Marketing in single-person operations

The density of E’ixample, the district of Barcelona I currently live in, is so high that there are at least six barbershops within 100m of the front door to my apartment. So when I had to get a haircut (for the first time in my life outside India), there was plenty of choice.

Cursory observations and price enquiries (some had listed prices on the door, while at others I’d to enquire) led me to this one-man barbershop called “Urban Cuts Barbershop” (the name is the only English thing about this barbershop – the barber spoke only Spanish). I think the barber has done a pretty good job, but while I had placed my head in his hands, I was thinking about his marketing.

One of the ways in which shops and restaurants advertise quality is through herding and display of crowds. Ceteris paribus, a full restaurant is seen as being better than an empty one – why else would so many others have made the choice to go there? When in doubt, people seek comfort in company; making the same bad choice as everyone else is seen as being less worse than going out of the way and making a bad choice.

So when you are seeking a barber, you seek a barber who others seem to approve of, and the only way you can find this out is by seeing how crowded it is every time you walk past (six barbershops in close proximity to your residence means it’s possible to collect sufficient data points before you make a decision). And if you see it consistently has customers, you are more likely to go there than to a barbershop that hardly has customers.

The problem with a one-seat barbershop is that its fullness is binary – the shop is either operating at 0% capacity (no customers), or at 100% (one customer). If there is no one in the shop, prospective customers walking past might assume this shop is not good. If there is one customer in the shop, prospective customers might reason more favourably about the quality of service, but might be put off by the possible waiting time (range of services barbers offer means that the service time can have a large range).

With more seats, on the other hand, there can be an “optimal level” of fullness, where the shop appears full to a customer walking past, but has enough room to serve a random customer who happens to walk in.

In other words, “marketing ability” is something to take into account while deciding the optimal number of servers. And there’s some food for thought here for consulting businesses like mine (though my fullness is not as binary as the barber’s since I work on longer term projects which can be multiplexed).

More optionality in startup valuations

Mint reports that Indian e-commerce biggies Flipkart and Snapdeal are finding it hard to raise more money at the valuations at which they raised their last funding rounds. One line from the report:

Despite Morgan Stanley’s markdown in February, Flipkart is still approaching investors asking for a valuation of $15 billion, but it hasn’t had any takers yet, the first two people cited above said.

The problem with the valuations is that it includes significant option value. It is common in startup funding to include implicit options in favour of the new round of investors to protect them from the downside of any future decrease in valuation.

Typically designed in the form of “ratchets”, when the firm raises a fresh round at a lower valuation, the investors in the previous round will get additional shares so that their overall share in the investment remains the same (won’t go into the exact mechanics here). This downside protection allows investors to be more aggressive on their valuations of the company, and the company is able to report higher headline numbers.

Ratchets have two problems, both of which are illustrated in the difficulty of Flipkart and Snapdeal in raising more funds. Firstly, optionality in funding means an automatic markdown of funds held by investors in progressively earlier rounds. This is not explicit, but a ratchet is basically existing investors writing an option in favour of the new investors. While the cost of this option is not explicit, it is the earlier investors who bear the cost.

So Series C (and earlier) investors bear the cost of the optionality given to Series D investors. Series B and earlier investors bear the cost of Series C’s optionality. And so on. Notice that this telescopes, so the founders (original owners of equity) have written options to everyone who has invested (of course they also benefit from the higher overall valuation).

Now, if a “down round” (funding round at lower overall valuation than previous round) happens, this optionality gets immediately gets “paid out”. So if the Series D valuation is lower than Series C valuation, Series B and earlier investors (and founders) immediately “pay” the difference to the Series C investors (these options are American, and usually without an expiry date). So Series B and earlier investors (and especially founders) will not like this round. And they will hunt around for offers that will ensure that they don’t have to pay out on the options they’ve written. I suspect this is what is happening at Flipkart and Snapdeal now.

The second problem with ratchets is that stated valuations are inflated. A common share in Flipkart (don’t think one exists. All investors in that firm are effectively either long or short an option in the same stock) is not valued at $15 billion, so that valuation is essentially a misnomer. When Morgan Stanley says on its books that Flipkart is actually worth $11 billion, it is possible that that is the “true value” of the stock, without accounting for the optionality that latest round of investors receive. In other words, the latest round of investors invested at a price, which if extended to all stock, would value the company at $15 billion. But the rest of the company’s stock is not the same as the stock these investors hold! 

