The Economics of Loyalty: Points, Perks, and Predictable Behavior

A customer is great for a business to have, but a loyal customer is better still.  Loyal customers, who routinely purchase certain categories of goods and services from the same seller, are advantageous because they cost the seller less money to generate sales.  Returning customers need less advertising and customer service to achieve a sale, as they are already familiar with the products, services, and layout of the store.  Therefore, economically speaking, offering loyalty programs can be seen as a cost-effective investment rather than catering to customers. 

Customer Loyalty Programs Explained

Many businesses offer these programs through the form of discounts to customers who buy certain amounts of their goods and services.  These discounts can take different forms, from straight percentage discounts off of entire orders to specialized coupons to preferential access to sale items, locations, or times.  A strong majority of all businesses offer some form of customer loyalty programs, though some are more generous than others.  Most programs offer tiers of rewards based on volume of sales, with the most frequent and generous customers receiving the most benefits.

Popular customer loyalty programs are often seen in regard to travel, with airlines, hotel chains, and rental car companies offering points to customers that can be collected and then cashed in for free services or products.  These travel-related companies offer tiers of service, which provide easy upgrades that can be offered to loyal customers.  Fast food companies typically offer free food as part of their customer loyalty programs, with regular customers winning points that can be cashed in via an app to add free items to their order.  Credit card companies often offer users various options as part of customer loyalty programs, incentivizing users to use that credit card more often, or for expensive purchases, allowing the company to earn credit card fee revenue from the seller.

Economic Rationale Behind Customer Loyalty

Seller Benefits

Loyal customers cost less money to convince to buy additional stuff, require less assistance, provide the seller with valuable consumer taste and preference data, serve as word-of-mouth advertising, and tend to spend more money than new customers.  Thanks to the substitution effect, loyal customers may begin purchasing additional items beyond their initial focus from a preferred seller due to convenience.  The loyal customer may view the time and transportation expense to purchase the good or service from a separate seller as being high enough to justify purchasing it now, even if the price is not lower.

Firms also benefit from offering customer loyalty programs through the psychological pull of sunk costs.  Many consumers fall prey to the sunk cost fallacy, in which they refuse to give up on transactions with no benefit simply due to a belief that they have invested considerable time and resources.  Even when a loyalty program is no longer “paying out” benefits, many customers may feel obligated to continue purchasing from that seller due to the sunk cost fallacy.  It is hard for many consumers to break consumption habits, meaning loyalty programs, even if expensive up front for the seller, can be profitable in the long run.

Finally, firms may be willing to sacrifice some per-unit profit in exchange for being confident in a higher volume of sales.  Loyalty programs require discounts, but generally result in greater sales.  The benefit comes from economies of scale, where sellers accept lower per-unit revenue in exchange for selling more total units.  In fact, producing more units for sale may be advantageous for the seller, who achieves lower per-unit costs by buying resources at scale.  If a loyalty program helps a seller achieve mass volumes of sales, it could mean more long-run profits (provided that the loyalty discounts are less than the buying-in-bulk discounts for inputs).

Consumer Benefits

Loyalty programs benefit consumers through access to lower-cost goods and services.  However, even if the loyalty program does not create the lowest cost on the market, consumers can still benefit when value is attributed to convenience and customer service.  For some consumers, the perks of a loyalty program may provide enough utility (satisfaction) to overcome a somewhat higher product price.  Consumers may also benefit from deeper personal connections with business managers and owners, who may be a valuable resource in the future.  Thus, consumers may view their customer loyalty as an investment as well, which can be referenced when necessary to advocate for a benefit.

Over time, customer loyalty programs can lead to more desirable products being produced and sold thanks to collection and analysis of consumer shopping data.  This leads to better shopping experiences, at least for most customers.  If a strong majority of loyal customers prefer X to Y, the seller will stock more of X, potentially leading to a decrease in the price of X due to buying or producing in bulk, and less of Y.  This will increase consumer satisfaction.

Gamification of Customer Loyalty

Effective customer loyalty programs need to draw in additional sales on a continuous basis.  To do so, these programs need to be easy-to-understand, visually appealing, and convenient for the customer.  When there are many available substitutes, consumers won’t spend long trying to work a loyalty or rewards programs.  As a result, many companies have effectively used gamification techniques to keep loyal customers hooked.  Through apps and websites, these sellers use features like point trackers and customer rankings to encourage more purchases.  If customers easily can see that they are relatively close to achieving the next level or discount, they are more likely to make an additional purchase.

Nudge Theory: Design Your Rewards Program to Get Desired Sales

Companies can use behavioral economics and psychology to design loyalty programs to “nudge” consumers toward desired behaviors - more frequent purchases.  Nudge theory states that it is possible to use psychological principles to guide consumer behavior.  A common example is placing the desired consumer action at the center of all options, making them more likely to choose it.  For example, a seller would not put the lowest-cost, lowest-profit-margin item front-and-center, but rather a more expensive option with a much higher profit margin.  Some consumers will do the work to find the lower-cost version, but many will purchase the first option they see…even if it was the lower-cost version that was advertised and drew them in.

Ethical Implications in Customer Loyalty Programs

Frequently, both sellers and buyers benefit from a customer loyalty program: the seller gets more predictable revenue, and the customer enjoys the offered perks.  However, the situation can become unethical when the rewards are not advertised honestly.  Occasionally, customers claim that sellers intentionally devalue their rewards points to avoid providing rewards, fail to engage in reasonable customer service when there are problems with receiving rewards, or set up convoluted reward programs that make it unreasonably difficult to choose different sellers in the future.  Some complainants feel that companies are selling their data to third parties, setting them up for either lots of spam emails, calls, and texts…or making them more likely targets of hackers and fraudsters.

Sellers can also be taken advantage of through customer loyalty programs, with loyalty fraud occurring when scammers pretend to have had their rewards wiped or stolen and demand restoration, or hack into the rewards program to manipulate it directly.  Legitimate customers may also abuse these programs by demanding ample free points for any grievance, legitimate or fraudulent.  Because these are loyalty reward points at stake instead of cash (although the points have some cash value), authorities may have less incentive to actively investigate these types of fraud or abuse.