There are some times when it is profitable for a company to offer better prices to its current customers to retain them, and other times when it is best to offer those price benefits to competitors' customers to acquire them, according to a study by the Yale School of Management's Center for Customer Insights, which explains the rules that govern those times.
Whether to charge a lower price to current customers or to new customers is a debate that has perennially divided marketers. Some argue that current customers value their firm's products more so they should be charged a higher price. Others argue that charging lower prices to current customers makes them more loyal, and therefore profitable, in the long run.
Two deciding factors
According to Yale School of Management's professors Jiwoong Shin and K. Sudhir, the question can be answered by considering two simple but important features of real world markets.
First, only a small number of best customers contribute disproportionately to profits (i.e. the '80/20 rule' or 'Pareto Principle' in which, for example, 20% of customers account for 80% of the sales). Second, customers often switch companies or products as their preferences change based on the purchase occasion.
When to reward existing customers
The authors found that it is most profitable for a company to reward its own best customers in markets that have both of these characteristics:
- Customer profits follow the 80/20 rule;
- Customers routinely switch to competitors (high 'churn' markets).
Examples of markets that exhibit both of these factors might include airlines and catalogue-based apparel retailing. "When markets operate under the 80/20 rule, you have an information advantage," explained Sudhir. "Only I can identify who bought goods from me and who my best customers are. My competitors only know that my customers didn't buy from them, but they don't know which ones are the most profitable. This asymmetry of information is very valuable. And if customers are likely to switch around often, I really have an incentive to stop my best customers from defecting to the competition by giving them the better deal."
When to reward the competitor's customers
Despite this information advantage, the 80/20 rule alone is not sufficient to reward current customers. In industries such as banking and financial services (where customers almost universally follow the 80/20 rule but rarely switch institutions due to cost or inconvenience) it is seldom best to reward current customers, mainly because these customers are very unlikely to defect.
Similarly, if customers are prone to switching to the competition but are nearly identical in terms of how much they buy (as is the case with many consumer products) then offering the better price to competitors' customers is bound to be more profitable, although perhaps only marginally so. Competitors' customers should also be rewarded with the better price in sectors such as printed magazines and computer software, where purchase quantities are similar and customers are unlikely to switch to the competition.
The key finding in the research is that pricing differentially for existing customers and non-customers is almost always profitable because the 80/20 rule is prevalent in most markets.
According to Shin, "When you factor in the threat of your customers switching to the competition you can find the right balance between retention and acquisition. When switching is high, you should value retention and offer the better deal to current customers. When switching is low, you should value acquisition and offer the better deal to competitors' customers."
The full study, entitled 'Behaviour-based pricing: When to punish or reward current customers', has been made available for free download from Yale's web site - click here (537Kb PDF document, no registration required).