The problem, though, is that the latest “headline valuation” (inclusive of optionality) is anchored in the minds of founders and other earlier investors, and they see any lower price as unacceptable. And so the logjam continues. It will be interesting to see how this plays out.

With IPO being way too far off an event for determining if a company has “arrived” I propose a new metric, with shorter horizon. A company can be declared as having arrived if it manages to raise a round of equity with no embedded options. Think about it!

The problem with premium ad-free television

I watched snippets of the just-concluded ICC WorldT20 final using an illegal streaming service, which streamed content drawn from SkySports2.  The horrible quality of the streaming aside (the server seemed to have terrible bandwidth issues), the interesting thing to note was that it was completely devoid of advertisements.

With the quality of cricket coverage in India currently being abysmal due to the frequent cutting for advertisements (I remember getting thoroughly pissed off with the cuts for advertisements before the replay of a wicket was shown during the India-Australia series earlier this year), it made me think about the economics of a separate premium service that is ad-free.

The infrastructure for delivery is in place, given that internet-based legal streaming services are fairly common now (the likes of HotStar). Internet-based delivery also makes it easy to charge pay per view, so payment is also not a problem. This raises the question of whether it is a good idea for channels to monetise the demand for ad-free cricket by providing the service through online streaming, leaving the mainstream broadcast to be monetised via advertisements.

While in theory this appears like a good idea, the problem is with the kind of people who will migrate to the new service – they will be people who have the ability and willingness to pay for a higher quality broadcast. Such people are likely to belong to two overlapping categories – loyal fans of the game and people who can afford to pay a premium.

It is unlikely that the union of these two sets will comprise of too high a proportion of the overall viewership of the game, but the point is that these are the two groups who are likely to be most lucrative to advertisers – the loyal fans watch regularly and the people who are able to pay have more disposable income.

Moving such customers to an ad-free online channel might reduce the supply of advertisements which can be used to reach them, and this might not make advertisers happy. And given that television channels have cosy relationships with advertisers (or at least media buyers), they are unlikely to piss them off by moving the most lucrative customers to a premium platform.

Of course if this segmentation (between ad-free and free broadcasts) is implemented, it will also impact the price of advertisements in the free broadcast. That will need to be taken as an input while setting prices for the ad-free service. In other words, pricing is going to be a challenge!

If some television channel wants to work on this, I’m available for hire as a consultant. I’ve done a fair amount of prior work on pricing and dynamic pricing, am pretty good at quantitative methods and am in the course of writing a popular economics book.

On the death of credit cards

An article that was recently recommended to me on Medium talks about the death of credit cards (among other things that are currently incumbent in the banking system). As someone who has worked a fair bit in “FinTech”, I broadly agree with what he says. As someone who has worked a fair bit in “FinTech”, I’m also not sure how easy it is to disrupt.

The article says:

The two primary use cases for a credit card today could be illustrated thus:

  1. I’m at the grocery store, swiped by debit card and the transaction was declined because my salary hasn’t yet hit my bank account. I need to buy these groceries for the family today, so I’ll use my credit card and worry about why my salary hasn’t hit the account later, or

  2. I really want this new iPad Pro, but I can’t afford it based on my current savings. If I use a credit card I can pay it off over the next few months

And proceeds to explain why each of the above situations can be unbundled to some kind of an instant credit scenario, rather than the bank having extended a lien to you through which you can borrow.

While the idea of instant credit (on the lines of Affirm) makes intuitive sense, the problem is with transaction costs. Irrespective of algorithms significantly slashing the time required and marginal cost of underwriting loans, the fact remains that the marginal cost of underwriting and extending new credit can never be brought down to zero.

There are costs to updating the information the bank knows about you. There are costs to creating any kind of legal documentation, and insuring that. If you were to list down all such costs, you would find that even if the cost of actual underwriting itself were to be zero, the marginal cost of issuing a loan is significant.

