The Costs of Loyalty. On Loyalty Rewards and Consumer Welfare

Abstract

Loyalty rewards are pervasive. Airlines offer frequent flyer programs; credit cards offer miles, points, and cash-back; and groceries stores and pharmacies offer points to redeem “free” products. Despite their framing, however, “rewards” can harm consumers. Eminent academics have recently noted that while rewards lock consumers in and increase the prices of goods, courts and regulators have paid little attention to them. Noting how a “No Contract” trend emerged in long-term commitments after consumers learned that teaser introductory rates with a lock-in clause triggered subsequent exploitative rates, they concluded that consumers can also learn the costs of loyalty.

In this paper, I develop an alternative view, arguing that there are economic and psychological obstacles for the rise of “No Loyalty”. Concerning the former, facing greater competition sellers need to retain consumers to stay in the market and make a profit. Loyalty rewards can lock consumers in, but they also allow sellers to obtain information about their customers. This information is critical for sellers, because it allows them to segment the market, and target tailored promotions and advertising to the most valuable costumers. The lack of a good database places a firm in a serious competitive disadvantage. Regarding the psychological obstacles, consumers tend to overestimate their value. Rewards can develop affective reactions and cravings on buyers. Consumers also prefer market with rewards because the bundle product-reward appears to be more valuable than it really is for a significant part of the market.

The main implication of this work is that both, consumers and sellers, prefer markets with rewards. Accordingly, further research should shed light on the merits of legal intervention in particular markets. This work surveys the evolution rewards have shown in the financial and airline sectors, arguing that loyalty programs trigger particular problems in specific markets. This article also suggests that the costs of rewards are more severe than lock-in and higher prices. In addition to market-specific problems (such as regressive cross-subsidization and over-spending), rewards can create an illusion of advantage (which derives from the “medium effect”), triggering a behavioral market failure.