The efficiency of loyalty programs

from knowledge@wharton

When making a purchase, a consumer has a choice between using frequent-flier miles, cash, or some combination thereof. Which will he or she choose? Another consumer has an opportunity to participate in a special program to get a free car wash after paying for a certain number of washes. What's the best way for the car-wash owner to motivate the customer to participate?
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For example, a consumer may be indifferent as to whether he spends $500 or 25,000 miles on an airline ticket, but prefers paying $400 plus 5,000 miles rather than paying either of the single-currency alternatives. "At $0.02 per mile, the combined-currency price brings in the equivalent revenue to the airline, yet inflicts a smaller psychological cost to the consumer," the researchers write.

It is important to note, they add, that this consumer's preference for the combined-currency price indicates that each mile or dollar spent is not valued equally. The perceived cost of paying more dollars and/or miles increases as the payment in that currency increases. As a result, it will be best for a company to charge a combined-currency price for, say, an airline ticket when two conditions exist: The consumer does not value each unit within a currency equally and the perceived cost function for one of the currencies is said to be "convex." Convexity means, for example, that 25,000 miles appears to be worth more to the consumer than twice as much as 12,500. Why? "Twenty-five thousand miles will get you a free round-trip ticket within the United States, while 12,500 miles might only get you an upgrade," says Drèze.
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"You would think that if people were offered money and miles, they would always take the money, but a lot of people want the miles instead," Dreze says. "Their feeling is, 'Money is only money and if I take money instead of miles, I'll just use the money to pay a bill.' There's nothing special about paying a bill. But when they take frequent-filer miles as a reward instead of cash, they will use them to take trips and that gives them memories. That makes the miles special. The airlines consider their programs 'aspirational' as fliers earmark their miles for special trips. There's a lot going on psychologically when it comes to taking miles or some other kind of rewards points. People don't consider miles or points to be the same thing as money."

"Artificial Advancement"

In another paper, "The Endowed Progress Effect: How Artificial Advancement Increases Effort," Nunes and Drèze outline how companies can structure certain rewards programs to make them more attractive to customers and hence more profitable. Endowed progress means that people who are provided with artificial advancement toward a goal show greater persistence towards reaching the goal than they otherwise would. By artificial advancement, a company advances a customer toward a goal while simultaneously moving the goal further away, so that the task requirements and the reward remain unchanged.

and a caveat... the always returning causality:

But Nunes points out that the long-term impact of loyalty programs is not yet completely understood. For instance, an online study by Maritz, a market research and consumer loyalty program consulting and implementation company, found that members of programs spend more. But it was unknown whether the program drives spending or whether big spenders are just more prone to join programs and get rewards for their spending.

and finally the never-ending quest for status:

Drèze and Nunes are continuing their research into loyalty programs. Among other issues, they are currently exploring the use and effectiveness of "status" -- gold cards, platinum cards and the like -- in loyalty programs. "A lot of loyalty programs endow customers with status, which they earn through purchases or other actions," Nunes explains. "Our research is looking into how stratifying customers and endowing some with status makes them feel different and thus behave differently."

The researchers have just begun investigating the topic. But from what they have discovered so far, it appears that assigning a customer to a category -- such as gold status -- may put them in the top 5% of all customers but it does not necessarily make the customer feel special. It turns out that gold customers feel much more distinctive and apt to spend more if they know that there is another class of people -- those endowed with 'silver' status, for instance -- below them. This paper is tentatively titled, "A Cut Above: Exclusivity and Status in Consumer Loyalty Programs."

"If you go back 10 or 15 years, a gold card was really special," Drèze says. "Today, if you don't have a platinum card, which confers greater status than gold, you're nobody. The interesting thing is that what has evolved over time is that more and more customers need status. Marketers need to find ways to separate one class of customer from another."