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Yale School of Management Study Identifies When it is Profitable to Reward - or Punish - Customers

Business Wire, March 18, 2008

NEW HAVEN, Conn. -- A study from the Yale Center for Customer Insights at the Yale School of Management sheds new light on when it is profitable for a firm to offer better prices to its current customers to retain them or to its competitors' customers to acquire them.

Whether to charge a lower price to current customers or to new customers is a debate that has perennially divided marketers. Some argue that current customers value their firm's products more so they should be charged a higher price. Others argue that charging lower prices to current customers makes them more loyal, and therefore profitable, over the long run.

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According to Yale School of Management professors Jiwoong Shin and K. Sudhir, the question can be resolved by considering two simple but important features of real world markets. The first is that only a small number of "best" customers contribute disproportionately to profits (commonly referred to as the 80-20 rule, i.e., 20% of customers contribute to 80% of sales or profits). Second, customers often switch firms or products as their preferences change based on the purchase occasion.

The authors found that it is profitable for a firm to reward its own "best" customers in markets that have both these characteristics: customer profits follow the 80-20 rule and customers routinely switch to competitors. Markets that experience both features include airlines and catalog retailing for items such as apparel.

"When markets operate under the 80-20 rule, you have an information advantage," said Sudhir. "Only I can identify who bought from me and who my 'best' customers are. My competitor only knows that my customers didn't buy from her, but she does not know which ones are the most profitable. This asymmetry of information is very valuable. And if customers are likely to switch around often, I really have an incentive to protect my best customers from going to the competition by giving them the better deal."

Despite the information advantage, the 80-20 rule alone is not sufficient to reward current customers. In industries like banking and financial services where customers almost universally follow the 80-20 rule but rarely switch institutions due to cost or inconvenience, it is never optimal to reward current customers because these customers are unlikely to defect. Similarly, if customers are prone to switching to the competition but are nearly identical in terms of how much they buy, as is the case with many consumer products, offering the better price to competitors' customers is always more profitable, although only marginally so. Competitors' customers should also receive the better price in markets such as magazines and software where purchase quantities are similar and customers are unlikely to switch to the competition.

"The key takeaway from our research is that pricing differentially to your customers and non-customers is almost always profitable because the 80-20 rule is prevalent in most markets," said Shin. "When firms then factor in the threat of their customers switching to the competition they can find the right balance between retention and acquisition. When switching is high, they should value retention and offer the better deal to current customers. And, when switching is low, they should value acquisition and offer the better deal to competitor's customers."

The study "Behavior-Based Pricing: When to Punish or Reward Current Customers" is available online.

The Yale Center for Customer Insights at the Yale School of Management provides superior insight and understanding of customers to enhance business and society. The Center welcomes inquiries from organizations interested in research partnerships and sponsorship opportunities. For more information visit http://www.cci.som.yale.edu or contact Eugenia Hayes at 203-432-6069 or Eugenia.hayes@yale.edu.

Business Services Industry

Yale School of Management Study Identifies When it is Profitable to Reward - or Punish - Customers

Business Wire, March 18, 2008

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