parse the above link there are a number of insights to be gleaned.

Firstly, a full 63% of flight delays in India (for the month of June) have been classified as “reactionary” (not cutting and pasting the image here because I don’t want to desecrate this blog by putting a pie chart on it). This is what airport announcers term as “delay caused due to delay in incoming aircraft”.

In other words, what happens is that airlines try to over-optimise their schedules too much leaving little slack between two consecutive flights for a particular aircraft. And so any delay in any flight cascades through the length of the day for that particular aircraft. My hypothesis (haven’t found data to back this up) is that Vistara has a more relaxed schedule than other airlines and hence has better on-time performance.

It is also pertinent to mention that Vistara has a much lower passenger load factor compared to other airlines. The average Vistara flight in June was only about 60% full, comfortably putting it in last place. Perhaps the premium pricing hasn’t been attracting the kind of passengers as hoped for. Or they’re not marketing well to the right kind of people.

The other airline which merits mention here is Indigo, which seems to be literally running away with the market. Not only is it comfortably number 1 with a consistent 37% market share, it also has the lowest proportion of cancelled flights, a pretty high passenger load factor (86%) and better on-time performance than any of the other large airlines.

Airlines is an industry where there are significant positive feedbacks – if you are on time, not only do more people want to fly you but you can also have a more efficient schedule. And so forth. And there are definite economies of scale in maintenance and schedule density and so forth. Indigo is taking advantage of all of those.

It may not be a particularly profitable industry, but the airline industry is surely interesting to watch!

No dosa on Saturdays and Sundays

Back when I was a student at IIM Bangalore a decade ago, I had tried to run this series on this blog (its predecessor, to be precise) on “delivery mechanisms in South Indian Fast Food restaurants”. I had half a mind to do a project on that, too, but then worse sense prevailed, and I did some random shyte on post offices.

Anyway, given that I’ve been living alone for a year now, I tend to frequent South Indian Fast Food Restaurants fairly often for breakfast (and tiffin, sometimes), and thought I should resume this series.

So this morning I went to “duplicate Brahmin’s” for breakfast. This is a place in Jayanagar 4th Block (next to the 560041 post office) and should not be confused with the “original Brahmin’s” in Shankarpuram. I don’t know if this Brahmins has anything to do with that Brahmins, though I’m pretty sure people would have outraged about a restaurant with a (upper) casteist name in these times. Some hypotheses go that this restaurant was started by disgruntled employees of the “original” Brahmins. Anyway, it doesn’t matter since the food here is pretty good (though not as good as at the original Brahmins).

This restaurant has aped a large number of features from the “original” Brahmins. The first is a limited menu – there are only some five or six items made daily. This is usually a good feature of fast food restaurants since it results in aggregation of demand and lower wastage, resulting in lower costs. It also results in significantly quicker service since there are only so many “lines” that need to be maintained in the kitchen.

The other feature this has aped from the “original Brahmin’s” is that there is no sambar. While this might shock Tamilians and North Indians, it’s a fairly normal thing in Bangalore. In fact, Sambar with breakfast is not normal for Bangalore, and most “traditional” restaurants only serve chutney. The advantage of this is (as Pavan pointed) that people can hold their plates in their hands (chutney is cold, unlike hot sambar), so you don’t need that much table space!

There are normally six items on the menu in the duplicate Brahmin’s (apart from beverages) – idli, vada, kesribhath, kharabhath, “ricebhath” (a redundant term like Avenue Road, I know; and this is only served during lunch. It’s a catchall term encompassing “tomato bhath”, “veg pulao”, puLiyOgare, chitrAnna, etc.) and masala dosa. And the odd man out is the last one for the rest are “made to stock”. Masala dosa is usually “made to order” since its quality “decays” quite quickly after it’s made.

It was pleasantly surprising to see a board saying “no masala dosa on Saturdays and Sundays” when I went to duplicate Brahmin’s this morning. The restaurant was already fairly crowded when I went, and there was a queue about five people long at the cash counter. The restaurant is designed in a way that there is this one not-so-large counter across which everything (coupons, food, beverages) is served, and there was a crowd today at every part of the counter (only the cash counter had a queue, at the rest of the places people just crowded around).

That’s where the “no masala dosa on weekends” board makes sense. With the dosa being made to order, people have to linger around the  counter once they’ve handed in their order until they have received their dosa. And given the rather small size of the counter and the weekend crowds, this simply leads to unnecessary crowding and shoving. It also seems like the demand for Masala Dosa at duplicate Brahmin’s is not high or predictable enough to warrant making it to stock. And hence, it’s a rational decision to ration the supply of dosas (to zero) on weekends.

The question is why the restaurant makes dosas at all (on weekdays), given that the original Brahmin’s doesn’t. The answer to this lies in a cost-benefit analysis. On weekdays, the supply chain is not tight and there are no people crowding at the counter. This means that the strain imposed on the system by people waiting around for their dosas is not too high.

