Review of

Marketing
Research
Naresh K. Malhotra
Editor
Review of
Marketing
Research
VoluME 6
M.E.Sharpe

Armonk, New York
London, England
Copyright © 2010 by M.E. Sharpe, Inc.
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v
REVIEW OF MARKETING RESEARCH
Editor: NarEsh K. Malhotra,
GEorGia iNstitutE of tEchNoloGy
Editorial Board
Rick P. Bagozzi, University of Michigan
Russ Belk, University of Utah
Ruth Bolton, Arizona State University
George Day, University of Pennsylvania
Morris B. Holbrook, Columbia University
Michael Houston, University of Minnesota
Shelby Hunt, Texas Tech University
Dawn Iacobucci, Vanderbilt University
Arun K. Jain, University at Buffalo, State University of New York
Barbara Kahn, University of Miami
Wagner Kamakura, Duke University
Donald Lehmann, Columbia University
Robert F. Lusch, University of Arizona
Debbie MacInnis, University of Southern California
Nelson Ndubisi, Monash University, Malaysia
A. Parasuraman, University of Miami
William Perreault, University of North Carolina
Robert A. Peterson, University of Texas
Nigel Piercy, University of Warwick
Jagmohan S. Raju, University of Pennsylvania
Brian Ratchford, University of Texas, Dallas
Jagdish N. Sheth, Emory University
Itamar Simonson, Stanford University
David Stewart, University of California, Riverside
Rajan Varadarajan, Texas A&M University
Michel Wedel, University of Maryland
Barton Weitz, University of Florida
vi
AD HOC REVIEWERS
Sunil Gupta, Harvard University
Dominique Hanssens, University of California, Los Angeles
Scott Neslin, Dartmouth College
Shuba Srinivasan, Boston University
Russ Winer, New York University
Lisa Bolton, Pennsylvania State University
Meg Meloy, Pennsylvania State University
Bill Ross, Pennsylvania State University
vii
CONTENTS
Review of Marketing Research: Analyzing Accumulated Knowledge and
Infuencing Future Research
Naresh K. Malhotra ix
Contents, Volume 1 xix
Contents, Volume 2 xx
Contents, Volume 3 xxi
Contents, Volume 4 xxii
Contents, Volume 5 xxiii
1. A Review of Prior Classifcations of Purchase Behavior and a
Proposal for a New Typology
Hans Baumgartner 3
2. Measuring Customer Lifetime Value: Models and Analysis
Siddharth S. Singh and Dipak C. Jain 37
3. Learning Models
S. Sriram and Pradeep K. Chintagunta 63
4. Customer Co-Creation: A Typology and Research Agenda
Matthew S. O’Hern and Aric Rindfeisch 84
5. Challenges in Measuring Return on Marketing Investment:
Combining Research and Practice Perspectives
Koen Pauwels and Dave Reibstein 107
6. Service-Dominant Logic: A Review and Assessment
Stephen L. Vargo, Robert F. Lusch, Melissa Archpru Akaka, and Yi He 125
7. Marketing in a World with Costs of Price Adjustment
Shantanu Dutta, Mark E. Bergen, and Sourav Ray 168
About the Editor and Contributors 189
ix
REVIEW OF MARKETING RESEARCH
Analyzing Accumulated Knowledge and
Infuencing Future Research
NarEsh K. Malhotra
Overview
Review of Marketing Research, now in its sixth volume, is a fairly recent publication covering the
important areas of marketing research with a more comprehensive state-of-the-art orientation. The
chapters in this publication review the literature in a particular area, offer a critical commentary,
develop an innovative framework, and discuss future developments, as well as present specifc
empirical studies. The six volumes feature some of the top researchers and scholars in our discipline,
who have reviewed an array of important topics. The response to the frst fve volumes has been
truly gratifying, and we look forward to the impact of the sixth volume with great anticipation.
Publication Mission
The purpose of this series is to provide current, comprehensive, state-of-the-art articles in review of
marketing research. Wide-ranging paradigmatic, theoretical, or substantive agendas are appropriate
for this publication. This includes a wide range of theoretical perspectives, paradigms, data (quali-
tative, survey, experimental, ethnographic, secondary, and so forth), and topics related to the study
and explanation of marketing-related phenomena. We refect an eclectic mixture of theory, data, and
research methods that is indicative of a publication driven by important theoretical and substantive
problems. We seek studies that make important theoretical, substantive, empirical, methodological,
measurement, and modeling contributions. Any topic that fts under the broad area of “marketing
research” is relevant. In short, our mission is to publish the best reviews in the discipline.
Thus, this publication bridges the gap left by current marketing research publications such as
the Journal of Marketing Research (USA), International Journal of Marketing Research (UK),
and International Journal of Research in Marketing (Europe) that publish academic articles with
a major constraint on the length. In contrast, Review of Marketing Research will publish much
longer articles that are not only theoretically rigorous but also more expository, with a focus on
implementing new marketing research concepts and procedures. This will also serve to distinguish
this publication from Marketing Research magazine, published by the American Marketing As-
sociation (AMA).
x REVIEW OF MARKETING RESEARCH
Articles in Review of Marketing Research should:
• Criticallyreviewtheexistingliterature
• Summarizewhatweknowaboutthesubject—keyfndings
• Presentthemaintheoriesandframeworks
• Reviewandgiveanexpositionofkeymethodologies
• Identifythegapsinliterature
• Presentempiricalstudies(forempiricalpapersonly)
• Discussemergingtrendsandissues
• Focusoninternationaldevelopments
• Suggestdirectionsforfuturetheorydevelopmentandtesting
• Recommendguidelinesforimplementingnewproceduresandconcepts
Articles in the First Volume
The inaugural volume exemplifed the broad scope of the Review of Marketing Research. It
contained a diverse set of review articles covering areas such as emotions, beauty, information
search, business and marketing strategy, organizational performance, reference scales, and cor-
respondence analysis. These articles were contributed by some of the leading scholars in the
feld, fve of them being former editors of major journals (Journal of Marketing and Journal of
Consumer Research).
Johnson and Stewart provided a review of traditional approaches to the analysis of emotion
in the context of consumer behavior. They reviewed appraisal theory and discussed examples
of its application in the contexts of advertising, customer satisfaction, product design, and retail
shopping. Holbrook explored and reviewed the concept of beauty as experienced by ordinary con-
sumers in their everyday lives. His typology conceptualized everyday usage of the term “beauty”
as falling into eight categories distinguished on the basis of three dichotomies: (i) extrinsically/
intrinsically motivated; (ii) thing(s)-/person(s)-based; and (iii) concrete/abstract. Xia and Monroe
frst reviewed the literature on consumer information search and then the literature on browsing.
They proposed an extended consumer information acquisition framework and outlined relevant
substantive and methodological issues for future research. Hunt and Morgan reviewed the progress
and prospects of the “resource-advantage” (R-A) theory. They examined in detail the theory’s
foundational premises, showed how R-A theory provides a theoretical foundation for business
and marketing strategy, and discussed the theory’s future prospects. Bharadwaj and Varadarajan
provided an interdisciplinary review and perspective on the determinants of organizational per-
formance. They examined the classical industrial organization school, the effciency/revisionist
school, the strategic groups school, the business policy school, the PIMS paradigm, the Austrian
school, and the resource-based view of the frm. They proposed an integrative model of business
performance that modeled frm-specifc intangibles, industry structure, and competitive strategy
variables as the major determinants of business performance. Vargo and Lusch focused attention
on consumer reference scales, the psychological scales used to make evaluations of marketing-
related stimuli, in consumer satisfaction/dissatisfaction (CS/D) and service quality (SQ) research
and proposed social judgment-involvement (SJI) theory as a potential theoretical framework to
augment, replace, and/or elaborate the disconfrmation model and latitude models associated with
CS/D and SQ research. Finally, Malhotra, Charles, and Uslay reviewed the literature focusing on
the methodological perspectives, issues, and applications related to correspondence analysis. They
concluded with a list of the creative applications and the technique’s limitations.
REVIEW OF MARKETING RESEARCH xi
Articles in the Second Volume
The second volume continued the emphasis of the frst by featuring a broad range of topics con-
tributed by some of the top scholars in the discipline. The diverse articles in the second volume
can all be grouped under the broad umbrella of consumer action. Bagozzi developed a detailed
framework for consumer action in terms of automaticity, purposiveness, and self-regulation. Mac-
Innis, Patrick, and Park provided a review of affective forecasting and misforecasting. Ratchford,
Lee, and Talukdar reviewed the literature related to use of the Internet as a vehicle for information
search. They developed and empirically tested a general model of the choice of information sources,
with encouraging results. Miller, Malhotra, and King reviewed the categorization literature and
developed a categorization-based model of the product evaluation formation process, which assists
in the prediction of set membership (that is, evoked, inert, or inept). Lam and Parasuraman proposed
an integrated framework that incorporated a more comprehensive set of various individual-level
determinants of technology adoption and usage. Recently, marketing has come under increased
pressure to justify its budgets and activities. Lehmann developed a metrics value chain to capture
the various levels of measurement employed in this respect. Finally, Oakley, Iacobucci, and Du-
hachek provided an exposition of hierarchical linear modeling (HLM).
Articles in the Third Volume
Bolton and Tarasi described how companies can effectively cultivate customer relationships and
develop customer portfolios that increase shareholder value. They reviewed the extensive litera-
ture on customer relationship management (CRM), customer asset management, and customer
portfolio management, and summarized key fndings. They examined fve organizational processes
necessary for effective CRM: making strategic choices that foster organizational learning; creating
value for customers and the frm; managing sources of value; investing resources across functions,
organizational units, and channels; and globally optimizing product and customer portfolios.
