Loyalty in relationships: A theoretical framework – LOYALTY

Loyal relationships between firms and consumers—whether through formal loyalty programs or informal repeat interactions—are a defining feature of many markets. At its core, designing and managing loyalty boils down to offers of rewards in return for repeat business with the goal of retaining and increasing revenue from consumers. Firms invest heavily in customer acquisition and retention, employing a range of strategies to encourage repeat purchases and discourage consumer churn. Across industries—from airlines and hotels to digital platforms, subscription services, and financial products—businesses compete not just for one-time transactions but for long-term customer relationships. At the heart of these strategies lies a fundamental question: What makes a consumer stay with a firm?

This proposed research provides a unified analytic framework for understanding standard practices aimed at detecting and nurturing loyalty—whether through formal schemes such as limited-time offers, value-based programs, and multi-tier loyalty systems, or through informal attempts to turn trading partners into trusted cooperators. Existing work in marketing has emphasized the importance of loyalty programs but has remained largely descriptive. This project fills that gap by bringing the tools of game theory, mechanism design, and dynamic industrial organization to bear on loyalty, capturing its strategic role in imperfectly competitive environments.

The starting point for the analysis is a series of observations that motivate the design of five tightly connected projects. First, consumers differ not just in how much they value a product, but in how frequently they need it—a dynamic trait that plays a central role in shaping firms’ optimal retention strategies. High-frequency consumers are harder to retain, as they have more incentive to explore alternatives. This insight, developed in Hörner and Sanktjohanser (2024), forms the foundation of the project and is critical for understanding loyalty in both consumption goods and insurance markets (Project 5), where consumers’ need frequency is tightly linked to risk exposure. Second, firms do not operate in isolation. They compete for loyal consumers (Project 1) and in some cases collaborate across geographic or product-market boundaries to enhance loyalty, as seen in airline alliances or platform networks (Project 4). The strategic importance of retention is amplified in imperfectly competitive markets, where pricing power and consumer heterogeneity make customer relationships central to firm strategy. The research in this proposal provides models in which differentiation, pricing, and loyalty schemes all arise endogenously from market dynamics. Third, consumers are multi-dimensional. Their frequency of use may not align with their profitability. For example, a high-frequency buyer may also be more price-sensitive or have lower per-purchase value. These interactions explain why many loyalty programs have shifted from frequency-based to value-based designs (Project 3). By modeling buyers with heterogeneous types along multiple axes, the project shows when and why firms choose one reward structure over another. Fourth, loyalty is challenged by volatility. Firms’ ability to retain customers depends not just on consumer traits, but on their own shifting fundamentals—e.g., changing input costs, supply disruptions, or macroeconomic shocks. Project 2 explores how firms adapt loyalty strategies when conditions shift, using a dynamic framework that models seller non-commitment and cost uncertainty.

Beyond theoretical contributions, the project aims to generate testable predictions and provide tools for understanding observed loyalty strategies across industries. It offers novel perspectives on dynamic pricing, consumer welfare, and market power in contexts where retention is crucial. Its insights are relevant for both policy-makers and firms seeking to optimize their retention strategies under uncertainty.