The Costs of Loyalty. On Loyalty Rewards and Consumer Welfare

Abstract

Loyalty rewards are pervasive. Airlines offer frequent flyer programs; credit cards provide miles, points, and cash-back; and groceries stores and pharmacies offer points to redeem “free” products. Despite their framing, however, “rewards” can harm consumers. Academics have recently argued that while rewards lock-in consumers and increase the prices of goods, courts and regulators have paid little attention to them. However, they have also suggested that consumer learning can cure current problems loyalty rewards produce on markets. In this article, I develop an alternative view, arguing that there are economic and psychological constraints to the self-corrective power of markets, and that loyalty rewards are more harmful than previously stated. Regarding the limits of markets to eradicate rewards, I argue that loyalty rewards provide sellers with valuable information about consumer behavior in an efficient way. This information allows sellers to segment the market and tailor especial marketing strategies to keep their most valuable consumers loyal to them and enhance their spending. In addition, I discuss that consumers tend to overestimate the value of rewards, which leads them to pick bundles that include rewards as part of the deal. According to psychological evidence, this is more patent when a reward is not valuable in itself but a medium that allows redeeming a valuable good in the future. This is the case of miles and points, which consumers tend to maximize despite not assessing their real exchange value. I survey the evolution of rewards in the credit card and airline markets, claiming that loyalty programs cause particular problems in each market. Nonetheless, I argue that successful loyalty programs, in addition to lock-in and higher prices, may generally produce three other issues. First, loyalty rewards might produce affective reactions and cravings on buyers, which soften switching rates and lessen market competition. Second, loyalty rewards that involve “media” tend to create an illusion of advantage that distorts people’s preferences and might lead to inefficiencies. Third, loyalty rewards can impose distributional costs on low-income consumers. This is patent in the credit card market, where loyalty rewards cause a general increase in prices but only a handful of high-income consumers benefit from loyalty rewards. The main implication of this article is that both consumers and buyers tend to prefer markets with loyalty rewards. If the self-corrective power of markets is limited, then legal intervention may be necessary, as demonstrated by countries where regulators have in fact regulated rewards. Of course, a detailed market-specific assessment is necessary to determine whether regulation is worth its costs.