It is for this reason that banks have traditionally settled down on a model of “approve once, borrow multiple times”. For retail borrowers, this translates to a credit card, where they can borrow up to a predetermined limit, with no questions asked for each borrowing. For corporate borrowers, this translates to something like a “working capital lien” or “overdraft”.

The article I’d linked above talks about one of the solutions being an “overdraft”. In that sense, what it says is that the physical credit card might disappear, but not the fundamental principle, which is “approve once, borrow multiple times”.

In fact, as companies come up with new and innovative ways of slashing marginal cost of underwriting to enable “on-demand approval” (I’ve been involved in such efforts with a couple of companies), the question is whether such costs can actually be brought to zero, and if not, whether the model can be sustainable.

As long as the marginal cost of underwriting remains even mildly positive, it is not profitable for lenders to lend out small amounts with “on-demand approval”. How this problem can be solved will determine how well “FinTech” lenders can disrupt banks (on the lending side).

The Economics of Shakespeare and Company

During my vacation, I finished reading Salil Tripathi’s Detours, an enhanced collection of his columns in Mint Lounge of the same name. I quite liked the book. In fact, I liked it much more than his columns in Mint Lounge. I think the lack of word limit constraints meant he could add depth when necessary making it a steady and pleasing read (read Sarah Farooqui’s formal review of the book here).

In one of the chapters, he describes Paris in the way Hemingway saw it (literature and art are constant figures in this book, and the fact that I could connect to it (the book) despite my general lack of interest in these topics speaks volumes about the quality of the book). More specifically, this is about the Shakespeare and Company bookshop in Paris where Hemingway occasionally lived, and wrote his books.

George Whitman, a US army veteran who settled down in Paris after the Second World War, bought the store and ran it until his death. During these years, he hosted writers who wanted to visit Paris in an upstairs room, allowing them to basically live in the store as they wrote. There were frequent readings organised in the store where writers could connect with their readers, and writers and other regular patrons were frequently allowed to use the bookshop as a library – to simply read rather than buy books.

There was an occasion when Whitman’s store license ran out and he got into a dispute with the municipal authorities who refused to renew it, to which he responded by stopping the sale of books and running the shop as a library until the license was ultimately renewed.

While Salil describes this as a measure of Whitman’s commitment to good literature and helping authors, it was hard for me to read this chapter without wondering about Whitman’s finances, for none of the above is cheap. One of the biggest costs to running a bookshop is the cost of real estate, and if Whitman had an upstairs room for writers to live and write in, and could redeploy his shop as a library, it came at a significant cost of real estate. While readings might help sell additional books (most readers who attend buy at least a copy of the book that is being discussed), it can disrupt the regular flow of business in the store, and affect sales. The question that I couldn’t escape while reading the book was about the store’s finances and how Whitman managed all these activities.

One hypothesis is that he had alternate sources of funding (patrons of literature’s contributions, or family funds, for example) that allowed him to spend in writer welfare. The other is that margins from the book selling business were fat enough to allow Whitman to spend on writer welfare, and this spending paid him back by way of improving overall sales from his store. Back in the day when you could only buy books from shops, shops that curated well or stocked rare books could afford to charge a premium, and make significant margins which could go into activities such as writer promotion and welfare.

If this hypothesis is correct, it could explain why the traditional literature industry, including authors, are so incensed by Amazon’s rise, even if it leads to significantly better revenues. What Amazon allowed, by its initial print book mailing model, was for readers to access the “long tail” of books which they could purchase at a reasonable cost (they weren’t beholden to curator-bookseller any more). While the more passionate readers remained loyal to their curator-bookseller, the mass moved to the cheaper option.

While this created value for readers (in terms of lower prices for their books), it had the effect of cutting retail margins for books by a significant amount. Several bookshops became unprofitable under this new regime, and with the new margins not compensating for increasing real estate costs, many of them (including chains such as Borders) closed down. Writers weren’t directly affected economically – for readers who would have earlier purchased in such shops could now simply purchase the same books at Amazon for a lower price, but the dropping profitability of conventional bookstores affected them in other ways.

As Salil’s chapter on Shakespeare & Co illustrates, independent bookshops performed a social function far higher than curating and selling books – they provided an author a platform to connect with readers and enabled authors to meet and exchange ideas. They organised events for authors which raised their profile, and helped sell more books.

