Where is the Money? Part 4 of 36: Operating in Oversupply

Authors’ Note: In this fourth installment of our new “Where is the Money?” series, we look at front-of-house optimization and its counter-intuitive impact on pricing strategies. Furthermore, as this is the 40th “Where is the Money?” article, we’d like to thank our readers for their support over the last three years. You will be pleased to know that we are busy collating these articles into our second book, The Math that Gaming Made, 2nd Edition. To celebrate this milestone we will revisit our very first article in the series and take another look at horizontal innovation and how it relates to front-of-house optimization. Horizontal innovation is flourishing in the gaming industry with new products hitting the gaming floor from all angles. These new products are being driven from different directions, ranging from innovative new gaming machines to new player development tools.

This year we have seen the complete transformation of the gaming manufacturer. In simple terms, there are now two massive groups: Scientific Games and GTECH, and what seems like a number of specialist companies. Both of these massive groups are, at least on the surface, very similar in their range of products. Their diverse products range from lottery to gaming, from slot systems to lottery systems and from VLTs to slot machines. It is too early to predict the final shape of these companies, but we can say with certainty that the nature and culture of these new entities will be shaping forces in the gaming industry for the next 10 years.

At the same time these massive companies are forming, there are a multitude of new vendors emerging with new product lines that are, in many cases, horizontally focused. For example, we now have a number of pure play slot machine manufacturers, such as Ainsworth, Aruze and Incredible Technologies, and we can see a large number of specialist product companies as well, such as Joingo, Acres and VizExplorer.

This new playing field is showing that the gaming manufacturer/systems company that existed and flourished in the past is now transforming in quite unexpected ways. To explore this, let’s reexamine the horizontal innovation series that started this “Where is the Money?” series 40 articles ago.

A Crazy Retail Pricing Plan
In our May 2011 CEM article we described how the world of gaming was seeking a new equilibrium in pricing, but we were unsure how this pricing adjustment would happen. When looking at pricing in gaming, it is tempting to look at factors such as the hold percentage of the games and the average bet on the game—for example, on a blackjack game the cost of an hour of playing is, approximately, the price of one single bet.

Imagine a retailer that allowed a consumer to choose the price of goods. This retailer would be flooded with people paying pennies for expensive products and this crazy pricing plan would likely result in a large number of executives losing their jobs. Yet in gaming we implement this pricing plan every day. A patron can easily pay three times as much for the same product as the person sitting next to them at blackjack—and this is not considered the slightest bit crazy.

One of the fundamental components of economics is price, and it is with adjustments to price that economists are able to model all manner of sophisticated behaviors in the markets. We have come up with a “price” in gaming that seems to make sense, but before looking into this, let’s first examine the fundaments of economics.

Primer on Economics and Price
The law of supply and demand is “A theory explaining the interaction between the supply of a resource and the demand for that resource. The law of supply and demand defines the effect that the availability of a particular product and the desire (or demand) for that product has on price. Generally, if there is a low supply and a high demand, the price will be high. In contrast, the greater the supply and the lower the demand, the lower the price will be.”1

In more formal terms, Figure 1 shows that the price (P) is a balance between supply and demand. The diagram shows that an increase in demand from D1 to D2 will result in an increase in price from P1 to P2 and an increase in quantify sold from Q1 to Q2. The critical observation is that we are modeling an increase in demand here and it is this increase in demand that is driving an increase in price and an increase in quantity. If this were the case in gaming right now, then the price of a gaming experience and the amount of gaming would both be increasing. Later in this article, however, we argue that in many markets the price is in fact decreasing, and we’ll describe what this price actually means.

A scenario that seems more likely in the U.S. gaming market is that supply is increasing but price is decreasing. This will result in an increase in quantity but a decrease in price. In Figure 2 we can see that the increase in supply from Supply to New Supply results in an increase in quantity from Q1 to Q2 but a decrease in price from P1 to P2.2 The question that remains now is “What is price?”

Resort Gaming Price
We argue that in terms of the law of supply and demand, price is not reflected in the price of the gaming experience but in the value of the resort experience. To understand how the cost of resort features, such as the parking garage, could affect the price of gaming, let’s dig deeper.

Our equation for the resort gaming price is:
Resort Gaming Price = Price of Gaming Experience – Value of Resort Experience

In this equation, the resort gaming price is the overall price as experienced by the gambler; it is this price that we can see in the economic models. The price of the gaming experience is the actual price of sitting down and gambling, and the value of the resort experience is the result of all the marketing costs, resort costs and any other costs associated with operating the complete property product.

The value of the resort experience is largely set by the operator and is measured by its overall reinvestment into players and the property. Consider the case of freeplay in over-supplied markets, where freeplay reinvestment levels are often seen at as high as 30 percent. This increase in freeplay reinvestment is dramatically changing the price of the gaming experience. In addition, night clubs, expensive restaurants and up-market hotels are often required to be competitive, further increasing the value of the resort experience but decreasing the resort gaming price.

Going back to Figure 2, when thinking about the price of the gaming experience as being the resort gaming price, we can see that the increase in supply (new casinos) has resulted in increased volume (at least part of the $1.8 billion annual U.S. growth number).

Now let’s go back to our retailer analogy. Imagine that a retailer has been selling widgets at $100 apiece for a long period, but then a competitor introduces a similar product at $90. Unless the retailer reduces its price to the level of the competition, we would expect its sales quantity to drop significantly.

