$1 Discount or $1 Reward? The Effect of Consumers' Preferences on Reward Programs

The effectiveness of consumers’ reward programs has been the object of recent criticism. Researchers have questioned the ability of reward schemes to lock-in their customers, and stressed the high costs of such investments. Despite these claims, for several industries such as airlines, hotels, gas stations, and credit cards, reward programs today represent a prevalent and apparently successful form of investment. In this paper I investigate why, in markets such as travel, firms have an advantage when they use reward programs that they might not have in other markets. I develop and estimate a a structural dynamic model of consumer purchase and redemption choice in order to compare the value that consumers attach to rewards with the value of money they spend on their purchases. I find that there exists a significant portion of frequent consumers who extract more value from one dollar worth of rewards than from one dollar bill paid for the good purchased. This result is consistent with the idea that in these markets an important segment of customers are employees who travel for work, and make purchase decisions using the money of their employer. In this situation, the reward scheme can exploit the principal-agent separation between employer and employee by inducing the latter, who is the recipient of the rewards, to choose higher-priced goods. I estimate the model on a unique dataset provided by an Italian chain of retail gasoline stations. Instead of using reported information on the nature of consumers, in my analysis I rely exclusively on revealed preferences to identify consumers who, defacto, behave as employee-agents. The results show a significant presence of such consumers, which can make the reward program investment particularly effective compared to other policies such as price reduction.