How banning loyalty penalties can help – or hurt – consumers

While regulators are scrutinising loyalty penalties, banning these practices without competition safeguards may strengthen monopolies and harm consumers

The loyalty penalty – when a company offers more favourable terms to lure new customers, effectively exploiting its existing ones – is increasingly attracting the attention of regulators. However, new research shows attempts to ban these unfair practices in a market without the proper competition settings can ultimately make things worse for consumers.

Loyalty penalties have become particularly notorious in important sectors like finance and communications, and these practices reportedly cost Australian home loan customers as much as $4.5 billion a year. In 2019, the Australian Competition & Consumer Commission (ACCC) issued a report recommending improvements and broader legislative reforms, calling out frequent-flyer, supermarket and hotel loyalty schemes; earlier this year, ACCC chair Gina Cass-Gottlieb said the agency was investigating banks’ deposit rates as a potential “loyalty tax”.

Other countries have attempted to tackle the loyalty penalty through legislation and regulation, including the UK, which has officially banned the practice in certain markets. But as well-intentioned as these efforts can be, they also have unintended consequences that can potentially do more damage than good in a non-competitive market, according to a research paper, Fairness regulation of prices in competitive markets, published recently in Manufacturing & Service Operations Management.

These regulations are a “win-win outcome” when competition is intense, as they can alleviate cutthroat competition, making room for more firms to earn higher profits. But in a weak competitive landscape, they can have the opposite effect, instead contributing to a firm’s existing monopoly power, explained Dr Xingyu Fu, lecturer in the School of Marketing at UNSW Business School and co-author of the paper.

“This is because undercutting competing firms by offering competitors’ loyal consumer segment lower prices may violate the fairness regulation, and as a result, these firms tacitly collude not to undercut each other,” said Dr Fu, who co-wrote the paper with Zongsen Yang and Pin Gao of the School of Data Science at Chinese University of Hong Kong, Shenzen and Ying-Ju Chen of the School of Business and Management, Hong Kong University of Science & Technology. “This potentially leads to collusive high prices that are detrimental to consumers and society.”

A ’counterintuitive’ strategy

In business, loyalty refers to the relationship between firms and consumers making repeated purchases, with loyal consumers able to save time and effort by sticking with, for instance, their current insurance provider rather than searching for and switching to a new one. While loyalty is generally considered a positive consumer characteristic, it’s also something companies can exploit to engage in discriminatory pricing practices.

In researching these tactics, Dr Fu said he found the loyalty penalty both interesting and counterintuitive as a pricing strategy. “Usually, we would imagine firms offer value to their loyal customers by, say, providing coupons or exclusive access to some premier services or products,” he said.

“But nowadays, penalties on loyal customers, such as secret price increases for existing consumers in the telecommunications industry, challenge this conventional wisdom,” he added. “I was intrigued by this business phenomenon and investigated regulators’ and industries’ responses to this controversial practice.”

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The loyalty penalty is an especially important issue given that these tactics, prevalent in essential services, disproportionately hurt more vulnerable consumers, Dr Fu noted. “For instance, in the United Kingdom’s insurance market, 32% of those penalised for loyalty are above the age of 65, compared with 23% in the general population,” he said. “Similar statistical patterns are observed among individuals with low incomes and those with mental/physical health issues.”

A look at regulatory changes

Public engagement around these concerns has led to attempts to ban loyalty penalties as an unethical business practice and prompted some regulators to take action. The researchers highlighted the example of the UK’s response to the loyalty penalty, or ‘price walking’.

In 2018, the consumer rights charity Citizens Advice lodged a super-complaint with the UK’s Competition and Markets Authority (CMA) regarding the use of loyalty penalties in five essential markets: insurance, mortgages, savings, mobile and broadband internet. In response, the CMA committed to ‘direct pricing intervention’ measures, such as restricting price gaps, and the Financial Conduct Authority subsequently banned the loyalty penalty in the country’s home and motor insurance markets, mandating that insurers provide fair value to their customers.

And in Australia, many companies claim to price fairly, Dr Fu noted. For example, the online mortgage platform Athena has implemented an ‘automatic rate match’ mechanism to ensure loyal customers don’t receive worse rates than new customers on similar loans.

These regulatory changes and business trends drove the team’s research. “Instead of approaching it solely from a moral standpoint, we adopt an economic perspective to examine how price fairness regulation impacts various stakeholders in the market and society overall,” the paper stated. “Our aim is to offer insights and guidance to policymakers, consumers and industries with regard to the potential economic consequences of such interventions.”

Research questions and model

Noting that conventional wisdom connects price fairness regulation with limitations on firms’ decision-making flexibility, potentially reducing their business profitability, the researchers first explored whether price fairness regulation can yield benefits for businesses in the form of higher profits.

They then sought to interrogate the idea that the purpose of fairness regulation is to protect consumers from exploitation by examining whether and under what conditions these regulations might have detrimental effects. To do so, they developed a theoretical model to study the impacts of price fairness regulation and its entanglement with competition.

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The model looked at duopoly competition in two symmetric markets, where consumers exhibit loyalty to different firms in each market.

“Each firm faces the temptation to exploit its loyal customer base by charging higher prices while simultaneously attempting to entice non-loyal customers from competitors by offering lower prices,” the paper explained. “The regulator intervention in our model requires firms to adopt fair pricing practices, specifically by limiting the price differential between the two markets to a certain threshold.”

Win-win – or monopoly

Addressing the first research question, Dr Fu said the findings “surprisingly” suggest fears about business risk from price fairness regulation are likely exaggerated.

“In fact, when competition between firms is intense, fairness regulation on prices (e.g. limiting penalties on loyal customers) can alleviate cut-throat competition between firms, possibly resulting in higher profits for firms,” he explained. “This is counterintuitive because conventional wisdom suggests that regulation usually results in lower industry profits.

“In addition, price fairness regulation on prices can save consumers from constant switching between brands/firms, resulting in higher consumer surplus,” he added. “To sum up: if competition is intense, a win-win outcome, where both firms and consumers are better off, is possible under fairness regulation on prices.”

However, there is a flipside to this positive finding when competition in the market is subdued. “When competition between firms is weak, fairness regulation on prices can further enhance firms’ existing monopoly power” by laying the groundwork for collusive high prices, Dr Fu said.

“This unexpected finding raises concerns that policies aimed at protecting consumers, such as the banning of loyalty penalties as implemented by the FCA in the UK’s home and motor insurance industry, may actually backfire and harm consumers and society.”

Getting the settings right

To counter unintended negative consequences like high-price collusion, the researchers concluded that additional policies are needed to complement fairness regulation. “To this end, we propose a two-pronged regulator approach that combines price fairness regulation with price cap regulation,” the paper said.

Addressing these issues is also vital to the increasingly important concept of corporate social responsibility as corporations shift their purpose from simply maximising shareholder profits to creating value for all stakeholders. “It is crucial for firms to incorporate socially responsible considerations into their everyday operations, such as responsible sourcing, fair pricing, consumer privacy protection and pollution abatement,” the paper said.

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According to Dr Fu, the study has two main practical implications for policymakers. “First, the impact of price fairness regulation can vary significantly depending on the level of competition in the market,” he said. “As such, conducting comprehensive market investigations to assess the competitive landscape in the regulated sector/industry is crucial prior to the implementation of fairness-related policies.

“Second, our study also reveals the unintended economic consequences of price fairness regulations such as limiting loyalty penalties,” he added. “Firms can benefit financially by following these fairness regulations and pricing fairly, but well-intentioned fairness regulations may have adverse effects on consumers.”