Points for Peanuts or Peanuts for Points? Dynamic Management of a Loyalty Program

Abstract

A loyalty program introduces a new currency -- the points -- through which customers transact with a firm. We study the problem of optimally setting the monetary value of points, i.e., pricing in this new currency, in a multi-period setting. We first show that point pricing is different from cash pricing primarily due to the way points are accounted for, as liabilities on the firm's balance sheet. This introduces subtle channels through which the firm's decisions affect its financial performance, and exacerbates the importance of certain managerial considerations such as taxation or earnings smoothing incentives.We characterize the optimal cash and point pricing policies, and find that they mimic base-stock, list price'' policies in inventory management. In particular, point prices/values are always set so that the total value of points reaches a base-stock'' target, and cash prices are charged so as to maximize the firm's cash flows under the optimal loyalty point values. Under a profit-maximizing policy, the total value of loyalty points is set independently of the firm's realized financial performance. In contrast, we find that under the aforementioned managerial considerations, the optimal value of points becomes state-dependent, and is increasing (decreasing) under strong (weak) operating performance. In this sense, our work shows that loyalty points can act as a hedging tool against uncertainty in future performance, providing a new rationale for their existence, even in the absence of competition.