Thursday, September 23, 2010

The Gift Card Paradox

Imagine a retailer with many outlets nationwide. Two stores in particular have $1,000 in monthly fixed costs, which are not impacted by the amount of products sold (rent, payroll, utilities, etc.). The products have an insignificant marginal cost, which we can round down to zero.

Suppose that each store only makes an $800 monthly profit in cash for sold merchandise. However, Store A also sells $300 in gift cards each month, but no customers redeem gift cards there. Meanwhile, customers redeem $300 worth of gift cards each month at Store B, but no one buys gift cards there.

If these are the company's only two stores, it will quickly go bankrupt. It's only taking in $1,900 a month while spending $2,000. Assuming that nothing can be done to stimulate business or cut costs, the best option is to shut down.

If instead the company has thousands of stores, does it make sense to shut down either or both of the stores detailed above? This answer is much more difficult.

One crucial factor is how the demand for gift cards would change. Perhaps the closure of Store B would have little or no effect on gift card sales at the other stores. This is a reasonable assumption for a company like Starbucks, which has a store seemingly every few blocks. The recipients will likely be able to find another Starbucks near Store B anyway, so it makes sense to close that store. (Indeed, Starbucks closed 300 stores last year.) Here, the firm's existing stores make a decent substitute for any stores to be closed.

Whether to close Store A depends on how receiving a gift card affects customers' spending. If the typical customer increase his spending by the amount of the gift card, Store A should stay open. If instead he keeps his spending constant, except now he's paying partly in cash and partly in gift cards, Store A should be closed.

Another scenario: perhaps the closure of Store B reduces the chain's gift card sales by the full $300 a month that was redeemed there. This could be plausible for a store like IKEA, which typically only has one outlet per metropolitan area. If IKEA closes Store B in a college town, it's easy to imagine many grandparents spending less on IKEA gift cards (not just at Store A, but at many stores nationwide), because their college-aged grandchildren no longer have a local store at which to redeem them. Here, consumers will likely substitute not to other stores within the same chain, but to stores of its competitors. That does not necessarily mean that both stores should remain open; I think the decision is unclear under this scenario.

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