A Customer Management Dilemma: When to Punish or Reward Own Customers

Firms routinely use behavior based pricing (BBP), to segment customers by past purchase behavior. This paper answers a dilemma facing such firms – When should the firm reward existing customers as opposed to new customers? Further, the paper sheds insight on when behavior based pricing will increase or decrease profits in a competitive market. The analysis adds two features of customer behavior hitherto ignored in the literature: (1) heterogeneity in customer value and (2) mobility in preferences, i.e., customer preferences are correlated but not fixed over time. We identify conditions for when it is optimal to reward/punish own customers and when BBP can increase/decrease profits. To the best of our knowledge, we are the first to show analytically that it can be optimal to reward one’s own customers under symmetric competition and that BBP can increase profits even when consumers and firms are fully strategic and forward looking.