Their replacement by low-cost retailing models has cut out this additional social function they performed (without direct rewards). Without independent bookshops organising readings and offering writing spaces, writers have lost something they had access to earlier (though they’ve been monetarily compensated for this by means of higher sales driven by lower prices on Amazon). Hence it’s no surprise that writers have taken sides with their publishers in the battle against Amazon, online retailing and e-books.

In this context, this old piece by Matthew Yglesias in Vox is worth reading, where it talks about why Amazon is performing a socially useful function by curtailing the book publishing industry. Yglesias writes:

My best guess is that this is too pessimistic about the financial logic behind giving advances. It is not, after all, just a loan that you may or may not pay back. An advance is bundled with a royalty agreement in which a majority of the sales revenue is allocated to someone other than the author of the book. In its role as venture capitalist, the publisher is effectively issuing what’s called convertible debt in corporate finance circles — a risky loan that becomes an ownership stake in the project if it succeeds.

 

Maximum Retail Price is a conspiracy by FMCG companies

A few months back, Anupam Manur, a colleague at the Takshashila Institution, had written an Op-Ed in The Hindu that the Maximum Retail Price (MRP) mechanism is archaic and needs to be shelved.

Introduced in 1990 by the Department of Civil Supplies, this regulation governs that the maximum price at which packed goods can be sold be printed on the packet, and makes any transactions at a price higher than this price illegal. This was intended to be a mechanism to protect consumers from usurious shopkeepers (remember this was introduced just before economic reforms were launched), and Anupam’s piece also treats the intention as such.

Having now briefly lived in a country with no such regulations (Spain), I must say that my entire perspective of how retail works has been turned upside down (and this, having spent a year consulting for a major retail chain in India).

The existence of the MRP in India means you tend to look at everything in retail from that perspective – the manufacturer/packager, for example, can set margins (a percentage of the MRP) that each segment of the supply chain can earn. As a consequence, players in the chain have little leverage on what prices to charge – at best, they can forego a part of their (usually tiny) margins in order to drive sales.

Without the existence of MRP, however, the (power) equation is turned upside down. Two supermarkets close to my home in Barcelona (about 200m from each other), for example, charge €0,79 and €0,96 respectively for identical cartons of milk (of the same brand, etc.). This price difference (17% or 21% the way you look at it) of a retail commodity between two nearby stores would be impossible to see in India.

Given the broad similarity in these two supermarkets, it is unlikely that there’s too much difference in what they would have paid to procure these cartons of milk. In other words, one supermarket makes a far higher margin selling this milk (which is possibly compensated by the other’s higher sales).

In other words, in a market without MRP, the manufacturer/brand loses control over the pricing once he has sold products down the chain – it is up to the respective player in the chain to determine what he will charge for from his buyers, and thus manage his own revenues. While free markets mean that prices of products broadly converge across stores, the manufacturer/brand can do little in order to dictate them beyond a point.

With this kind of pricing power missing from retailers in a market like India (with MRP), the retailer is at a greater mercy of the manufacturer. The manufacturer can allow the retailer some leeway in pricing, for example, by setting an artificially high MRP, but the question is whether the manufacturer wants the retailer to have this leeway.

Under the current system (MRP), the retailer is mostly at the mercy of the manufacturer. The manufacturer has bargaining power over how much stocks to distribute to the retailer and when, and there is little leeway for the retailer to manage his stocks intelligently. In fact, for some products, manufacturers even control discounts and don’t allow retailers to sell below a particular price (threatening to stop supplies in case they do so). Without the MRP, this kind of coercion on behalf of manufacturers will be significantly reduced.

In this context, it is useful to look at the MRP as a tool that shifts the balance of power in the packaged goods supply chain in favour of the manufacturers/brands and away from the retailers. As Anupam has established in his piece, customers don’t necessarily benefit from this regulation. They are merely an excuse for manufacturers of packaged goods to exert bargaining power over the retailers.

In other words, the MRP is a conspiracy by the FMCG companies, who stand to benefit most from such regulations (at the cost of retailers and customers).

