Washington Post consumer columnist Margaret Webb Pressler writes:
I also got a huge response about the growing use of buy-one-get-one-free promotions, or BOGOs, as they’re called in the industry….Shoppers don’t understand why retailers offer this kind of promotion when it’s no better for customers and no more profitable for stores than a half-price sale.
On the contrary, BOGOs can be much more profitable for stores than a half-price sale. To see why, assume that you value your first pizza of the night at $15.01 and the second at $5.01 and let’s say it costs the store $2 to make each pizza. If the pizza store has a buy-one-get-one-free offer at $20 then you will buy two pizzas and the store will have profits of $16 ($20-$2-$2). But if the store sells pizzas for half price, $10 each, you will buy just one pizza and the store will have profits of just $8 ($10-$2). The BOGO doubles the store’s profits!
Carefully designed BOGOs increase profits because they let the firm price more flexibly, what economists unfortunately call “price discrimination.” At $20, the BOGO is equivalent to charging $15 for the first pizza and $5 for the second. Notice that these prices are ideal for the firm since they are the maximum the consumer will pay – any more and the consumer won’t buy.
Although BOGOs may make consumers worse off they generally increase total welfare because the price on the last unit sold is pushed closer to marginal cost and because of this output expands. Even if the efficiency gain from price discrimination goes mostly to firms don’t forget that firms are owned by people too!
For more on price discrimination see Hal Varian’s classic, Differential Pricing and Welfare.