Chandrasekaran and Tellis critically reviewed research on the diffusion of new products,
primarily in the marketing literature and also in economics and geography. While other reviews
on this topic are available, theirs differs from prior ones in two important aspects. First, the prior
reviews focus on the S-curve of cumulative sales of a new product, mostly covering growth. Chan-
drasekaran and Tellis dealt with phenomena other than the S-curve, such as takeoff and slowdown.
Second, while the previous reviews focus mainly on the Bass model, Chandrasekaran and Tellis
also considered other models of diffusion and drivers of new product diffusion.
Eckhardt and Houston reviewed, compared, and contrasted cultural and cross-cultural psy-
chological methods. They presented the underlying conceptions of culture that underpin both
streams and discussed various methods associated with each approach. They identifed the con-
sumer research questions best answered using each perspective and discussed how each approach
informs the other. Finally, they examined how consumer research can beneft from understanding
the differences in the two approaches. While cultural and cross-cultural perspectives adopt distinct
views about culture and psychological processes, it is possible to view them as complementary
rather than incompatible. Several suggestions by Malhotra and his colleagues can be useful in
this respect (Malhotra 2001; Malhotra, Agarwal, and Peterson 1996; Malhotra and Charles 2002;
Malhotra and McCort 2001; Malhotra et al. 2005). For example, one can start with an etic approach
and then make emic modifcations to adapt to the local cultures. Alternatively, one can start with
an emic perspective and then make etic adaptations to get an understanding across cultures. This
systematic theory building and testing process is illustrated by Kim and Malhotra (2005).
xii REVIEW OF MARKETING RESEARCH
Grewal and Compeau synthesized research from consumer behavior, psychology, and applied
economics to address how price as an information cue affects consumers’ responses in the context
of other information cues. They developed a conceptual framework, using adaptation-level theory
and transaction utility theory, that synthesized prior research on price, reference price, and other
information cues and their effects on consumers’ price expectations, evaluations, and behavioral
intentions. Their conceptual model contributes to our understanding of the way imperfect infor-
mation affects consumers’ decision processes, goes well beyond the original price–perceived
quality paradigm, and integrates knowledge from consumer research, psychology, and applied
economics.
Sayman and Raju provided a review of research on store brands. Their review focused on
integrating research in key areas and identifying directions for future research. There is limited
theoretical and empirical research regarding optimal counterstrategies of national brands against
store brands; studies tend to focus on one aspect, and national brand quality is typically assumed
to be exogenous. Researchers have, by and large, focused on me-too-type store brands. Future
research should consider premium store brand products as well.
Merunka and Peterson examined an intrapersonal aspect of language, namely, whether the
structure of a language, per se, infuences the thoughts of those who speak it. They reviewed
empirical research conducted over the past half-century on the effects of language structure on
a variety of mental activities. They found support for the weak form of the linguistic relativity
hypothesis, the notion that the structure of a language does indeed infuence (but not determine)
cognition. The estimation of independent and joint effects of language is diffcult at best. We
need comprehensive studies that incorporate the order in which bilinguals acquire their respec-
tive languages, how they acquire their languages, and when they acquire their languages. Future
research should also compare the possible infuence of a single language on mental processing
across different cultures.
Belk discussed the implications of getting visual for research, teaching, and communicating. He
identifed basic opportunities, threats, and consequences of becoming visual. Several techniques
for collecting visual data were discussed in the realm of interviewing as well as observation. We
might well be entering a Golden Age of visual and multimedia marketing research, and Belk helps
us to get a good handle on it.
Articles in the Fourth Volume
Consistent with the frst three volumes, the fourth volume also featured a broad array of topics
with contributions from some of the top scholars in the feld. These articles fall under the broad
umbrella of the consumer and the frm.
Louviere and Meyer considered the literature on behavioral, economic, and statistical approaches
to modeling consumer choice behavior. They focused on descriptive models of choice in evolving
markets, where consumers are likely to have poorly developed preferences and be infuenced by
beliefs about future market changes. They called for a better alliance among behavioral, economic,
and statistical approaches to modeling consumer choice behavior. Economic and statistical model-
ers can constructively learn from behavioral researchers and vice versa.
Folkes and Matta identifed factors that infuence how much an individual consumes on a single
usage occasion by drawing on research in consumer behavior as well as allied disciplines. They
developed an integrated framework to understand how, and at what stage, various factors affect
usage quantity based on Gollwitzer’s (1996) “action goals” model. Initially, factors such as a prod-
uct’s price and social norms infuence consumption-related goals and their perceived desirability
REVIEW OF MARKETING RESEARCH xiii
and feasibility. In the next phase, factors such as self-control strategies and product instructions
infuence the implementation of the goal. Finally, the consumer’s motivation to use feedback, and
the type of feedback about consumption, has an infuence on subsequent goal setting.
Kumar and Luo also examined consumption, but from a modeling perspective. In order to
allocate scarce marketing resources effciently and effectively, it is important for a frm to know
what to sell, when to sell, and to whom. Kumar and Luo reviewed how the purchase timing, brand
choice, and purchase quantity decisions have been modeled historically, as well as the issues
within each decision that have been addressed. A vast majority of these studies use scanner data
or transaction data. Since recent research has shown that common method variance may not be
a serious problem (Malhotra, Kim, and Patil 2006), surveys can also be a useful source of such
data and should be increasingly employed.
Despite the interest in global branding, studies involving brand extension strategies in foreign
markets remain very limited. The fact that so few studies exist limits our understanding of effec-
tive brand extension strategy in a cross-cultural context. Merz, Alden, Hoyer, and Desai proposed
a new conceptual framework and several propositions regarding effective global brand extension
strategy in a cross-cultural context. In doing so, they frst reviewed more commonly examined
antecedent variables of (national) brand extension evaluation. Then they proposed a defnition of
culture and subsequently reviewed the existing cross-cultural brand extension research.
Given the growing importance of visual marketing in practice, Wedel and Pieters reviewed
eye-tracking research in marketing and evaluated its effectiveness. Specifcally, they reviewed eye-
tracking applications in advertising (print, TV, and banner), health and nutrition warnings, branding,
and choice and shelf search behaviors. Finally, they discussed fndings, identifed current gaps in
our knowledge, and provided an outlook on future research.
Singh and Saatcioglu reviewed different approaches for examining role theory implications for
boundary spanners such as salespeople, frontline, and customer contact employees. They focused
on universalistic and contingency approaches and developed the confgural approach by extending
confgurational theory principles to role theory. They compared and contrasted different approaches
and reviewed literature that has remained less accessible to marketing researchers.
John considered price contract design templates governing procurement and marketing of
industrial equipment. He argued that price formats choices precede the selection of a price level.
These price formats are an integral aspect of the institutional arrangement devised to govern an
exchange. John reviewed institutions, that is, rules of interaction that govern the behavior of actors
in dealing with other actors, with a focus on their pricing elements.
Articles in the Fifth Volume
The existence of two discrete, parallel, interactive cognitive systems underlying human judgment
and reasoning has been postulated in several psychological and behavioral disciplines (Agarwal and
Malhotra 2005; Malhotra 2005). One system is relatively unconscious, based on associations, and
tends to be rapid. The other system is consciously guided, based on symbolic manipulation, and
tends to be slower. The two systems generally operate in parallel, contributing interdependently to
decision outcomes. Bond, Bettman, and Luce reviewed recent developments in consumer behavior
in terms of this dual-systems paradigm. They frst examined a variety of frameworks that have
been proposed, focusing on both their commonalities and their application domains. Then, they
applied these frameworks to review selected topics from the recent marketing literature, including
persuasion, metacognition, and immersive experiences.
The “chasm” is a well-accepted paradigm among new-product marketing practitioners that has
xiv REVIEW OF MARKETING RESEARCH
taken root in the last decade. According to this paradigm, the market for new products is composed
of “early” and “mainstream” markets with a “chasm” in between them. A fundamental premise
of such an approach is that there is a communication break, at least to some degree, between the
consumers in the early adopters and the mainstream market segment. Libai, Mahajan, and Muller
examined empirical support for the existence of a communication break in the diffusion of innova-
tions using aggregate product growth data, typically used in the diffusion of innovation research.
They reviewed three alternative models due to Bass, Rogers, and Moore. Their results provide
some support for the dual-market phenomenon and show the existence of a partial communica-
tion break. As the authors pointed out, aggregate adoption data are not suffcient for answering
these questions. More in-depth and disaggregate investigation across various time points should
be conducted (Kim and Malhotra 2005).
Rajagopalan and Bayus explored two of Eric Raymond’s key open-source product develop-
ment principles embodied in the bazaar community development model involving developers and
users. They empirically examined the relationships between project community size (“eyeballs”)
and development activity, and between development activity and product adoption. Their analysis
supports the premise that “developer eyeballs” are positively related to development activity and
that product development activity is signifcantly related to the speed of product adoption. Thus,
they fnd support for some key principles of the open-source bazaar. However, some of their results
are contrary to the bazaar model. Therefore, Raymond’s bazaar community development model
involving developers and users should be revised to accommodate the more typical open-source
development project. Future research should explore the applicability of different new-product
diffusion models to open-source innovations.
The Segmentation-Targeting-Positioning (STP) process is fundamental to the formulation of
marketing strategy (Malhotra, Charles, and Uslay 2005). DeSarbo, Blanchard, and Atalay briefy
reviewed the STP framework and optimal product positioning literature. Then these authors
presented a new constrained clusterwise multidimensional unfolding procedure for perform-
ing STP, in which the brand coordinates are a linear function of product characteristics. Their
method simultaneously identifes consumer segments, derives a joint space of brand coordinates
and segment-level ideal points, and creates a link between specifed product attributes and brand
locations in the derived joint space. Generalizing the proposed methodology to the analysis of
nonmetric and three-way data would extend the range of applications for this approach.