With the current union government supposedly enjoying support of the trading community, there is no better opportunity for this MRP regulation to go.

Revenue management at Liverpool Football Club

Liverpool Football Club, of which I’ve been a fan for nearly eleven years now, is in the midst of a storm with fans protesting against high ticket prices. The butt of the fans’ ire has been the new £77 ticket that will be introduced next season. Though there will be few tickets that will be sold at that price, the existence of the price point has been enough to provoke the fans, many of whom walked out in the 77th minute of the home draw against Sunderland last weekend.

For a stadium that routinely sells out its tickets, an increase in ticket prices should be a no-brainer – it is poor revenue management if either people are scrambling for tickets or if there are empty seats. The problem here has been the way the price increase has been handled and communicated to the fans, and also what the club is optimising for.

At the outset, it must be understood that from a pure watching point of view, being in a stadium is inferior to being in front of a television. In the latter case, you not only have the best view of the action at all points in time, but also replays of important events and (occasionally) expert commentary to help you understand the game. From this point of view, the reason people want to watch a game at the ground is for reasons other than just watching – to put it simply, they go for “the experience”.

Now the thing with stadium experience is that it is a function of the other people at the stadium. In other words, it displays network effects – your experience at the stadium is a function of who else is in the stadium along with you.

This can be complex to model – for this could involve modelling every possible interaction between every pair of spectators at the ground. For example, if your sworn nemesis is at the ground a few seats away from you, you are unlikely to enjoy the game much.

However, given the rather large number of spectators, these individual interactions can be ignored, and only aggregate interactions considered. In other words, we can look at the interaction term between each spectator (who wants to watch the game at the ground) and the “rest of the crowd” (we assume idiosyncrasies like your sworn enemy’s presence as getting averaged out).

Now we have different ways in which a particular spectator can influence the rest of the crowd – in the most trivial case, he just quietly takes his seat, watches the game and leaves without uttering a word, in which case he adds zero value. In another case, he could be a hooligan and be a pain to everyone around him, adding negative value. A third spectator could be a possible cheerleader getting people around him to contribute positively, organising Mexican waves and generally keeping everyone entertained. There can be several other such categories.

The question is what the stadium is aiming to optimise for – the trivial case would be to optimise for revenue from a particular game, but that might come at the cost of stadium “atmosphere”. Stadium atmosphere is important not only to galvanise the team but also to enthuse spectators and get them to want to come for the next game, too. These two objectives (revenue and atmosphere) are never perfectly correlated (in fact their correlation might be negative), and the challenge for the club is to price in a way that the chosen linear combination of these objectives is maximised.

Fundamental principles of pricing in two-sided markets (here it’s a multisided market) say that the price to be charged to a participant should be a negative function of the value he adds to the rest of the event (to the “rest of the crowd” in this case).

A spectator who adds value to the crowd by this metric should be given a discount, while one who subtracts value (by either being a hooligan or a prude) should be charged a premium. The challenge here is that it may not be possible to discriminate at the spectator level – other proxies might have to be used for price discrimination.

One way to do this could be to model the value added by a spectator class as a function of the historic revenues from that class – with some clever modelling it might be possible to come up with credible values for this one, and then taking this value into account while adjusting the prices.

Coming back to Liverpool, the problem seems to be that the ticket price increase (no doubt given by an intention to further maximise revenue takings) has badly hit fans who were otherwise adding positive value to the stadium atmosphere. With such fans potentially getting priced out (in favour of fans who are willing to pay more, but not necessarily adding as much value to the ground), they are trying to send a message to the club that their value (toward the stadium atmosphere) is being underestimated, and thus they need greater discounts. The stadium walkouts are a vehicle to get across this point.

Maximising for per-game revenue need not be sustainable in the long term – an element of “atmosphere” has to be added, too. It seems like the current worthies at Liverpool Football Club have failed to take this into account, resulting in the current unsavoury negotiations.

Now that I’ve moved to Barcelona, Liverpool FC need not look too far – I’ve done a fair bit of work on pricing and revenue management, and on two-sided markets, and can help them understand and analyse the kind of value added by different kinds of spectators, and how this can translate to actual revenues and atmosphere. So go ahead and hire me!