Membership Has Its Punishments
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Strategy Economics Jan 1, 2010

Membership Has Its Punishments

Loyalty programs dissuade firms from pricing products competitively

Based on the research of

Yuk-fai Fong

Qihong Liu

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 (Assistant Professor of Management and Strategy at the Kellogg School of Management) and Qihong Liu (Assistant Professor of Economics 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.

Fong specializes in research of tacit collusion among firms. Tacit collusion arrangements are not illegal price-fixing or gouging schemes, as the dictionary definition of the term collusion would imply. Rather, tacit collusion results from conditions that influence companies to behave in certain ways. When Fong checked the literature for 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. Adding confusion, some of these results seemed dependent on the specific conditions of the programs, such as whether repeat customers got a fixed lower price or a percentage discount.

A Dynamic Model
“It was out of frustration with the state of the literature that we started to work on this article,” recalls Fong. The models he and Liu found in the literature weare relatively static, testing only two conditions: they recreated distinct periods in which first one thing happens (e.g., firms set prices, customers make purchases), then another (firms change prices, customers react accordingly). Fong and Liu’s model of customer loyalty programs is more realistic. Fong says, “It’s the first time a fully dynamic model is used to analyze this issue and we’re producing robust results. We are pointing out a tradeoff that has been absent in the literature.” In what they call an overlapping generation 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 participate in tacit collusion. In other words, they determined the chances that firms would try to engage in competition, attempting 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 in which firms do not offer loyalty programs to loyal customers, and 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.

Keeping Customers
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 in order 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&rrsquo;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, both old and new, 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 offering future rewards for customer loyalty, either in the form of a lower fixed price or with a discount off the regular price. Unlike the two-period models in the literature, which returned different results depending on the details of the deals for customers, 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. This is especially true when the commitment is for a percentage off the regular price. If that regular price is decreased from, say, $12 to $10 and repeat customers enjoy a 20 percent discount, the company is now reaping only $8 per unit sold to a repeat customer rather than $9.60. Again, firms are dissuaded from making competitive moves.

Loyalty Rewards the Firm
Fong says 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. The researchers initially worked their model in homogenous conditions, meaning that all the products, firms, and customers appear to be on a level playing field so that no complicating conditions—such as customers who prefer blue flower pots or products that are meant for women in particular—interfere with their decision-making process. To round out their work, the authors also ran their model using heterogeneous conditions: different customers are willing to pay different prices depending on which firm they are doing business with. “Let’s say if you fly different airline companies to the same destination, you may have to transfer in different places and then you have a preference because of that,” Fong explains. “Customers value products from different companies differently.” Under these less predictable conditions, Fong and Liu generated the same results from their model: firms were less likely to engage in competitive pricing when customer loyalty programs were in place.

This means consumers are paying higher prices. “In the short run you may feel the benefit,” Fong says. “It looks like you should sign up for some kind of loyalty program and once you purchase from one company you should stay loyal. But what you don’t manage to see is if there were not any loyalty programs in the industry, what prices would you have paid? That’s something that consumers cannot tell.”

Featured Faculty

Member of the Department of Strategy faculty between 2003 and 2011.

Yuk-fai Fong was a member of the Department of Management & Strategy faculty between 2003 and 2011.

About the Writer
Leah Kauffman is a freelance writer living in Pittsburgh, Penn.
About the Research

Fong, Yuk-fai and Qihong Liu. 2011. Loyalty rewards facilitate tacit collusion.Journal of Economics and Management Strategy, Fall, 20(3): 739-775

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