By Grace Dobush

Let’s say you’re a company trying to spark word of mouth about your service and reach new customers. One option is to use that magic word “free”: offer a version of the service that costs nothing, hoping that word of the bargain will spread and reach new customers, who will fall in love with the service and upgrade to a paid version. Another is to turn to your existing customers, giving them a discount or better service in exchange for spreading the word to their friends—what’s called referral bonuses. Which of these is a better incentive to get customers to talk about your product? 

The answer might be both, according to a new study by Aniko Öry, assistant professor of marketing at Yale SOM, and Yuichiro Kamada, associate professor of marketing at the Haas School of Business at the University of California Berkeley. They find that a combination of free accounts and financial incentives can be effective in encouraging users to talk about a product. The optimal incentive scheme depends on whether the product caters to a niche or mass audience, and whether the product has a social aspect or is private, used by each customer in isolation. 

“Word of mouth is a strategic decision,” Öry says. “We’re each deciding what we talk about and weighing the tradeoffs. The implications of these incentives of talking hadn’t been looked at in a more macro sense.”


Read the study: “Contracting with Word-of-Mouth Management”

Companies often employ one or more forms of referral incentives, so Öry and Kamada wanted to determine if there was a formula for optimizing success. They assembled a model weighing multiple factors. 

One is the cost of a word-of-mouth strategy—for the customer. Customers may have psychological barriers to talking about a product. They also have opportunity costs—there is something else they could be doing with their time and with their relationship capital. So the benefit they would get—the referral bonuses, for example—has to outweigh the cost of talking. 

Then there’s a cost for the company. For example, financial referral bonuses, in the form of cash or savings, are very good at inspiring people to talk, but they can end up being unprofitable for companies if the product has mass appeal. 

Let’s say you’ve got a new service that serves a very specific group of people, people who are willing to pay for the service and tell their friends about it. Using a financial incentive helps spread the word to the high-value customers you’re looking for. If your new service is a product with positive network externalities—that is, one where users benefit from interacting with others—the freemium strategy of offering a free contract with optional paid upgrades helps increase referrals because people are driven to connect with friends, and the cost of taking a chance on a free product is very low. 

If the goal of a word-of-mouth incentive program is to raise awareness, advertising may be detrimental to the campaign. “If I think you’ve already seen an advertisement, there’s no point in me telling you about a product.”

For a specific cohort of companies with a product that has large potential network externalities, but few premium customers who are willing to pay a high price, and where the cost of production is low, a strategy that combines free contracts and referral rewards works best.

One example is the cloud storage service Dropbox. Before the company introduced its referral program and gave the service a social aspect by offering file sharing, it spent more than $200 per customer acquisition for a product that cost $99 per year. But when Dropbox introduced referrals and sharing (it also increased the visibility of the free tier), there were 2.8 million direct referral invites created in 30 days. Today, just a very small fraction of users pay for the service—but they are high-value customers. “For professionals and small businesses, people value it a lot,” Öry says. 

For Uber, another company that employs word-of-mouth marketing, the product is private—there’s no direct social aspect of taking an Uber— and it has a mass market: many people are willing to pay for the service. Öry and Kamada’s model shows that the optimal marketing scheme is not to use a free contract but to offer referral rewards, which is exactly Uber’s strategy. 

The researchers also found that if the goal of a word-of-mouth incentive program is to raise awareness, advertising may be detrimental to the campaign. “If I think you’ve already seen an advertisement, there’s no point in me telling you about a product,” she says. “I’m more likely to talk about it if I think you’re not aware of it.” 

Öry and Kamada identify a few areas where further research could be done in the area of word-of-mouth marketing. How do the benefits of referral reward a person’s initial impression of a product? How does quality of the product affect the efficacy of referral programs?

Another new piece of research, conducted with Joyee Deb, associate professor of economics at Yale SOM, and Ishita Chakraborty, a PhD student in marketing at Yale SOM, on the effectiveness of word-of-mouth strategies investigates how likely consumers are to post a review of a restaurant online based on whether they had a positive or negative experience. 

“You see a skew towards positive reviews, but looking a little deeper, we want to explain how consumers decide to talk about certain experiences,” Öry says. Independent restaurants are more likely to get four- or five-star reviews, while chain restaurants are much more likely to receive one-star reviews. One reason may be the customer’s beliefs about their friends’ expectations for the quality of the restaurant. 

Öry says, “If I go to a restaurant and have a positive experience, I share it if I think my positive experience will make you go”—which might be true if it’s an independent restaurant that doesn’t have the brand awareness of chains. “With a negative experience, I would tell you only if I think I can convince you not to go.”