Kellogg World Alumni Magazine Winter 2009

Kellogg Insight: Focus on Research

Membership has its punishments

Yuk-fai Fong finds that loyalty programs dissuade firms from pricing products competitively

By Leah Kauffman

  Yuk-fai Fong

If you think that frequent flier programs and other tactics that reward customers for their loyalty to a particular company ensure good deals for consumers, think again.

According to Yuk-fai Fong, a Kellogg assistant professor of management and strategy, and Qihong Liu, an assistant economics professor at the University of Oklahoma, consumers may not benefit from programs that reward customer loyalty as much as they would if good old-fashioned competition determined prices.

When Fong reviewed existing models of loyalty programs, he found wildly varying results. Some models concluded that loyalty programs reduced competition and increased prices; others found that loyalty programs revved up competition among firms. To add to the confusion, some of these results seemed to hinge on the specific conditions of the programs.

"It was out of frustration with the state of the literature that we started to work on this article," Fong says.

In Fong and Liu's model, consumers enter the marketplace continuously, remaining for at least two purchases. They are assumed to be new customers when they first arrive; if they purchase from the same firm a second time, they are redefined as loyal customers. Under these conditions, Fong and Liu modeled the likelihood that firms would try to engage in competition and attempt to steal business from one another. Further, they altered their model to represent the likelihood of business-stealing under several sets of conditions. "We wrote a more realistic model and showed that the theoretical results continue to hold," explains Fong.

Fong and Liu first ran their model with a relatively simple set of conditions under which firms do not offer loyalty programs but instead price their products uniformly. A company that undercuts the market price by only a slight margin can easily steal its competitor's customers, but it risks instigating a price war that will result in the loss of those brand-new customers to a company with even more aggressive pricing. So even in the absence of programs that reward customers for loyalty, companies face a difficult choice about whether to use prices to compete for customers, leading to an implicit agreement among them to avoid competitive blood baths.

Next, Fong and Liu changed their model to reflect a market in which repeat customers enjoy lower prices, but without a commitment from companies that those low prices will persist. In this model, a firm can undercut the price its competitors charge to first-time customers to woo them away. At the same time, it can increase its profits from its own repeat customers by charging them the full price. But the firm cannot hope to gain its competitor's loyal customers as well unless it beats the competition's price scheme for repeat customers. While this move might cause a stampede of all customers from one firm to another, the price-slashing firm is unlikely to realize much profit from charging universally low prices. This makes such a move an unattractive business choice and reinforces a policy of tacit collusion among the firms.

In additional model runs, Fong and Liu recreated conditions in which firms commit to offer future rewards for customer loyalty, either in the form of a lower fixed price or with a discount off the regular price. The results in Fong and Liu's models held firm. In these cases, a company that decides to steal business from the competitor by lowering the price for first-time customers is even less likely to profit because it cannot balance those price cuts by charging repeat customers higher prices; it must honor its commitment to discount the repeat-purchase price.

Fong notes a firm's leader may think, "'I can always steal some of my competitors' shares by lowering the price a little bit.' We know it will work, but the question is: Is it worth it?" Fong and Liu's work shows that when customer loyalty programs are in place, no matter the specific details, stealing business becomes a less attractive option.

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