Moral Hazard and Customer Loyalty Programs†

Frequent flier plans (FFPs) -operated by almost all of the world’s major airlines -have become the most famous, and probably the most valuable, customer loyalty programs in the world. In addition, plans created on the FFP model are now offered by sellers in a number of other industries such as hotels, car rental agencies and credit cards. In this paper we present a theory of FFPs that models them as efforts to take advantage of the agency relationship between employers -who pay for airline tickets -and employees -who book those tickets. In this view, FFP benefits constitute “bribes”, inducing employees to book flights on airlines with higher prices. The model considers two airlines competing in a differentiated product environment and shows that a single airline offering an FFP has a large advantage. However, when both airlines operate plans, it is very possible that, while raising prices, competition (now via FFP benefits) will be intensified so much that the airlines end up worse off than had they not created the plans. Thus, in contrast to switching cost treatments of FFPs, we may observe prices and profits moving in opposite directions. † The authors thank Jim Dana for contributions that significantly improved this paper. We are also grateful to the Social Sciences and Humanities Research Council of Canada and the Phelps Centre for the Study of Government and Business in the Sauder School of Business at the University of British Columbia for financial support; to Mark Armstrong, David Gillen, Mara Lederman, Anming Zhang and seminar participants at Lingnan University, the Hong Kong University of Science and Technology, Peking University, the University of British Columbia, Cornell University, Vanderbilt University, Carleton University, Simon Fraser University and the Pan American Conference on Transport Engineering for helpful discussions; and to Jennifer Ng for excellent research assistance. * Department of Civil Engineering, Universidad de Chile ** Department of Economics, University of Texas at Austin *** Sauder School of Business, University of British Columbia