Rewards or Upgrades? Incentive Designs in Referral Programs

Referral programs are widely adopted to expand the awareness of newly launched products and to boost their sales and profits. In these programs, customers, upon purchasing a product, are invited to refer their friends, and to stimulate their referral actions, firms promise them certain benefits provided that their referrals have positive outcomes and generate new purchases. In the commonly used referral-reward program, referral incentives are made in the form of monetary rewards. In this paper we propose a referral-upgrade strategy, under which firms sell a basic product and compensate each purchasing customer with a free upgrade to a high-quality product provided that the customer refers a friend and her friend is willing to purchase the basic product too. Under this strategy, we first demonstrate the suboptimality of making the quality upgrade exclusively available through referrals and then focus on a case in which customers with unsuccessful referrals can return to purchasing the upgrade. Our model allows each purchasing customer to make multiple referrals and parameterizes the degree of potential overlaps between customers' friendships by a referral reachability value. We focus on linear pricing of quality to facilitate a fair comparison between our proposed referral-upgrade program and the referral-reward program. Our findings are summarized by a threshold policy upon three key factors: referral cost, referral cap, and referral reachability. We show that the referral-upgrade program dominates the referral-reward program in profitability under a high referral reachability, a low referral cost and a low referral cap. We further find that the relative difference between these two referral programs is non-monotone in the referral cap, and that firms can achieve the most gains from adopting the referral-upgrade program under intermediate values of the referral cap. Collectively, our results suggest that firms should meticulously evaluate their referral decisions via our identified crucial factors and consider capping the number of referrals allowable to each referring customer when offering referral incentives in the quality dimension. Our results illustrate the scope and applicability of each referral program, and provide concrete actionable insights for firms devising their referral programs suited in different contexts.