Optimum advertising policy over time for subscriber service innovations in the presence of service cost learning and customers’ disadoption

Abstract

On the theoretical side, this paper characterizes qualitatively optimal advertising policy for new subscriber services. A monopolistic market is analyzed first for which customers’ disadoption, discounting of future profits streams and a service cost learning curve are allowed. After characterizing the optimal policy for a general diffusion model, the results pertaining to a specific diffusion model for which advertising affects the coefficient of innovation that incorporates the disadoption rate are reported. The results of the theoretical research show that the advertising policy of the service firm in the presence of customers’ disadoption could be very different from the same when disadoption is ignored.

On the empirical side, four alternative diffusion models are estimated and their predictive powers using a one-step-ahead forecasting procedure compared. The diffusion data analyzed are related to the Canadian cable TV industry. Empirical research findings suggest that the specific diffusion model considered above is not only of theoretical appeal but also of major empirical relevance.

The analytical findings of the study are documented in six theoretical propositions for which proofs are provided in a separate Appendix. The results of a related numerical experiment together with the analytical findings pertaining to the competitive role of advertising are included. Managerial implications of the study together with directions for future research are also discussed.

Introduction

In the early 1900’s, less than one third of the labor force in the United States was employed by the services sector. By 1950, the service industry employed almost half of the workforce. With the introduction of new services over the past three decades, including cable TV, cell phones, Internet, online banking, satellite radio, health clubs, etc., the services sector in the US now employs most of the workforce. Approximately, 80% of the US gross domestic product comes from the services sector which continues to grow considerably faster than the goods sector (US Department of Commerce, Bureau of Economic Analysis, 2003, Zeithaml and Bitner, 2003).

Despite the growing role of the services sector and the declining role of the manufacturing sector in Western societies (Metters and Marucheck, 2007), published research on the diffusion of new subscriber consumer services innovations remains scant relative to the literature on new consumer durable (product) innovations (see Mahajan et al., 2000, Meade and Islam, 2006 for further details). The importance of studying subscriber consumer services becomes self-evident in light of the fact that, at present, almost every US household is involved in one way or another, in these services. The current study is applicable to services innovations that consumers adopt and purchase via a periodic subscription fee.

The modeling of diffusion of services provides unique challenges as stated by Libai et al. (2009a, p.163):

“A considerable influence on the market growth of a new service is customer attrition. Beginning with the initial stages of penetration into a market, there are customers who leave the service: they switch to competitors or, alternatively, leave the category. In this sense, the growth of a new service is similar to a leaking bucket – there is an inward flow of adopters and a concurrent outward flow of customers who leave.”

Several researchers model the diffusion of services such as online banking, cell phone, and landline phone service, in the same manner as the diffusion of durable goods (Hogan et al., 2003, Krishnan et al., 2000, Jain et al., 1991). The extant research focuses on consumer churn occurring when a competitor acquires an exiting customer. However, customers can also disadopt and leave the service category altogether (Hogan et al., 2003) as illustrated in previous research (Reichheld and Schefter, 2000, Meuter et al., 2005). Thus, attrition consists of both churning and disadopting customers and the attrition rate is the sum of the churn plus disadoption rate (Libai et al., 2009a).

The inherent differences between goods and services provide a motivation for this study. Basic differences between services and goods are attributed to the assertion that services are usually highly intangible (cannot be seen, handled, smelled, etc.), heterogeneous (customized making its mass production difficult), perishable and are produced and consumed simultaneously (lack of transportability) (Zeithaml and Bitner, 2003). The differences between goods and services led Rust and Chung (2006, p.575) in their review article on service and relationships to advocate the use of optimal control theory as a viable tool to optimally manage the dynamic relationship with customers.

While optimal control theory has been applied within the context of diffusion of service innovations in a monopoly by a few researchers (e.g. Fruchter and Rao, 2001, Mesak and Darrat, 2002), none of them considered the effect of disadoption (termination of service subscription) on the optimal advertising policy of the firm. Recent studies show that customer attrition, for which disadoption is a significant component, can have a considerable effect on growing markets (Hogan et al., 2003, Gupta et al., 2004, Libai et al., 2009a). The study reported here contributes in part by investigating the impact of customers’ disadoption on the optimal advertising policy of new subscriber services.

This paper demonstrates that the advertising policy of the firm changes with consideration of customers’ disadoption and is very different from the policy when one ignores disadoption. The modeling effort employed in this study considers the learning cost curve and the discount rate. More specifically, the model incorporates the key marketing variable of advertising into the diffusion model of services articulated by Libai et al. (2009a) and thus it explicitly considers the consumer disadoption rate. The related measure of performance that takes into account the cost learning curve is optimized afterwards using optimal control theory. Subscriber services for which advertising is a main source of revenue instead of being an instrument for generating subscriptions such as newspapers, magazines and contemporary electronic media (Internet websites) are beyond the scope of the present study. Kumar and Sethi (2009) provide a recent review of this particular literature.

The rest of the paper is organized as follows. The Section 2 provides a related background. The Section 3 outlines a general dynamic diffusion model for new subscriber service innovations, formulates the problem and presents the solution method. The Section 4 characterizes the optimal advertising policy. The last section summarizes and concludes the paper. To improve exposition, derivation of key formulas and proofs of all propositions are relegated to a separate Appendix. To adhere to space limitations, an empirical analysis aiming at estimating and choosing among alternative proposed diffusion models, the results of a numerical experiment and the findings of an analytical analysis pertaining to the competitive role of advertising together with other issues are made available on-line.