Conjoint analysis is one of the most versatile methods in marketing research. Although this
method has been popular in practice, one serious constraint has been dealing with the large numbers
of attributes that are normally encountered in many conjoint analysis studies. Rao, Kartono, and
Su reviewed thirteen methods for handling a large number of attributes that have been applied in
various contexts. They discussed the advantages and disadvantages of these methods. Based on
their analysis, three methods (self-explicated, partial profles, and upgrading) seem to stand out
and merit consideration by researchers in this area. Yet, no single study has systematically evalu-
ated these potential alternative methods in the context of a specifc applied problem. It would be
worthwhile to conduct large-scale empirical and simulation studies to compare the methods.
Laddering is a qualitative research technique that has great potential to uncover the factors
underlying consumer decision making. However, this potential has not been realized because the
time and costs of this qualitative technique as well as the lack of standard statistical measures to
assess data and solution quality have been obstacles. Reynolds and Phillips assessed the laddering
research practices of both professional and academic researchers. They proposed a set of quality
metrics and demonstrated the use of these measures to empirically compare the traditional face-
to-face interviewing method to an online one-on-one interviewing approach.
REVIEW OF MARKETING RESEARCH xv
The Internet provides marketers with an expanded set of communications vehicles for reaching
customers (Kim and Malhotra 2005; Malhotra, Kim, and Agarwal 2004). Two of the important
and fast-growing elements of this new communications mix are online advertising and electronic
word-of-mouth. Bucklin, Rutz, and Trusov reviewed recent research developments in marketing that
are most relevant to assessing the impact of these communications vehicles. They frst discussed
the two major forms of Internet advertising: display ads (also known as banners) and paid search.
Online communities, social networking sites, online referral programs, product reviews, and blogs
all allow word of mouth (WOM) to spread faster and farther than in the past. Research has shown
how electronic records of online word of mouth (for example, product reviews) can be connected,
via models, to performance outcome variables such as product ratings and sales levels.
Articles in This Volume
In keeping with the earlier fve volumes, this one also refects an eclectic mixture of theory, measure-
ment, data, and research methods, reinforcing the mission of Review of Marketing Research.
The purchase of products is at the heart of much of consumer and marketing research. Baumgartner
provides a review of prior classifcations of purchase behavior, discussing their strengths and weak-
nesses. He proposes a new, empirically derived typology based on purchase motives. A classifcation
of forty-four different purchase behaviors refecting various purchase motives yielded a typology of
eight distinct types of purchase behavior based on three underlying dimensions. These dimensions
are functional vs. psycho-social purchases, low vs. high purchase involvement, and spontaneous vs.
deliberate purchases. The typology was replicated using a task in which respondents rated how well
the forty-four different purchase behaviors described the purchase of forty different products, and
the interpretation of the three underlying dimensions was also validated. Baumgartner’s typology
better captures the important dimensions underlying different forms of buying behavior. His review
provides rich insights and contributes to a greater understanding of people’s purchase behavior.
Singh and Jain focus on the literature related to the measurement of customer lifetime value
(CLV). They highlight the issues related to the context of CLV measurement and propose a
contextual framework for understanding and categorizing models of CLV. They also review the
major models for measuring CLV in different contexts and discuss their comparative strengths and
weaknesses. Finally, they identify the key issues that impact CLV but have not been adequately
considered in its modeling. These factors include network effects (such as word-of-mouth effects),
cost of customer acquisition, cost of managing customer relationships, cross-selling, competition,
forecasting and planning, and endogeneity of CLV drivers.
Sriram and Chintagunta discuss learning models in the context of consumer choice. Typically,
choice models assume that agents know the utility they would derive from various alternatives with
certainty. Such an assumption is likely to be violated, and consumers may experience uncertainty
when the agent is new to the context or the choice set has new alternatives. Consumers resolve
uncertainty regarding products or their characteristics in such contexts by making use of learning
models. Sriram and Chintagunta provide a critical review of the learning literature in marketing and
economics, with a focus on models in which consumers update their beliefs in a Bayesian fashion,
with the extent of updating being related to their perceived precision of the signals that aid in such
learning. They discuss several possible extensions of the learning literature with an emphasis on
biased signals, changing value of the unknown entity, and integration of Bayesian and alternative
learning mechanisms. They also identify some directions for future research in this area.
O’Hern and Rindfeisch discuss customer co-creation in the context of new product develop-
ment. Traditionally, new product development (NPD) has been viewed largely as an internal frm-
xvi REVIEW OF MARKETING RESEARCH
based activity, with the customers being relatively passive buyers and users. They challenge this
traditional paradigm and discuss a new perspective in which customers are active co-creators of
the products they buy and use and, in some cases, are capable of creating new products with little
help from frms. They identify the origins of this paradigm shift and present a conceptual typology
of four different types of co-creation activity. Customer co-creation involves two key processes:
contribution by way of submitting content and selection by choosing which of these submissions
will be retained. Using these two processes as a foundation, the authors offer a conceptual typol-
ogy of four different forms of customer co-creation. Based on this emerging paradigm, they offer
an agenda for future research. Their agenda focuses on the impact of customer co-creation on six
distinct domains of inquiry: (1) organizational culture, (2) organizational learning, (3) organizational
dynamics, (4) resources and capabilities, (5) customer valuation, and (6) brand communities.
The Return on Marketing Investment (ROMI) metric holds promise in increasing the account-
ability for marketing spending. However, many organizations experience several roadblocks to
measuring ROMI and using it to make better marketing decisions and achieve higher performance.
Pauwels and Reibstein discuss the challenges in measuring return on marketing investment. They
defne ROMI as the incremental margin generated by a marketing program divided by the cost of
that program at a given risk level. They discuss ten such roadblocks, give examples, and critically
examine how research has addressed and should further address these issues.
The service-dominant (S-D) logic shifts the focus of marketing away from the production and
distribution of goods (goods-dominant logic) toward service, the application of operant resources
(knowledge and skills), as the basis of exchange. The central tenet of S-D logic is that reciprocal
service is the fundamental basis of economic exchange, that is, service is exchanged for service.
Vargo, Lusch, Akaka, and He give a review and assessment of the S-D logic. They present an S-D
logic perspective of the market and marketing and summarize its current state of development. They
clarify major theoretical misconceptions and review the extension of S-D logic and its integration
with existing knowledge. They provide an assessment of the role of S-D logic in the evolution of
academic marketing, and identify directions for future research in this area. Initially, S-D logic was
not developed as a testable theory, and there is a great need to further develop testable hypotheses
based on the service-centered mindset. Moreover, these hypotheses should be empirically tested
in a variety of settings so that a wealth of fndings could accumulate.
Dutta, Bergen, and Ray deal with costs of price adjustment in marketing. They review the
literature in marketing and economics to summarize what we know about the nature, magnitude,
and broad impact of these costs. The literature on the nature and scope of these costs has been
evolving from simple menu costs to richer decision-making, organizational, and customer-based
costs. These costs have substantial implications for research in pricing; they infuence the mag-
nitude and frequency of price changes, asymmetric pricing, pass-through in channels, and price
synchronization. The authors also identify some areas of potential interest, where consideration
of price adjustment costs are likely to yield greater insights into marketing decisions for both re-
searchers and practitioners. Their basic conclusion is that there are signifcant domains of pricing
decisions that are under-researched from the perspective of price adjustment costs. An explicit
consideration of these costs should lead to greater understanding of pricing and also to better
pricing decisions.
It is hoped that collectively the chapters in this volume will substantially aid our efforts to un-
derstand, model, and make predictions about both the frm and the consumer and provide fertile
areas for future research. Review of Marketing Research continues its mission of systematically
analyzing and presenting accumulated knowledge in the feld of marketing as well as infuencing
future research by identifying areas that merit the attention of researchers.
REVIEW OF MARKETING RESEARCH xvii
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spectives, Issues and Applications.” Review of Marketing Research 1: 285–316.
Malhotra, Naresh K., Sung Kim, and James Agarwal. 2004. “Internet Users’ Information Privacy Concerns
(IUIPC): The Construct, the Scale, and a Causal Model.” Information Systems Research 15 (4) (Decem-
ber): 336–355.
Malhotra, Naresh K., Sung Kim, and Ashutosh Patil. 2006. “Common Method Variance in IS Research:
A Comparison of Alternative Approaches and a Reanalysis of Past Research.” Management Science
(December): 1865–1883.
Malhotra, Naresh K., and Daniel McCort. 2001. “A Cross-Cultural Comparison of Behavioral Intention
Models: Theoretical Consideration and an Empirical Investigation.” International Marketing Review 18
(3): 235–269.
Malhotra, Naresh K., Francis Ulgado, James Agarwal, G. Shainesh, and Lan Wu. 2005. “Dimensions of
Service Quality in Developed and Developing Economies: Multi-Country Cross-Cultural Comparisons.”
