IDEAS home Printed from
MyIDEAS: Log in (now much improved!) to save this article

Reward Programs and Tacit Collusion

Listed author(s):
  • 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)

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.

If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.

File URL:
Download Restriction: no

Article provided by INFORMS in its journal Marketing Science.

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

in new window

Handle: RePEc:inm:ormksc:v:20:y:2001:i:2:p:99-120
Contact details of provider: Postal:
7240 Parkway Drive, Suite 300, Hanover, MD 21076 USA

Phone: +1-443-757-3500
Fax: 443-757-3515
Web page:

More information through EDIRC

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:

in new window

  1. Partha Dasgupta & Eric Maskin, 1986. "The Existence of Equilibrium in Discontinuous Economic Games, I: Theory," Review of Economic Studies, Oxford University Press, vol. 53(1), pages 1-26.
  2. Jagmohan S. Raju & V. Srinivasan & Rajiv Lal, 1990. "The Effects of Brand Loyalty on Competitive Price Promotional Strategies," Management Science, INFORMS, vol. 36(3), pages 276-304, March.
  3. Narasimhan, Chakravarthi, 1988. "Competitive Promotional Strategies," The Journal of Business, University of Chicago Press, vol. 61(4), pages 427-449, October.
  4. Joseph Farrell & Carl Shapiro, 1988. "Dynamic Competition with Switching Costs," RAND Journal of Economics, The RAND Corporation, vol. 19(1), pages 123-137, Spring.
  5. Partha Dasgupta & Eric Maskin, 1986. "The Existence of Equilibrium in Discontinuous Economic Games, II: Applications," Review of Economic Studies, Oxford University Press, vol. 53(1), pages 27-41.
  6. Chakravarthi Narasimhan, 1984. "A Price Discrimination Theory of Coupons," Marketing Science, INFORMS, vol. 3(2), pages 128-147.
  7. Joseph E. Stiglitz & G. Frank Mathewson (ed.), 1986. "New Developments in the Analysis of Market Structure," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262690934.
  8. Shaffer, G. & Zhang, Z.J., 1994. "Competitive Coupon Targeting," Papers 94-02, Michigan - Center for Research on Economic & Social Theory.
  9. K. Sridhar Moorthy, 1984. "Market Segmentation, Self-Selection, and Product Line Design," Marketing Science, INFORMS, vol. 3(4), pages 288-307.
  10. Caminal, Ramon & Matutes, Carmen, 1990. "Endogenous switching costs in a duopoly model," International Journal of Industrial Organization, Elsevier, vol. 8(3), pages 353-373, September.
Full references (including those not matched with items on IDEAS)

This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

When requesting a correction, please mention this item's handle: RePEc:inm:ormksc:v:20:y:2001:i:2:p:99-120. See general information about how to correct material in RePEc.

For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Mirko Janc)

If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

If references are entirely missing, you can add them using this form.

If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

Please note that corrections may take a couple of weeks to filter through the various RePEc services.

This information is provided to you by IDEAS at the Research Division of the Federal Reserve Bank of St. Louis using RePEc data.