Rewards or Upgrades? Incentive Designs in Referral Programs

Referral programs are widely used for customer acquisition. Traditionally, these programs adopt a referral-reward approach, offering monetary incentives for successful referrals. However, many firms, especially in digital industries, have embraced an alternative, referral-upgrade programs, that reward successful referrers with product upgrades such as premium features or enhanced services. Despite their growing use, little is known about when such programs can outperform the traditional referral-reward approach. This paper develops a stylized model to compare these two referral mechanisms. We address two questions: (i) when referral-upgrade programs are more (or less) profitable than referral-reward programs, and (ii) how key factors such as referral costs and referral reachability, captured by multiple referrals and the degree of overlaps among referred friends, affect firms’ decisions and customer behaviors. We find that referral-upgrade programs are generally more profitable than referral-reward programs, and this profit dominance remains robust to various extensions such as marginal costs or boundedly rational customers, but may reverse when referral costs are correlated with customer valuations or when referral reachability expands via multiple referrals. Our findings offer managerial insights into when firms should adopt upgrade-based incentives to manage their referral programs.