International Marketing Review 22 (3): 256–278.
xix
CONTENTS, VOLUME 1
Review of Marketing Research
Naresh K. Malhotra ix
1. A Reappraisal of the Role of Emotion in Consumer Behavior: Traditional and
Contemporary Approaches
Allison R. Johnson and David W. Stewart 3
2. The Eye of the Beholder: Beauty as a Concept in Everyday Discourse and
the Collective Photographic Essay
Morris B. Holbrook 35
3. Consumer Information Acquisition: A Review and an Extension
Lan Xia and Kent B. Monroe 101
4. The Resource-Advantage Theory of Competition: A Review
Shelby D. Hunt and Robert M. Morgan 153
5. Toward an Integrated Model of Business Performance
Sundar G. Bharadwaj and Rajan Varadarajan 207
6. Consumers’ Evaluative Reference Scales and Social Judgment Theory:
A Review and Exploratory Study
Stephen L. Vargo and Robert F. Lusch 245
7. Correspondence Analysis: Methodological Perspectives, Issues, and Applications
Naresh K. Malhotra, Betsy Rush Charles, and Can Uslay 285
About the Editor and Contributors 317
Index 319
xx
CONTENTS, VOLUME 2
Review of Marketing Research: Some Refections
Naresh K. Malhotra ix
1. Consumer Action: Automaticity, Purposiveness, and Self-Regulation
Richard P. Bagozzi 3
2. Looking Through the Crystal Ball: Affective Forecasting and
Misforecasting in Consumer Behavior
Deborah J. MacInnis, Vanessa M. Patrick, and C. Whan Park 43
3. Consumer Use of the Internet in Search for Automobiles: Literature
Review, a Conceptual Framework, and an Empirical Investigation
Brian T. Ratchford, Myung-Soo Lee, and Debabrata Talukdar 81
4. Categorization: A Review and an Empirical Investigation of the
Evaluation Formation Process
Gina L. Miller, Naresh K. Malhotra, and Tracey M. King 109
5. Individual-Level Determinants of Consumers’ Adoption and Usage of
Technological Innovations: A Propositional Inventory
Shun Yin Lam and A. Parasuraman 151
6. The Metrics Imperative: Making Marketing Matter
Donald R. Lehmann 177
7. Multi-level, Hierarchical Linear Models and Marketing: This Is
Not Your Adviser’s OLS Model
James L. Oakley, Dawn Iacobucci, and Adam Duhachek 203
About the Editor and Contributors 229
Index 231
xxi
CONTENTS, VOLUME 3
Review of Marketing Research: A Look Ahead
Naresh K. Malhotra ix
Contents, Volume 1 xv
Contents, Volume 2 xvii
1. Managing Customer Relationships
Ruth N. Bolton and Crina O. Tarasi 3
2. A Critical Review of Marketing Research on Diffusion of New Products
Deepa Chandrasekaran and Gerard J. Tellis 39
3. On the Distinction Between Cultural and Cross-Cultural Psychological
Approaches and Its Signifcance for Consumer Psychology
Giana M. Eckhardt and Michael J. Houston 81
4. Consumer Responses to Price and Its Contextual Information Cues:
A Synthesis of Past Research, a Conceptual Framework, and Avenues for
Further Research
Dhruv Grewal and Larry D. Compeau 109
5. Store Brands: From Back to the Future
Serdar Sayman and Jagmohan S. Raju 132
6. Language, Thought, and Consumer Research
Dwight R. Merunka and Robert A. Peterson 152
7. You Ought to Be in Pictures: Envisioning Marketing Research
Russell W. Belk 193
About the Editor and Contributors 207
xxii
CONTENTS, VOLUME 4
Review of Marketing Research: Taking Stock
Naresh K. Malhotra ix
Contents, Volume 1 xv
Contents, Volume 2 xvii
Contents, Volume 3 xix
1. Formal Choice Models of Informal Choices: What Choice Modeling
Research Can (and Can’t) Learn from Behavioral Theory
Jordan J. Louviere and Robert J. Meyer 3
2. How Much to Use? An Action-Goal Approach to Understanding Factors
Infuencing Consumption Quantity
Valerie S. Folkes and Shashi Matta 33
3. Integrating Purchase Timing, Choice, and Quantity Decisions Models:
A Review of Model Specifcations, Estimations, and Applications
V. Kumar and Anita Man Luo 63
4. Brand Extension Research: A Cross-Cultural Perspective
Michael A. Merz, Dana L. Alden, Wayne D. Hoyer, and Kalpesh Kaushik Desai 92
5. A Review of Eye-Tracking Research in Marketing
Michel Wedel and Rik Pieters 123
6. Role Theory Approaches for Effectiveness of Marketing-Oriented Boundary
Spanners: Comparative Review, Confgural Extension, and Potential Contributions
Jagdip Singh and Argun Saatcioglu 148
7. Designing Price Contracts for Procurement and Marketing of Industrial Equipment
George John 183
About the Editor and Contributors 201
xxiii
CONTENTS, VOLUME 5
Review of Marketing Research: The First Five Volumes
Naresh K. Malhotra ix
Contents, Volume 1 xvii
Contents, Volume 2 xviii
Contents, Volume 3 xix
Contents, Volume 4 xx
1. Consumer Judgment from a Dual-Systems Perspective: Recent Evidence and
Emerging Issues
Samuel D. Bond, James R. Bettman, and Mary Frances Luce 3
2. Can You See the Chasm? Innovation Diffusion According to Rogers, Bass, and Moore
Barak Libai, Vijay Mahajan, and Eitan Muller 38
3. Exploring the Open Source Product Development Bazaar
Balaji Rajagopalan and Barry L. Bayus 58
4. A New Spatial Classifcation Methodology for Simultaneous Segmentation,
Targeting, and Positioning (STP Analysis) for Marketing Research
Wayne S. DeSarbo, Simon J. Blanchard, and A. Selin Atalay 75
5. Methods for Handling Massive Numbers of Attributes in Conjoint Analysis
Vithala R. Rao, Benjamin Kartono, and Meng Su 104
6. A Review and Comparative Analysis of Laddering Research Methods:
Recommendations for Quality Metrics
Thomas J. Reynolds and Joan M. Phillips 130
7. Metrics for the New Internet Marketing Communications Mix
Randolph E. Bucklin, Oliver J. Rutz, and Michael Trusov 175
About the Editor and Contributors 193
Review of
Marketing
Research
3
chaptEr 1
A REVIEW OF PRIOR CLASSIFICATIONS OF
PURCHASE BEHAVIOR AND A
PROPOSAL FOR A NEW TyPOLOGy
haNs BauMGartNEr
Abstract
The purpose of this chapter is twofold: (1) to critically review prior typologies of purchase behavior,
recognizing their strengths and weaknesses; and (2) to propose a new, empirically derived typology
based on purchase motives that better captures the important dimensions underlying different forms
of buying behavior. Although the purchase of products is only one aspect of consumer behavior,
it is at the heart of much of consumer research, and it is hoped that a comprehensive review of
previous attempts to classify purchase behaviors and the proposed new typology will contribute
to an improved understanding of the whys and wherefores of people’s buying behavior.
Prior Typologies of Purchase Behavior
Many different types of purchase behavior have been distinguished in the consumer behavior and
marketing literatures. In this section we will review the major typologies of consumer buying behavior
that have been proposed. We will not discuss work on individual forms of purchase behavior such
as impulse buying, or general models of consumer decision making and choice such as the Nicosia
(1966), Engel, Kollat, and Blackwell (1968), Howard and Sheth (1969), and Bettman (1979) models,
because they are not concerned with classifying buying behavior. The review will be structured into
three sections: (1) approaches that distinguish purchase behaviors along a single dimension of varia-
tion (unidimensional typologies), (2) approaches that differentiate among purchase behaviors using
multiple dimensions of variation (multidimensional typologies), and (3) approaches that present an
unstructured collection of distinct categories of purchase behavior (categorical typologies).
Unidimensional Typologies of Purchase Behavior
Unidimensional approaches distinguish purchase behaviors based on one dimension of variation.
The underlying dimension may be unipolar (for example, degree of involvement) or bipolar (such
as thinking vs. feeling purchases). Frequently, the dimension is dichotomized and only the low and
high poles of the underlying continuum are distinguished in order to simplify the discussion and
highlight the differences (for example, low and high involvement). The approaches to be discussed
include functional versus psycho-social bases of decision making, Howard and Sheth’s (1969)
stages of decision making, and involvement as a determinant of purchase behavior.
4 HANS BAUMGARTNER
Functional vs. Psycho-social Bases of Decision Making
Based on the traditional distinction in philosophy and psychology between cognition, reason, intel-
lect, mind, and logic on the one hand and affect, emotion, passion, soul, and intuition on the other
hand, many researchers have attributed purchase decisions to either thinking or feeling processes.
As early as 1924, Copeland proposed a rational versus emotional classifcation of consumers’ buy-
ing motives (Copeland 1924). The distinction is also implicit in the literature on perceived risk,
where several authors have contrasted choice situations involving functional (economic) risk and
purchases involving psycho-social risk (e.g., Taylor 1974).
The most infuential recent discussion of the two positions was provided by Hirschman and
Holbrook (1982; Holbrook and Hirschman 1982), who argued that, after some early interest in
motivation research (Dichter 1960) and product symbolism (Gardner and Levy 1955; Levy 1959),
consumer research had narrowly focused on the rational aspects of decision making and that it
was necessary to reorient the feld toward the more experiential aspects of consumption. Specif-
cally, they suggested that the dominant information processing view of consumer behavior could
be contrasted with an emerging experiential or hedonic perspective of consumption. While the
former sees the consumer as a “logical thinker who solves problems to make purchase decisions”
(Holbrook and Hirschman 1982, p. 132), the latter is concerned with the “multisensory, fantasy
and emotive aspects of one’s experience with products” (Hirschman and Holbrook 1982, p. 92).
According to Hirschman and Holbrook, in the information processing view the consumer focuses
on the verbal elements of products and marketing communications, defnes tasks as consumption
problems to be solved, is cognitively involved in the purchase, acquires relevant information
in order to evaluate products based on how well they perform utilitarian functions, and is more
interested in product purchase than consumption. In contrast, the consumer in the experiential
perspective attends to the sensory elements of products and messages; is driven by pleasure seek-
ing; gets emotionally absorbed in tasks; engages in diversive exploration; experiences fantasies,
feelings, and fun; and is more interested in consuming a product than buying it.
