Publication Date: July 2016
Revision Date: August 2018
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.
Supplement pages: 31
Word-of-mouth, Referral rewards, Freemium, Contract theory
JEL Classification Codes: D82, L21, M3