Benefits of Customer Loyalty in Markets with Endogenous Search Costs

Abstract

Managers have long appreciated having loyal customers, and academic research has explored the benefits of loyal consumers as coming from reduced price competition. This paper extends this research by considering how loyalty affects firms’ decisions to facilitate search for nonloyal consumers. We show that in equilibrium, the store with more loyal customers ends up having lower search costs even if facilitating search is costless. The intuition for this result is that nonloyal consumers expect higher prices at a store with a larger loyal segment, and therefore, this store has to set a lower search cost to counteract the negative effect of this expectation. Given this, it is optimal for the other store to set a higher search cost to avoid intensifying price competition. As a consequence, a larger loyal segment may lead to both higher prices and a higher market share among nonloyal customers. In other words, an advantage in customer loyalty leads to the store becoming the search hub of the nonloyal customers. This, in turn, implies that even a small advantage in customer loyalty may lead to a large increase in profits and may help explain why some managers place such a high value on earning customer loyalty. This paper was accepted by David Simchi-Levi, marketing.