Similar to Hirschman and Holbrook, Mittal (1988) distinguished between the information pro-
cessing mode of consumer choice and the affective choice mode. In the former, the consumer is
viewed as a rational information processor who acquires pertinent information, evaluates products
on relevant choice criteria, and then chooses on the basis of some decision rule. In the latter, judg-
ments are holistic, implicate the self, and are diffcult to explicate. Mittal argues that consumption
might be motivated by either utilitarian/functional goals or hedonic, symbolic, or psycho-social
goals. He calls the latter expressive goals and regards sensory enjoyment, mood-states attainment,
social goals (such as impression management), and self-concept fulfllment as subdomains of
expressive concerns. Although he suggests that many product choices involve both functional and
expressive considerations, he argues that some products are primarily functional or expressive in
nature and thus promote either an information processing or affective choice mode.
Mittal, Ratchford, and Prabhakar (1990) also proposed that brand evaluations could be based
on functional or expressive attributes (or both). Functional attributes are objective, instrumental,
performance-oriented, and utilitarian; expressive attributes, in contrast, are subjective, experiential,
image-oriented, and hedonic. Examples of functional attributes are: gets rid of dandruff, cleans
hair, gives hair shine (for shampoo); and masks body odor, convenient to apply, does not irritate
the skin (for perfume). Examples of expressive attributes are: it is a high-fashion brand, the bottle
is attractive, it is for beautiful people (for shampoo); and it will impress people, it is feminine, the
fragrance is fowery (for perfume). The authors argue that the relative importance of functional and
expressive attributes depends on whether the consumer’s buying motive is functional or expressive.
PURCHASE BEHAVIOR AND A PROPOSAL FOR A NEW TYPOLOGY 5
When functional motives govern a purchase, consumers are mostly concerned with the physical
function of the product and try to satisfy physiological and safety needs. When expressive motives
are dominant, consumers are focused on how they feel and how others feel about them, and they
try to satisfy esteem, social, and self-actualization needs. In two studies, Mittal, Ratchford, and
Prabhakar showed that attributes could be classifed into functional and expressive sets and that
brand attitudes for shampoo were mostly infuenced by functional attribute beliefs, whereas brand
attitudes for perfume were primarily driven by expressive attribute beliefs.
Johar and Sirgy (1991) draw a similar distinction between utilitarian and value-expressive
attributes. They argue that with utilitarian attributes, the consumer evaluates the congruity of
performance-related product beliefs with referent (for example, ideal) attributes (so-called func-
tionalcongruity).Ontheotherhand,withvalue-expressiveattributes,self-andsocial-congruity—
orthematchbetweenvalue-expressiveattributesandtheself-concept—matter.Theself-concept
consists of actual and ideal forms of the self- and social-image, and self-congruity thus involves
assessments of the degree of self-consistency (with one’s actual self-image), self-esteem (with
one’s ideal self-image), social consistency (with one’s actual social-image), and social approval
(with one’s ideal social-image).
The distinction between cognitive and affective bases of decision making is also refected in
research on attitudes. Batra and Ahtola (1991) distinguish between hedonic and utilitarian sources
of consumer attitudes (see also Ahtola 1985). The hedonic component is assumed to be “based
on the consumer’s assessment of how much pleasure he gets,” while the utilitarian component is
“based on his assessment about the instrumental value of the brand’s functional attributes” (p. 161).
These two determinants of an attitude correspond to the two reasons for purchasing and consum-
ing products: “(1) consummatory, affective (hedonic) gratifcation (from sensory attributes), and
(2) instrumental, utilitarian reasons concerned with ‘expectations of consequences’ (of a means-
end variety, from functional and nonsensory attributes)” (p. 159). Batra and Ahtola constructed
scales to measure the two components (for example, pleasant/unpleasant, nice/awful, and happy/
sad for the hedonic component, and useful/useless, valuable/worthless, and benefcial/harmful
for the utilitarian component; see Crowley, Spangenberg, and Hughes 1992 for a replication; and
Crites, Fabrigar, and Petty 1994 for a similar attempt) and showed that (a) the hedonic (utilitar-
ian) attitude component was more strongly related to sensory (instrumental) attribute adequacy
composites; (b) the overall attitude of consumers buying toothpaste for emotional/feel-good/
pleasure (rational) reasons was primarily determined by the hedonic (utilitarian) component; and
(c) for some behaviors (such as test-driving a Mercedes Benz), the hedonic component was the
more important infuence on overall attitudes, while for others (such as having dental checkups)
the utilitarian component had a greater impact (see also Millar and Tesser 1986).
More recently, Voss, Spangenberg, and Grohmann (2003) reported the development of a ten-item
instrument that assesses the hedonic and utilitarian dimensions of consumers’ product and brand
attitudes (called the HED/UT scale). The scale includes such items as fun/not fun and exciting/
dull for the hedonic dimension and effective/ineffective and helpful/unhelpful for the utilitarian
dimension, and the authors provide evidence of superior reliability and validity of their instrument
vis-à-vis the Batra and Ahtola (1991) scale.
Using the functional approach to attitudes as a theoretical guide (Katz 1960; Smith, Bruner,
and White 1956; see also Lutz 1979), Shavitt (1989, 1990; Shavitt and Lowrey 1992; Shavitt et
al. 1994) proposed that two important functions served by attitudes were the utilitarian and the
social identity (or symbolic) functions. Utilitarian attitudes are based on rewards, and punishments
associated with an attitude object. They are generally linked to outcomes derived from intrinsic
product attributes and include sensory experiences the consumer has had with a product (which
6 HANS BAUMGARTNER
are usually classifed as hedonic). However, the most prototypical examples involve a product’s
performance on functional characteristics, such as providing protection from the sun for sunglasses
or obtaining relief from the heat for air conditioners. Social identity attitudes, on the other hand,
refect a desire to express one’s central values or social identity and to gain social approval. Shavitt
argues that some products generally engage the utilitarian function (for example, aspirin), others
tend to trigger the social identity function (for example, class ring), and still others may serve either
function (for example, watch). She also showed that an advertising appeal that was relevant to a
product’s primary function (such as a functional appeal for a functional product) led to higher ad
and brand attitudes and purchase intentions than a function-irrelevant appeal, and that the corre-
spondence between attitudes and behavioral predictions was stronger when the function that was
salient at attitude expression was consistent with the function engaged by the brand.
The distinction between functional and psycho-social purchase motives has also been considered
in the context of involvement (see the next section for a more detailed treatment of involvement).
Park and Mittal (1985) conceptualize involvement in terms of both its causes (type of involvement)
and its strength (level of involvement). They distinguish cognitive involvement from affective
involvement depending on the motives underlying consumers’ involvement: utilitarian motives or
value-expressive motives. In the former case the consumer is mainly concerned with the functional
benefts and costs of a product, whereas in the latter case self-concept congruity and self-image
enhancement are the reasons for a consumer’s involvement (see also Park and Young 1986).
Claeys, Swinnen, and Vanden Abeele (1995) studied consumers’ cognitive structures as-
sociated with low-involvement “think” (for example, batteries, glue, detergent) and “feel” (for
example, birthday cards, indoor plants, liquor) products. They defne think products as those for
which the motive for buying is utilitarian and cognitive, the mode of processing is logical, rational,
and sequential thinking, and the focus of concern is functional performance, costs/benefts, and
tangible features. In contrast, feel products are those for which the motives for buying are value-
expressive and affective, the mode of processing is holistic, synthetic, and image-based think-
ing, and the focus of concern is enhancement of the self, subjective meanings, and intangible
features. They conducted laddering interviews with one hundred subjects, in which respondents
were repeatedly asked why certain attributes of think and feel products were important to them.
They then classifed responses into the following levels: concrete attributes, abstract attributes,
functional consequences, psycho-social consequences, instrumental values, and terminal values.
The major fnding was that the cognitive structures associated with think products were dominated
by functional consequences and concrete attributes (80 and 70 percent of subjects mentioned
product meanings at those levels, respectively), whereas the cognitive structures associated with
feel products were dominated by psycho-social consequences and abstract attributes (80 and 60
percent of subjects mentioned meanings at those levels, respectively). According to the authors,
this supports the notion that buying motives for think products lie at the functional consequence
level and that reasons for the purchase of feel products are at the psycho-social level.
In the context of research on shopping motivations, Babin, Darden, and Griffn (1994) argue
that shopping can produce either utilitarian or hedonic value. Utilitarian value is based on whether
the goal that motivated the shopping trip was attained. When shopping has a utilitarian purpose,
it is extrinsically motivated by the need for a product or the acquisition of product information,
and effciency of shopping is desirable. Utilitarian shopping is perceived as work, and successful
completion of the shopping task is the goal. In contrast, hedonic value derives from the intrinsic
enjoyment of shopping as an activity. Hedonic shopping is like play, gives the consumer pleasure,
and may sometimes be a means of escape from a stressful situation. The authors constructed a scale
(the personal shopping value scale) that assesses the two kinds of shopping value with items such
PURCHASE BEHAVIOR AND A PROPOSAL FOR A NEW TYPOLOGY 7
as “I accomplished just what I wanted to on this shopping trip” (for functional value) and “This
shopping trip was truly a joy” (for hedonic value). They also showed that the hedonic dimension
of their shopping value scale was positively correlated with consumers’ experiential shopping
motivations, compulsive buying behavior, and unplanned spending, and that the correlation with
the degree of pleasure and arousal experienced in a store was stronger than for the utilitarian di-
mension. Both dimensions were equally strongly related to perceptions of the number of bargains
available in the store, amount spent, and overall satisfaction with the shopping trip.
The difference between utilitarian and hedonic products has also fgured prominently in some
of the recent choice literature (e.g., Dhar and Wertenbroch 2000; Okada 2005; Shiv and Fedorikhin
1999). These studies have focused on the conditions that favor consumer choice of utilitarian and
hedonic products, but the important point for the present purposes is that functional and psycho-
social purchase motivations are a key dimension differentiating buying behaviors and choices.