Studying fast food restaurants can be a fascinating exercise.

 

Barriers to entry in cab aggregation

The news that Reliance might be getting into the cab aggregation game got me thinking about the barriers to entry in this business. Considering that it is fundamentally an unregulated industry, or rather an industry where players actively flout regulations, the regulatory barrier is not there.

Consequently, anyone who is able and willing to make the investment and set up the infrastructure will be able to enter the industry. The more important barrier to entry, however, is scale.

Recently I was talking to an Uber driver who had recently switched from TaxiForSure. The latter, he said had lost “liquidity” over the last couple of months (after the Ola takeover), with customers and drivers deserting the service successively in a vicious cycle. Given that cab aggregation is a two-sided market, with prominent cross-sided network effects (number of customers depends on number of cabs and vice versa), it is not possible to do business if you are small, and it takes scale.

For this reason, for a new player to enter the cab aggregation business, it takes significant investments. The cost of acquisition for drivers and passengers is still quite high, and this has to be borne by the new player. Given that a significant number of drivers have to be initially attracted, it takes deep pockets to be able to come in.

Industry players were probably banking on the fact that with the industry already seeing consolidation (when Ola bought TaxiForSure), Venture Capitalists might stop funding newer businesses in this segment, and for that reason Uber and Ola might have a free rein. Ola had even stopped subsidising passengers in the meantime, reasoning (correctly for the time) that with their only competition being Uber they might charge market rates.

From this perspective it is significant that the new player who is entering is an industrial powerhouse with both deep pockets and with a reputation of getting their way around in terms of regulation. The first ensures that they can make the requisite investment (without resorting to VC money) and the second gives the hope that the industry might get around the regulatory troubles it’s been facing so far.

I once again go back to this excellent blog post by Deepak Shenoy on the cab aggregation industry. He had mentioned that what Uber and Ola are doing is to lay down the groundwork for a new sector and more efficient urban transport services. That they may not survive but the ecosystem they create will continue to thrive and add value to urban transport. Reliance’s entry into this sector is a step in making this sector more sustainable.

Will I switch once they launch? Depends upon the quality of service. Currently I’m loyal to Uber primarily because of that factor, but if their service drops and Reliance can offer better service I will have no hesitation in switching.

The ET article linked above talks about drivers cribbing about falling incentives by Uber and Ola. It will be interesting to see how the market plays out once the market stabilises and incentives hit long-run market rates (at which aggregators need to make a profit). A number of drivers have invested in cabs now looking at the short-term profits at hand, but these will surely drop with incentives as the industry stabilises.

Reliance’s entry into cab aggregation is also ominous to other “new” sectors that have shown a semblance of settling down after exuberant VC activity – in the hope that VCs will stop funding that sector and hence competition won’t grow. After the entry into cab aggregation, I won’t be surprised if Reliance Retail were to move into online retail and do a good job of it. The likes of Flipkart beware.

Reverse auction platforms

Before my recent trip to Indonesia, I used this website called Cash Kumar to buy my foreign exchange. It was rather simple to use. I posted my location and my requirement for foreign exchange. I had to provide my phone number (and verify it by entering an SMS code; I think this was to make sure only genuine buyers asked for a quote) and then a message went out to all foreign exchange dealers in this part of town, and a few of them responded to my request with quotes.

One of them was significantly cheaper than the other, so I chose him, and CashKumar connected us up. This dealer sent the foreign exchange home. It was an incredibly smooth process.

This is one example of a platform that conducts “reverse auctions”, where a customer states his preferences and you have providers who bid (in a competitive fashion) to provide the said product or service. This results in significant ease-of-use by the customers (though not for service providers since they need to have someone monitoring the requests and bidding for them).

There are several other websites that follow this model. TaxiForSure used to operate like this (I haven’t used it in a while so not sure if it still does). Your request would be broadcast to all taxis around and if one of them accepted it, a match would be made. The difference there was there was no bidding, just matching.

Then there is this AirBnB clone called TravelMob where you can post your requirements (rather than selecting an existing posting), and providers will start responding to that.

One of the “hot” sectors currently in India is hyperlocal delivery, where you request for a product, which a provider procures and delivers for you. In this context, I was thinking of reverse auctions for grocery. You upload your shopping list which goes to nearby grocers (with infrastructure to deliver to you). Since it’s all commodities, the platform can solve some kind of a set covering problem to determine which grocer has to sell you what for you to get the goods at the cheapest rate (after accounting for transaction costs). And in the next couple of hours, more than one delivery can come in to deliver the goods, which you’ve paid for on the platform!

And this multiple delivery thing reminds me of the time when I was doing my MBA (a decade ago), when Dell’s supply chain was widely hailed in Operations Management classes. And the beauty of that supply chain was apparently that once you specified your requirements, the Dell supply chain would get to work and within the next few days different components of the computer would land up at your door!