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Reward Programs and Tacit Collusion

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Author Info

  • Byung-Do Kim

    ()
    (Seoul National University, Seoul, South Korea)

  • Mengze Shi

    ()
    (Hong Kong University of Science and Technology, Clear Water Bay, Kowloon, Hong Kong)

  • Kannan Srinivasan

    ()
    (Carnegie Mellon University, Graduate School of Industrial Administration, Pittsburgh, Pennsylvania 15213-3890)

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    Abstract

    Reward programs, a promotional tool to develop customer loyalty, offer incentives to consumers on the basis of cumulative purchases of a given product or service from a firm. Reward programs have become increasingly common in many industries. The best-known examples include frequent-flier programs offered by airlines, frequent-guest programs offered by hotels, and frequent-shopper programs offered by supermarkets. Despite the widespread business practice of reward programs, research efforts on reward programs, particularly in marketing, have been scarce. Our paper takes an important step towards understanding the design of reward programs and its implications on pricing strategies. We study a market that consists of two segments: heavy- and light-user segments. The key distinction between the two segments is that the heavy-user segment purchases in each period and thus is a candidate for the reward programs. In contrast, the light-user segment exits the market after one purchase and is not in a position to exploit reward programs. An important feature of our model is that we allow for different price sensitivity between heavy-user and light-user segments. Our model closely examines the type of rewards. A reward worth a dollar to the consumer might have different cost implications for the offering firm, depending on the type of reward. For example, cash rewards have higher unit reward cost () for the firm than a free product of the firm, such as an airline ticket or long-distance minutes (). Specifically, we examine an interesting puzzle observed in the marketplace. Several firms offer a cash reward or a product made by the firm, such as jackets, electronic items, etc. These firms could offer their own product as rewards and significantly lower their cost. We examine whether there is any reason for such a seemingly suboptimal practice. Our analysis shows that reward programs weaken price competition. By offering the incentives for repeat purchases, reward programs increase a firm's cost to attract competing firms' current customers. Because firms gain less from undercutting their prices, equilibrium prices go up. Moreover, as consumers become unwilling to switch because of potential rewards, the firm with a larger market share in the heavy-user segment charges higher prices. Therefore, a low price in the first period, which leads to a larger market share in the heavy-user segment, will always be followed by a high price in the second period. In our model, consumers are rational and can correctly anticipate firms' incentive to offer lower prices initially to enroll them into the reward programs. Our paper offers an explanation as to why the type and amount of reward may vary across the programs. We identify two determining factors for the selection of rewards: size and relative price sensitivity of the heavy-user segment. We find that in a market with a small heavy-user segment that is also much more price sensitive than the light-user segment, it is optimal for firms to offer the rewards. The intuition is based on the firms' incentive to exploit the price-insensitive light-user segment. By offering inefficient rewards, firms are able to commit to weaker competition and, therefore, higher prices. When the heavy-user segment is large or not very price sensitive, when compared to the light-user segment, competing firms should adopt the most efficient rewards to maximize their profit. This may well be the case in a number of real-world situations in which efficient rewards are quite prevalent. We also find that optimal reward amount has a negative relationship with unit reward cost. Because both firms use rewards to attract the heavy users, they tend to offer more when they adopt the more efficient rewards. Finally, our paper identifies the relationship between market characteristics and theimpact of reward programs on firms' profits and consumers' benefits. We find that firms gain from the adoption of reward programs as long as light users are not too price sensitive. When light users are very price sensitive, firms engage in intense price competition, thus benefiting little from the loyalty of heavy users created through rewards. Because reward programs increase market prices, light users, who do not get the reward, earn strictly lower benefit. In contrast, heavy users often stand to gain more from the reward program. In most cases, firms and the heavy users are better off at the expense of light users.

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    File URL: http://dx.doi.org/10.1287/mksc.20.2.99.10191
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    Bibliographic Info

    Article provided by INFORMS in its journal Marketing Science.

    Volume (Year): 20 (2001)
    Issue (Month): 2 (June)
    Pages: 99-120

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    Handle: RePEc:inm:ormksc:v:20:y:2001:i:2:p:99-120

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    Related research

    Keywords: Reward Programs; Switching Cost; Price Competition; Game Theory; Loyalty;

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    Citations

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    Cited by:
    1. Son, Minhee & Hahn, Minhi & Kang, Hyunmo, 2006. "Why firms do co-promotions in mature markets?," Journal of Business Research, Elsevier, vol. 59(9), pages 1035-1042, September.
    2. Ramon Caminal, 2009. "The design and efficiency of loyalty rewards," UFAE and IAE Working Papers 789.09, Unitat de Fonaments de l'Anàlisi Econòmica (UAB) and Institut d'Anàlisi Econòmica (CSIC).
    3. Mark Armstrong, 2005. "Recent Developments in the Economics of Price Discrimination," Industrial Organization 0511004, EconWPA.
    4. Ramon Caminal, 2009. "The design and efficiency of loyalty rewards," Working Papers 408, Barcelona Graduate School of Economics.
    5. Mengze Shi, 2013. "A theoretical analysis of endogenous and exogenous switching costs," Quantitative Marketing and Economics, Springer, vol. 11(2), pages 205-230, June.
    6. Caminal, Ramón & Claici, Adina, 2005. "Are loyalty-rewarding pricing schemes anti-competitive?," CEPR Discussion Papers 5353, C.E.P.R. Discussion Papers.
    7. Kivetz, Ran & Simonson, Itamar, 2003. "The Role of Effort Advantage in Consumer Response to Loyalty Programs: The Idiosyncratic Fit Heuristic," Research Papers 1738r, Stanford University, Graduate School of Business.
    8. David Bell & Rajiv Lal, 2002. "The Impact of Frequent Shopper Programs in Grocery Retailing," Review of Marketing Science Working Papers 2-1-1006, Berkeley Electronic Press.
    9. Gandomi, A. & Zolfaghari, S., 2013. "Profitability of loyalty reward programs: An analytical investigation," Omega, Elsevier, vol. 41(4), pages 797-807.
    10. Pierre Volle & Aîda Mimouni, 2006. "Les bénéfices perçus des programmes relationnels : une approche de segmentation appliquée aux enseignes de distribution," Post-Print halshs-00164834, HAL.
    11. Matilda Dorotic & Dennis Fok & Peter Verhoef & Tammo Bijmolt, 2011. "Do vendors benefit from promotions in a multi-vendor loyalty program?," Marketing Letters, Springer, vol. 22(4), pages 341-356, November.
    12. Lindsey-Mullikin, Joan & Petty, Ross D., 2011. "Marketing tactics discouraging price search: Deception and competition," Journal of Business Research, Elsevier, vol. 64(1), pages 67-73, January.
    13. Dorotic, Matilda, 2009. "Do vendors benefit from marketing actions in a multi-vendor loyalty program?," Research Report 09001, University of Groningen, Research Institute SOM (Systems, Organisations and Management).
    14. Leenheer, J. & van Heerde, H.J. & Bijmolt, T.H.A. & Smidts, A., 2006. "Do Loyalty Programs Really Enhance Behavioral Loyalty? An Empirical Analysis Accounting for Self-Selecting Members," ERIM Report Series Research in Management ERS-2006-076-MKT, Erasmus Research Institute of Management (ERIM), ERIM is the joint research institute of the Rotterdam School of Management, Erasmus University and the Erasmus School of Economics (ESE) at Erasmus Uni.

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