Finally, in recent work by Chitturi, Raghunathan, and Mahajan (2008), (lack of) delivery of utilitar-
ian product benefts is shown to lead to prevention emotions of satisfaction (anger), while (lack of)
delivery of hedonic benefts is shown to lead to promotion emotions of delight (dissatisfaction). In
turn, the postconsumption emotions are related to word-of-mouth and repurchase intentions.
Although dichotomies between functional and psycho-social bases of decision making have
been the most common approach, several researchers have considered three classes. Park, Ja-
worski, and MacInnis (1986, p. 136) distinguish between functional, symbolic, and experiential
needs. Functional needs are “those that solve consumption-related problems (such as solve a cur-
rent problem, prevent a potential problem, resolve confict, restructure a frustrating situation; see
Fennell 1978).” Symbolic needs are “desires for products that fulfll internally generated needs
for self-enhancement, role position, group membership, or ego-identifcation. . . . A brand with a
symbolic concept is designed to associate the individual with a desired group, role, or self-image.”
Finally, experiential needs are “desires for products that provide sensory pleasure, variety, and/or
cognitive stimulation.” The authors argue that researchers have generally classifed products as
functional, symbolic, or experiential depending on which need they tend to satisfy, but point out
that in principle a brand could be positioned with any of these images.
Park, Jaworski, and MacInnis’s distinctions are an elaboration of an earlier proposal by Woods
(1960) that consumers demand products for ego-involving, hedonic, or functional reasons. Accord-
ing to Woods, ego-involvement is characteristic of prestige products (which are used to project
a certain self-image), maturity products (which signal that the consumer has reached a certain
state of maturity, as in the case of cigarettes or alcohol), status products (which symbolize class
membership), and anxiety products (for which ego-defense, instead of ego-enhancement, is the
primary motivator). Hedonic products are those for which demand is based on sensory appeal.
Finally, functional products have little cultural or social meaning and are simply bought because
of the function they perform.
In summary, the differentiation into functional (utilitarian) and psycho-social (hedonic, experi-
ential, value-expressive, and symbolic) bases of decision making is an old one, and it is refected
in various distinctions made in the information processing, attitude, and choice literatures. The
basic implication is that purchase (and, more generally, consumption) can be motivated by either
functional (cognitive) or psycho-social (emotional) considerations and that this leads to a corre-
sponding interest in utilitarian or hedonic products, or a focus on utilitarian or hedonic attributes
of products. Furthermore, researchers have speculated about and, less frequently, studied the
characteristics of cognitive and emotional decision processes. Although the distinction highlights
important differences between the two choice modes and therefore constitutes a relevant dimension
for differentiating between alternative purchase behaviors, by itself it provides a limited account
8 HANS BAUMGARTNER
of the ways in which purchase behaviors may differ, as will become clearer once other dimensions
and typologies have been described.
Howard and Sheth’s Stages of Decision Making
Howard and Sheth (1969) presented a dynamic model of buying behavior according to which
purchase decision making depends on a consumer’s familiarity with both the product class and
the brands in the product class, and the strength of preference for particular brands. The three
stages in the decision process are called extensive problem solving, limited problem solving, and
routinized response behavior.
In the frst stage, extensive problem solving, the consumer knows little about the product class
and does not have strong attitudes toward the various brands. Information search is extensive be-
cause the consumer has to acquire a product class concept, and the speed with which the decision
is made is slow. Many products are actively considered for purchase (that is, the size of the evoked
set is large), and consumers carefully deliberate which brand will best suit their needs.
In the second stage, limited problem solving, the consumer has developed a basic familiarity
with the product class and knows what the important choice criteria are but is still unsure about
how the different brands compare and does not yet have clearly defned brand attitudes. Both the
amount of information searched and the speed of decision making are moderate. The size of the
evoked set is smaller than in the case of extensive problem solving, but there is no strong prefer-
ence for any one brand. Apart from situations in which consumers gradually become more familiar
with a product category and decision making becomes less extensive, limited problem solving is
also characteristic of cases in which a new brand is introduced into an established market so that
existing buying habits are disrupted.
In the third stage, routinized response behavior, the consumer knows both the product class
and the brands within the product class well and has a clear preference for one or two brands in
the evoked set. Information search is minimal and purchase decisions are made quickly, often in
response to environmental cues such as a product display in a store. For example, impulse pur-
chases are mentioned as an instance of routinized response behavior.
In subsequent work, Howard (1977, 1989, 1994) extended the dynamic model of buying be-
havior in two ways. First, he explicitly related the three decision-making stages to the product
life cycle. Extensive problem solving is assumed to be characteristic of the introduction stage,
limited problem solving of the growth stage, and routinized response behavior (or routine problem
solving) of the maturity and, to some extent, the decline stage. Second, he developed the concept
of the decision-making model (consisting of the constructs of information, brand recognition, at-
titude, confdence, intention, and purchase) and considered modifcations of the basic model when
it is applied to buyer behavior in each of the product life cycle stages. Here we will discuss only
those aspects of the conceptualization that are relevant to a discussion of typologies of consumer
buying behavior.
Howard views extensive and limited problem solving as rational information processing tasks
during which consumers frst form a product category image (that is, what the product is, what
benefts it offers, and so forth) and then attain a brand concept (how the brands rate on the choice
criteria, and so forth). The major difference between the two stages is in the amount of information
needed and the deliberateness of the decision-making process involved. In routine problem solv-
ing, several distinct purchase patterns emerge. Some consumers buy the same brand habitually (or
loyally), usually with little thinking and low involvement in the purchase task. Others get bored
with buying the same brand again and again and engage in variety seeking (or boredom problem
PURCHASE BEHAVIOR AND A PROPOSAL FOR A NEW TYPOLOGY 9
solving). This means that consumers complicate the buying process by considering other product
benefts besides price and availability. In effect, this means that they return to the stage of limited
problem solving. Finally, emotional factors are more important in routine buying tasks because, in
the maturity stage of the product life cycle, brands become more and more similar on functional
characteristics, and emotions are used to differentiate parity brands.
A major contribution of the Howard and Sheth model is that these authors recognized early on
the importance of familiarity in infuencing a consumer’s decision-making process. Familiarity,
conceptualized in terms of both product category and brand familiarity, is, in combination with
the concept of strength of brand preference, the key driver determining the amount of information
searched and the speed with which purchase decisions are made. The model provides a useful
perspective on the temporal dynamics of decision making over the product life cycle and has many
strategic implications for the management of brands from the introduction to the decline stage.
The major shortcoming of the model is that because of its unidimensional nature, it ignores or
minimizes important differences between various forms of buying behavior. This problem is most
glaring in the routinized response behavior stage. Habitual purchase behavior, impulse buying, variety
seeking, and emotional buying are all regarded as instances of routine problem solving. Furthermore,
buying behavior in the early stages of the life cycle is restricted to utilitarian information-processing
tasks, in which consumers rationally acquire product information and assess the benefts of different
product features. Emotional factors are given insuffcient attention early in the product life cycle.
Involvement and Purchase Behavior
It is now well established that an important determinant of how consumers make purchase deci-
sions is their level of involvement. The concept of involvement was frst introduced into consumer
behavior to explain the persuasive effects of advertising (Krugman 1965), and many of the subse-
quent discussions of the construct dealt with the role played by involvement in the communication
process (e.g., Andrews, Durvasula, and Akhter 1990; Celsi and Olson 1988; Greenwald and Leavitt
1984; Park and Young 1986; Petty, Cacioppo, and Schumann 1983; Ray et al. 1973). Here we will
focus on the literature that has discussed the infuence of involvement on purchase behavior.
As mentioned by Kassarjian (1981, 1994), the increased interest in involvement as a determi-
nant of consumer behavior in the early 1980s was a counter-reaction to the then dominant view of
the consumer as an active information processor who carefully deliberates each purchase before
making a choice. In his presidential address at the Association for Consumer Research Annual
Conference, Kassarjian (1978) suggested that while “[i]mportant or expensive, high risk, high
involvement, psychologically or socially or ego related products, may under certain conditions,
lead to highly sophisticated actions and decisions . . . the world is mostly full of insignifcant
decisions and unimportant solutions” (p. xiii). Olshavsky and Granbois (1979) similarly argued
that “for many purchases a decision process never occurs, not even on the frst purchase” (p. 98).
Kassarjian (1981) specifcally proposed that there might be two felds of decision making, one
applicable to high-involvement decisions and the other to low-involvement decisions, and he
admonished consumer researchers to be cognizant of this distinction.
We will refer to a consumer’s involvement in purchase decisions as purchase involvement and,
consistent with current conceptualizations of involvement (Celsi and Olson 1988; Greenwald and
Leavitt 1984; Park and Young 1986; Zaichkowsky 1985), defne it as the personal relevance of a
purchase task. Personal relevance means that the consumer views the purchase as important, is
willing to expend cognitive effort on the purchase decision, and/or gets emotionally absorbed in
the purchase process. Other terms used to refer to purchase involvement are importance of the
10 HANS BAUMGARTNER
purchase (Howard and Sheth 1969), decision importance (Clarke and Belk 1979), and purchase-
decision involvement (Mittal 1989).
Purchase involvement is a function of the consumer, the product, and situational factors. As
suggested by Kassarjian (1981), some consumers fnd purchasing activities highly involving, re-
gardless of the product or situation in question. Building on this idea, Slama and Tashchian (1985)
developed a scale of purchasing involvement that assesses individual differences in the extent to
which a consumer is interested in shopping, values making careful purchase decisions, and enjoys
getting a bargain. They also showed that consumers high in purchasing involvement tended to be
women with children, moderate incomes, and relatively high levels of education.
