CFDP 2048R2

Contracting with Word-of-Mouth Management


Publication Date: July 2016

Revision Date: August 2018

Pages: 44


We propose a model for word of mouth (WoM) management where a firm has two tools at hand: referral rewards and offering a free contract. Current customers’ incentives to engage in WoM can affect the contracting problem of a rm in the presence of positive externalities of users. Formally, we consider a classic Maskin-Riley contracting problem for the receiver of WoM where the firm can pay the sender’s referral rewards and a sender experiences positive externalities if the receiver adopts. A free contract can incentivize WoM because the higher adoption probability increases the expected externalities that the sender receives. We characterize the optimal incentive scheme and show when the two tools serve as substitutes and complements to each other depending on whether the market is niche and whether the product is social. We show that offering a free contract is optimal only if the fraction of premium users in the population is small, which is consistent with the observation that companies that successfully offer freemium contracts oftentimes have a high percentage of free users.

Supplemental Material: Supplemental material

Supplement pages: 31


Word-of-mouth, Referral rewards, Freemium, Contract theory

JEL Classification Codes: D82, L21, M3

JEL Classification Codes: D82L21