Customer Referral Management: Optimal Reward Programs

Abstract

Sellers who plan to capitalize on the lifetime value of customers need to manage the sales potential from customer referrals proactively. To encourage existing customers to generate referrals, a seller can offer exceptional value to current customers through either excellent quality or a very attractive price. Rewards to customers for referring other customers can also encourage referrals. We investigate when referral rewards should be offered to motivate referrals and derive the optimal combination of reward and price that will lead to the most profitable referrals. We define a delighted customer as one who obtains a positive level of surplus above a threshold level and, consequently, recommends the product to another customer. We show that the use of referral rewards depends on how demanding consumers are before they are willing to recommend (i.e., on the delight threshold level). The optimal mix of price and referral reward falls into three regions: (1) When customers are easy to delight, the optimal strategy is to lower the price below that of a seller who ignores the referral effect but not to offer rewards. (2) In an intermediate level of customer delight threshold, a seller should use a reward to complement a low-price strategy. As the delight threshold gets higher in this region, price should be higher and the rewards should be raised. (3) When the delight threshold is even higher, the seller should forsake the referral strategy all together. No rewards should be given, and price reverts back to that of a seller who ignores referrals. These results are consistent with the fact that referral rewards are not offered in all markets. Our analysis highlights the differences between lowering price and offering rewards as tools to motivate referrals. Lowering price is attractive because the seller “kills two birds with one stone”: a lower price increases the probability of an initial purchase and the likelihood of referral. Unfortunately, a low price also creates a “free-riding” problem, because some customers benefit from the low price but do not refer other customers. Free riding becomes more severe with an increasing delight threshold; therefore, motivating referrals through low price is less attractive at high threshold levels. A referral reward helps to alleviate this problem, because of its “pay for performance” incentive (only actual referrals are rewarded.) Unfortunately, rewards can sometimes be given to customers who would have recommended anyway, causing a waste of company resources. The lower the delight threshold level, the bigger the waste and, therefore, motivating referrals through rewards loses attractiveness. Our theory highlights the advantage of using referral rewards in addition to lowering price to motivate referrals. It explains why referral programs are offered sometimes but not always and provides guidelines to managers on how to set the price and reward optimally.Referral Rewards, Customer Referrals, Customer Delight, Word-of-Mouth

Brand Loyalty Programs: Are They Shams?

“…Of course, there may be a fine line of distinction between recognition as a "thank you" and the incentive to buy that recognition. Biyalogorsky et al (2001) provide an extensive analysis of using loyalty programs to encourage referrals. Loyalty programs can also encourage positive wordof-mouth communications (Godes and Mayzlin 2004, Van den Bulte and Stremersch 2004, Magrath 2000.…”

Information and Online Reviews

“…9 The conventional result is that price discrimination is privately adopted by producers and can be also welfare improving, as it allows to serve weaker markets which would otherwise be cut out (see Schmalensee, 1981;Varian, 1985;Stigler, 1987, inter alia). Regarding the specific case of third-degree price discrimination, it may decrease welfare when the demand function is linear (Aguirre et al, 2010; Aguirre, 2012).…”

“…One of these is group buying, whereby consumers obtain a discount if they group and achieve a required group size (see Che and Gale, 1997; Anand and Aron, 2003; and Jing and Xie, 2011). Other marketing strategies are referral reward programs (see Biyalogorsky et al, 2001), one-to-one promotion (Shaffer and Zhang, 2002) and advance selling (Xie and Shugan, 2001), among others. These papers explore very interesting issues which are related to our basic idea.…”

Referral equity and referral management: the supplier firm's perspective

“…Another means to increase the effectiveness of referral reward programs comes from Biyalogorsky, Gerstner, and Libai (2001), who suggest supplier firms should not give referral rewards to (1) customers with a low ''delight threshold,'' as they are easily satisfied and therefore may give positive referrals even without rewards, or (2) customers with a high delight threshold, who are not easily satisfied, because referral rewards will not influence them sufficiently to give positive referrals. To lower the cost of referral programs, supplier firms should offer referral rewards only to those customers who fall between the two extremes of delight thresholds.…”