Purchase involvement also depends on the characteristics of the product to be bought (Clarke
and Belk 1979; see also Hupfer and Gardner 1971; Lastovicka and Gardner 1979; Laurent and
Kapferer 1985; Ratchford 1987; Zaichkowsky 1985). Across consumers and situations, some
products tend to generate more involvement than others. Laurent and Kapferer argue that product
involvement will be high when the product is important to the consumer (interest), when it has
emotional appeal (pleasure), when it says something about the product user (sign value), or when
the purchase of the product is risky, either because the likelihood of negative consequences is high
(risk probability) or the negative consequences are severe (risk importance).
Finally, purchase involvement is infuenced by situational factors. To begin with, the nature
of the buying task impacts consumers’ involvement in the purchase. Clarke and Belk (1979)
argue that a task will be involving if it relates to important goals, and they show that a product
bought as a gift leads to greater expenditure of effort than the same product bought for personal
use. Furthermore, the circumstances under which the purchase occurs may affect the consumers’
involvement. For example, time pressure is likely to decrease involvement, whereas the presence
of relevant others in either the purchase or usage situation should increase involvement (Houston
and Rothschild 1978). It is thus important to know not only who makes the purchase and what is
being bought, but also the task and context factors surrounding the purchase.
Previous research on the consequences of involvement on purchase decisions has generally
focused on the effects of cognitive forms of involvement, where a consumer is primarily con-
cerned with the functional performance of products, rather than affective forms of involvement,
where consumers focus on the hedonic and symbolic qualities of the product (see Park and Mittal
1985; Park and Young 1986). The basic hypothesis is that involvement leads to more extensive
decision processes in terms of the amount of internal and external information consulted and the
number of choice alternatives evaluated. The empirical evidence is consistent with this predic-
tion. For example, Beatty and Smith (1987) showed that purchase involvement was associated
with greater retailer, media, and interpersonal search, and similar results for search effort were
also obtained by Clarke and Belk (1979) and Zaichkowsky (1985), among others. Zaichkowsky
found that consumers who were involved with products were more likely to compare attributes
across brands, perceive differences among brands, and have a most preferred brand in the product
category. Gensch and Javalgi (1987) showed that low-involvement consumers tended to use an
attribute-based, noncompensatory choice heuristic, while high-involvement consumers were more
likely to use a brand-based, compensatory choice heuristic.
In summary, there is ample support for Kassarjian’s (1981) claim that low- and high-involvement
decision making differ, and the distinction between low- and high-involvement purchase behaviors
is well established. However, similar to the differentiation between functional and psycho-social
bases of decision making, the use of involvement as the sole dimension for classifying buying
behavior is simplistic and ignores other relevant considerations. We next turn to a discussion of
multidimensional frameworks, which consider several dimensions simultaneously.
PURCHASE BEHAVIOR AND A PROPOSAL FOR A NEW TYPOLOGY 11
Multidimensional Typologies of Purchase Behavior
Multidimensional typologies cross-classify purchase behaviors based on several underlying
dimensions. Usually, these typologies combine two of the dimensions discussed in the previous
sections, such as functional vs. psycho-social bases of decision making and degree of involve-
ment. Four specifc multidimensional models will be discussed in this section: Assael’s model,
the FCB grid and its modifcation by Rossiter and his associates, and Bagozzi’s classifcation of
choice processes.
Assael’s Model of Consumer Decision Making
Assael classifes consumer purchase processes on the basis of two dimensions (e.g., Assael 1995):
extent of decision making (ranging from decision making to habit) and degree of involvement
in the purchase (low to high). Decision making is characterized by information search and the
consideration of multiple brand alternatives, while habit entails little or no information search
and the repeated purchase of the same product based on previous experience. Involvement is a
function of the importance of the purchase to the consumer and depends on the fnancial, social,
and psychological risks associated with it. Combining the two dimensions yields four types of
consumer purchase processes: complex decision making (high-involvement decision making),
limited decision making (low-involvement decision making), brand loyalty (high-involvement
habit), and inertia (low-involvement habit).
Complex decision making occurs when a purchase is important to the consumer but little previ-
ous experience is available to guide the choice process. The consumer has to gather information
and carefully evaluates alternatives. Assael includes symbolic purchasing behavior in the category
of complex decision making and argues that it differs from high-involvement utilitarian purchase
decisions only in the nature of information processing and brand evaluation. Instead of judging
brands in terms of utilitarian performance, quality, and value, consumers view brands as symbolic
entities and evaluate their consistency with desired self-images.
When important purchases are made repetitively, decision making becomes a habit, but as long
as involvement stays high and the consumer is satisfed with the product, there will be strong
commitment to a particular brand. Assael calls this brand loyalty.
Even if consumers are not involved in a purchase task, they may have to engage in some infor-
mation search and alternative evaluation if they lack previous experience with the product. This is
referred to as limited decision making. Assael regards variety seeking and impulse buying as instances
of limited decision making because the consumer is not committed to a single brand and involvement
is low. He also argues that such decisions are not preplanned and are usually made in the store.
Low-involvement purchase decisions that are made habitually are termed inertia by Assael.
Although consumers tend to buy the same brand, this does not signal commitment to the brand
purchased, but simply refects the convenience of not having to consider different alternatives.
Assael’s model captures several important characteristics of consumer purchase processes.
First, it clearly differentiates between low- and high-involvement purchases, which entail very
different information-processing demands. Second, it considers amount of prior experience as an
important infuence on the kind of decision making that takes place and accords habit an important
role in the purchase process, which is congruent with its practical importance for many product
categories.Third,itdistinguishesbetweentwoformsofrepeatpurchasebehavior—brandloyalty
andinertia—thatdifferintheirpsychologicalmechanismsandhaveverydifferentimplications
for marketing practice.
12 HANS BAUMGARTNER
The model also has several weaknesses. First, the two dimensions of high/low involvement
and decision making/habit are probably not independent. For example, Assael himself argues that
when consumers are highly involved, they will fnd it worthwhile to consider product alternatives
carefully. However, information search and consideration of brand alternatives are seen as char-
acteristics of decision making. Thus, extent of decision making should be positively correlated
with degree of involvement. Second, with brand loyalty the consumer might be committed to
the product, but the purchase decision per se is probably not highly involving because it is made
habitually. Third, the phenomenology of high-involvement utilitarian and symbolic purchase deci-
sions, or of mundane, limited decision tasks, variety seeking behavior, and impulse purchases is
quite different, yet they are classifed in the same quadrant in Assael’s model. The simple 2 by 2
classifcation thus probably does not do justice to the richness of actual purchase decisions.
The FCB Grid
The FCB (Foote, Cone, & Belding) grid was developed as an advertising planning model and
classifes products and purchase decisions in terms of two dimensions: (1) thinking versus feeling,
and (2) low versus high involvement (Berger 1986; Ratchford 1987; Ratchford and Vaughn 1989;
Vaughn 1980, 1986). The thinking/feeling dimension is based on whether the purchase of a product
is triggered by cognitive or affective motives and whether the mode of information processing
is primarily cognitive or affective in nature. The major cognitive motive is a utilitarian need for
a product that performs well on functional attributes, and it leads to left-brained, analytical, and
semantic processing of relatively objective product features. Affective motives include consumers’
needs for ego gratifcation, social acceptance, and sensory pleasure, and purchase decisions in this
case are characterized by right-brained, holistic, and sensory processing of more subjective product
information. Involvement is conceptualized as the importance of a purchase to the consumer and
the resulting attention and concern that important purchases engender.
When the two dimensions are dichotomized and cross-classifed, four quadrants emerge: high-
involvement thinking, high-involvement feeling, low-involvement thinking, and low-involvement
feeling. Vaughn (1980, 1986) relates the FCB grid to the hierarchy-of-effects model and argues
that the high-involvement thinking quadrant is characterized by a learn-feel-do sequence, the
high-involvement feeling quadrant by a feel-learn-do sequence, the low-involvement thinking
quadrant by a do-learn-feel sequence, and the low-involvement feeling quadrant by a do-feel-learn
sequence. The advertising implications derived from the grid are as follows: high-involvement
thinking products require informational advertising; high-involvement feeling products, emotional
advertising; low-involvement thinking products, advertising that creates and reinforces habits; and
low-involvement feeling products, advertising that emphasizes personal satisfaction.
In order for the grid to be used in advertising planning, products have to be assigned to the ap-
propriate quadrant of the grid. Five studies were conducted to construct scales for measuring think/
feel and involvement (see Ratchford 1987 for a detailed description). Although thinking/feeling is
conceptualized as a bipolar dimension in the grid, the two poles are assessed with unipolar scales
measuring the extent to which the purchase decision is logical, objective, and based on functional
facts (for thinking) and the degree to which it expresses the consumer’s personality, is based on
feelings, and involves sensory considerations (for feeling). Placement on the think/feel dimension
depends on the relative amount of thinking or feeling associated with the purchase. Involvement
is assessed with items measuring how important the decision is, how much thought the decision
requires, and how much consumers stand to lose if they make the wrong decision. Grid studies
conducted all over the world show that products tend to be classifed in the same quadrant across
PURCHASE BEHAVIOR AND A PROPOSAL FOR A NEW TYPOLOGY 13
countries, although some interesting situational variations exist. For example, Berger (1986) re-
ports that life insurance is only a moderately involving decision in Sweden, possibly because of
the extensive social support available in that country.
The FCB grid has a great deal of heuristic value for analyzing purchase decisions and devel-
oping advertising that matches consumers’ natural way of buying products in different product
categories. The grid was one of the earliest attempts to come up with a simple, multidimensional
classifcation of purchase decisions, and it incorporated such emerging issues as experiential/
hedonic buying behavior and low-involvement decision making. The grid stimulated empirical
(although mostly nonacademic) research and yielded a validated set of measurement scales for
placing products along the think/feel and involvement axes.
However, the FCB grid has also been criticized on several fronts. One problem is that even
though thinking and feeling are measured on unipolar scales, they are eventually combined into
a single measure by subtracting the average think score from the average feel score and placing
products on a bipolar dimension ranging from thinking to feeling. This means that a product in the
middle of the grid might be either relatively high or relatively low on both thinking and feeling.