This leads to a competitive environment where industries are in a constant state of reinvention. If our model for resort gaming price is correct, then the law of economics states that given more competition in gaming, the operators that survive will be the ones that are able to reduce their resort gaming price to meet the new market pricing levels. This is a very harsh reality for many operators who are faced with new competition. Often these operators react by cutting costs in the business, but based on our formula above, this will have exactly the opposite effect. By cutting operational costs, these operators are reacting to increased competition by increasing the price—when in fact they need to decrease the price to be competitive.

Increasing Value and Reducing Price via Horizontal Innovation
According to Peter F. Drucker, “The test of an innovation is whether it creates value. Innovation means the creation of new value and new satisfaction for the customer. A novelty only creates amusement. Yet, again and again, managements decide to innovate for no other reason than that they are bored with doing the same thing or making the same product day in and day out. The test of an innovation, as well as the test of ‘quality,’ is not ‘Do we like it?’ It is ‘Do customers want it and will they pay for it?’”3

One of the critical ways of adding to the gaming experience is horizontal innovation. Back in the July 2011 issue of CEM, we described horizontal innovation in gaming.4# We defined horizontal innovation then as “innovative technologies on the gaming floor that apply broadly across multiple gaming devices.” These horizontal innovations are often applied to the whole gaming floor at one time. With the additional technologies available to provide mobile experiences and the broadening of many gaming operators, we need to adjust this definition to “innovative technologies in the casino that apply broadly across many aspects of the player experience.”

We strongly believe that horizontal innovation is one of the most cost effective ways to drive customer value—and that customers do want it and will pay for it. Now the definition of “pay” in the gaming industry is a little different than Drucker’s, as in gaming the best measure of payment is frequency of visit. In other words, the customers’ choice of one property over the competition is an expression of their willingness to pay for the product.

Consider a horizontal innovation that drives visitation to provide a 3 percent lift across a large number of slot machines, say 25 percent of the slot floor. Compare this to a vertical innovation, where a new penny game provides a 50 percent lift on the bank of poor performing games it replaces, representing 2 percent of the slot floor.

Assuming zero cannibalization, 100 percent of the lift is incremental dollars, as seen in Table 1.

So without cannibalization, the vertical innovation looks to be significantly more effective than the horizontal innovation. However, cannibalization is critical to understanding whether we are just moving money around on the gaming floor or actually making additional revenue.

Let’s suppose that we see 25 percent cannibalization from our horizontal innovation, meaning that 25 percent of the incremental play was seen to come from other areas of the slot floor, whereas 75 percent was incremental revenue. Let’s further suppose that the cannibalization of the vertical innovation is seen to be 50 percent. (In the experience of at least one of us authors, vertical innovations in fact tend to have a much higher cannibalization factor, often exceeding 70 percent). These variations in cannibalization are expected. For a horizontal innovation, it is impacting a large section of the casino floor and thus has less of the floor to cannibalize from. A vertical innovation, however, has nearly the entire casino floor to take business from.

Our math shows the results seen in Table 2.

The 3 percent horizontal lift exceeds the 50 percent vertical lift. As the slot landscape gets more competitive and cannibalization factors climb, clearly we need to look for more horizontal innovations to improve our business.

From Value to Perceived Value
Thus, with horizontal innovation we are able to increase gaming revenues in a more impactful way than with vertical innovation. In addition, these horizontal changes are less likely to cannibalize from other areas of the casino. As Drucker notes, a horizontal innovation is more likely to create value, and a vertical innovation is more likely to be a novelty.

Now add to this the ability to scale horizontal innovation across the gaming floor. Indeed, instead of being a per-machine cost (as is a vertical innovation change such as a game purchase or conversion), horizontal innovation can often be a per-casino cost, and thus the spread of the cost across all machines tends to be much less with horizontal innovation than it is with vertical innovation.

Armed with this knowledge, clear-thinking casino operators who find themselves in oversupplied markets inevitably will walk down the following logical path:

1. I need to reduce my resort gaming price.
2. I can do this by either reducing the price of the gaming experience or increasing the value of the resort experience (which is an increased cost).
3. If I must increase costs to compete, then the most effective means of doing so is via horizontal innovation.

Thus, we need to slightly revise our formula. It is not about the value of the resort experience, it is about the perceived value of the resort experience.

Bringing Together Economics and Horizontal Innovation
Tying this back into the laws of economics, we come to a very important observation: In a market where supply has increased, cannibalization is a measurement of the effectiveness of adjustments to the resort gaming price. The critical observation here is that the value of the price of the resort experience may be inflated with novelty items that customers are not prepared to pay for. This brings us to a potential new way of looking at the price of gaming:
Resort Gaming Price = Price of Gaming Experience – Perceived Value of Resort Experience

So, in summary, innovation is essential and the counterintuitive response to increased supply needs to be an increase in the value of the resort experience. However, in implementing this economic price adjustment, make sure you use math to determine if the customer is perceiving the value of the innovation.

Footnotes
1. Law of Supply and Demand, http://www.investopedia.com/terms/l/law-of-supply-demand.asp.
2. Refer http://www.raybromley.com/notes/equilchange.html, extracted September 2014.
3. Drucker, Peter F. (2009-10-13). The Daily Drucker (p. 70). HarperCollins. Kindle Edition.
4. Where is the Money Part 1, Horizontal Innovation and Gaming Standards, Cardno, Thomas, DeRaedt, July 2011.

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