Publication Date: July 2016
We incorporate word of mouth (WoM) in a classic Maskin-Riley contracting problem, allowing for referral rewards to senders of WoM. Current customers’ incentives to engage in WoM can aﬀect the contracting problem of a ﬁrm in the presence of positive externalities of users. We fully characterize the optimal contract scheme and provide other comparative statics. In particular, we show that oﬀering a free contract is optimal only if the fraction of premium users in the population is small. The reason is that by oﬀering a free product, the ﬁrm can incentivize senders to talk by increasing expected externalities that they receive and this can (partly) substitute for paying referral rewards only if there are few premium customers. This result is consistent with the observation that companies that successfully oﬀer freemium contracts oftentimes have a high percentage of free users.
Word-of-mouth, referral rewards, freemium, contract theory
JEL Classification Codes: D82, L21, M3