Referral Rewards as a Coordination Device in the Presence of Network Externalities

Abstract

Referral rewards programs are traditionally argued to be valuable in fostering word-of-mouth communication. However, they may also help to mitigate the coordination problem in the adoption of a new product that displays network externalities in consumption, by insuring early adopters against the risk that other consumers will wait-and-see. This paper analyzes a model that isolates this insurance purpose of referral rewards. A sufficiently generous referral reward can indeed incentivize early adoption, but this could be costly if not all consumers initially know about the product. The smaller the pool of potential early adopters relative to the population and the stronger network effects, the more likely it is that a price menu that includes referral rewards sufficient to overcome coordination failure is unambiguously beneficial for the firm.