Resolving the Customer Management Dilemma

This is the story of a customer who purchases a more expensive airline ticket to collect miles for his future vacation. It is the story of the 30-percent-off coupon that arrives in the mailbox of a well-shod fashionista, sent by the nearby boutique she frequents. It is the story of that free cup of coffee offered in response to the ten you’ve already purchased.

The world of rewards serves two ends: to build customer loyalty and entice new business. But is one more important than the other? To whom should firms offer a better deal?

On this question, practitioner intuition and academic literature have long butted heads. The wisdom among practitioners places customer loyalty at the heart of profitability: reward your customers to keep them coming back—a virtuous cycle. But academics have remained skeptical of this notion, some emphatically enough to argue that firms should never reward current customers; rewards should be used to pull business away from competitors, not benefit those already “hooked.”

In an award-winning paper, “A Customer Management Dilemma: When Is It Profitable to Reward One's Own Customers?,” Yale SOM’s Jiwoong Shin and K. Sudhir attempt to reconcile this divide. Shin and Sudhir find that a company’s decision to reward its own customers makes sense only in industries where two conditions apply.

First, the industry must be one in which the greatest percentage of profits comes from a small group of customers. Shin and Sudhir call this customer heterogeneity. For example, a national bank might serve a wide variety of account holders, from a teenager putting her babysitting money into her first checking account, to a multi-millionaire retiree couple living on investment dividends. While the bank would not turn away the teenage customer, a small group of account-holders like the retirees provide the bulk of the bank’s profits, indicating high heterogeneity.

The second condition is that the industry must be one in which customers can easily switch their business to competing firms. Shin and Sudhir call this variable preference. Business and leisure travelers staying in a major metropolitan area, for instance, typically have their pick of chain hotels, with competition among hotels of the same caliber offering very similar room prices. Differentiation comes instead from hotels that reward their most loyal customers and encourage repeat stays. The table below summarizes these results.

The takeaway: in cases where both customer value heterogeneity and variable customer preference are high, the research of Shin and Sudhir suggests that a company ought to reward its most valuable customers. So the next time you cash in your loyalty points for a free thank-you gift, remember that both you and your favorite brand are likely benefiting.

Areas of Interest