Another problem is that the two axes of the grid may not be independent. For example, Ratchford
(1987) reports that in one study the involvement and thinking items tended to load on the same
factor, which is not surprising since one of the involvement items (decision requires a lot/little
thought) looks very much like a thinking item. In an attempt to correct these problems, Kim and
Lord (1991) and Putrevu and Lord (1994) proposed a modifcation of the FCB grid in which high/
low cognitive involvement and high/low affective involvement with products are used as dimen-
sions. This avoids treating feel and think as opposite ends of a bipolar scale and allows cases in
which someone is in both a thinking and a feeling mode or does not experience either. However,
while the modifed model incorporates the high-involvement thinking and feeling quadrants of the
original FCB grid and allows mixtures of think/feel for both low- and high-involvement products
(that is, low cognitive and affective involvement and high cognitive and affective involvement),
it does not clearly accommodate low-involvement thinking purchases (such as habitual buying
behavior) or low-involvement feeling purchases (such as certain impulse purchases).
Rossiter, Percy, and Donovan (1991) also criticized the FCB grid. First, they argue that the FCB
conceptualization of involvement confuses product and brand involvement, does not take into
account the familiarity of the target audience with the brand to be chosen, and does not specify
the demarcation between low and high involvement. Second, the FCB conceptualization of think/
feel considers only one cognitive purchase motive, and the affective motives are not clearly cap-
tured by the measurement scale that was developed to measure the feel end of the dimension (for
example, the social approval motive was dropped because it could not be successfully assessed
with quantitative self-rating scales). Rossiter and his coauthors developed their own advertising
planning grid to correct these weaknesses; this model is discussed next.
The Rossiter-Percy-Donovan Grid
The Rossiter, Percy, and Donovan model (Rossiter, Percy, and Donovan 1991; Rossiter and Percy
1997) consists of a brand-awareness component and a brand-attitude component. Rossiter and
his colleagues argue that brand-awareness is an important communication objective, because
before a consumer can form an attitude, he or she must be aware of the brand. However, for
our purposes we are more interested in the brand-attitude component. The authors consider two
dimensions, type of decision (low or high involvement) and type of motivation (informational or
transformational), to arrive at a 2 by 2 grid that is superfcially similar to the original FCB grid.
14 HANS BAUMGARTNER
Involvement is defned as the risk perceived by a typical target audience member in choosing a
particular brand on a particular purchase occasion. Low involvement means that the consumer
is willing to try out the brand without information search, whereas high involvement means that
search and conviction are necessary before the brand is purchased. With respect to type of mo-
tivation, Rossiter, Percy, and Donovan distinguish between informational and transformational
motives. Informational motives are negatively reinforcing, in the sense that an aversive state is
relieved, and they include problem removal, problem avoidance, incomplete satisfaction, mixed
approach avoidance, and normal depletion. Transformational motives are positively reinforcing
because they promise a rewarding state, such as sensory gratifcation, intellectual stimulation, or
social approval (see Fennell 1978). Rossiter and his coauthors develop specifc advertising tactics
to be used in the four quadrants of the grid and argue that their model yields much richer insights
into the advertising planning process than the FCB grid.
The major advantage of the Rossiter-Percy-Donovan grid seems to be that the potential motiva-
tions underlying purchases are considered more explicitly than in the FCB grid (or, more gener-
ally, in discussions of the functional and psycho-social bases of decision making). However, the
model was developed as an advertising planning tool; as a framework for classifying different
purchase behaviors, it does not go much beyond the original FCB grid, and it cannot account for
the differences among purchase behaviors such as variety seeking, impulse buying, or simple
hedonic purchases.
Bagozzi’s Classifcation of Consumer Choice Processes
Bagozzi (1983) proposed that degree of involvement (low, medium, high) and extent of prior
learning (no, yes) could be used to classify consumer purchase behavior. Involvement is defned
as the saliency of a product for the consumer, or the importance of the product in a cognitive or
affective sense, whereas learning refers to previous experience with the product. When involve-
ment is low and no prior learning has occurred, consumer behavior is based on impulse. Bagozzi
includes exploratory or variety-seeking behaviors, instinctual behaviors, and actions prompted by
time or social pressures in this category. When involvement is low but the consumer has had previ-
ous experience with a product, behavior is driven by habit. Bagozzi argues that the consumer is
“programmed to act in a certain way” (1983, p. 151) in this case. When involvement is medium to
high and no or little prior learning has occurred, purchase behaviors follow what he calls the cogni-
tive response model. In this case, cognitive information processing precedes affective responses,
preference and intention formation, and overt choice behavior. Information processing is effortful
because the consumer has little prior experience with purchasing the product, and the purchase is
important so the consumer is willing to expend the necessary effort. When involvement is high
and the consumer has had previous experience with a product, Bagozzi suggests that the affec-
tive response model best describes choices. Here, affective processes are primary and precede the
remaining steps in the purchase sequence. He specifcally mentions several cases in which affect
plays a major role in purchases. These include situations of high-pressure communication or other
stimuli that induce intense emotions and self-attributions of likes or dislikes based on past behavior
(the so-called dissonance-attribution hierarchy). Finally, when involvement is medium and prior
learning has led to stored thoughts and feelings, the parallel response model is said to represent
consumer choice. Cognitive and affective processes work in tandem and can have independent
effects on preferences and purchase decisions. Bagozzi also warns that consumers may not adhere
to the choice process specifed for a given cell if environmental stimuli (particularly stimuli in
the social environment) are strong enough to dominate choice. For example, he also discusses a
PURCHASE BEHAVIOR AND A PROPOSAL FOR A NEW TYPOLOGY 15
social response model that introduces social stimuli as an additional infuence on cognitive and
affective processes and preference.
Bagozzi’s model is a novel attempt to classify choice processes, but it has several weaknesses.
First, it is highly speculative, and no empirical research has investigated its usefulness. Second,
although Bagozzi considers both cognitive and affective choice processes, this important dimen-
sion is not used explicitly in developing the classifcation. Third, the notion of prior learning is
not conceptualized very clearly; the demarcation between low, medium, and high involvement is
likely to create diffculties in empirical applications; and the relationship between involvement
and prior learning is somewhat ambiguous.
Categorical Typologies of Purchase Behavior
Categorical purchase typologies provide a discrete classifcation of purchase behaviors without
reference to underlying dimensions. This gives them greater fexibility, but it also makes it more
diffcult to see similarities and differences between the different forms of buying behavior and to
assess the exhaustiveness of the typology. Four specifc categorical typologies will be discussed
in this section: Sheth and Raju’s choice mechanisms, Belk’s extension of Sheth and Raju’s model,
the consumption-values approach of Sheth and his associates, and Sproles and Kendall’s research
on decision-making styles.
Sheth and Raju’s Choice Mechanisms
Sheth and Raju (1974) proposed that choice behavior was a linear function of four different
choice mechanisms: a situation-controlled choice mechanism (SCCM), a belief-controlled choice
mechanism (BCCM), a habit-controlled choice mechanism (HCCM), and a curiosity-controlled
choice mechanism (CCCM). In a given situation, an individual’s choice is dominated by one of
the mechanisms, but in order to account for individual differences in consumers’ choices, a linear
additive formulation is proposed.
In situational choice, choice is under environmental control, and personal stimuli (hunger,
thirst, and so forth), social stimuli (other people), signifcative stimuli (physical aspects of the
focal object), and symbolic stimuli (symbolic aspects of the focal object) are the major infuences
on the consumer’s buy/no buy decision. One common example of situational choice is unplanned
buying (including impulsive purchase behavior). Belief-controlled choice corresponds to rational
decision making under high-involvement conditions, where the consumer carefully compares
alternatives based on how well they satisfy his or her needs and wants. Habit-controlled choice
involves a binary decision between buying the usual alternative or some other alternative, and
it is based on a strong affective or conative tendency rooted in past experiences. It is especially
common for frequently purchased products. Finally, curiosity-controlled choice is a manifestation
of exploratory behavior in the consumer context in cases where the consumer is mainly motivated
by the desire for stimulating consumption experiences.
Sheth and Raju argue that there are cyclical sequential linkages among the four choice mechanisms,
such that consumers move either from habit-controlled choice to situation-controlled choice via curiosity-
controlled choice when decision making has become too simplistic, or from situation-controlled choice
to habit-controlled choice via belief-controlled choice when decision making has become too compli-
cated. Furthermore, they attempt to relate the four choice mechanisms to different choice rules such as
the compensatory, conjunctive, disjunctive, and lexicographic heuristics. However, the discussion is
highly speculative, and nobody seems to have investigated the authors’ proposals empirically.
16 HANS BAUMGARTNER
Belk’s Choice Mechanisms
Belk (1985) extended Sheth and Raju’s (1974) theorizing and, in addition to the four choice
mechanisms they discussed, considered an affect-controlled choice mechanism. In Belk’s scheme,
situation-controlled choice refers to direct infuences of the acquisition situation or anticipated
consumption situation on acquisition behavior. It does not include infuences of the anticipated
acquisition or consumption situation on choices that are mediated by behavioral intentions. Three
situational effects are considered: contextual effects, precipitating effects, and cuing effects.
Contextual effects are due to situational factors that enable or constrain behavior by infuencing
consumers’ perceptions of the appropriateness or feasibility of an action. Precipitating effects refer
to environmental stimuli that trigger action (such as emergencies, strong atmospheric infuences).
Cuing effects are more subtle environmental infuences that orient consumers toward some ac-
tion (for example, point-of-purchase displays, shelf location). Situational infuences need not be
recognized by the consumer as affecting behavior. Belief-controlled choice refers most directly to
acquisition behavior that is controlled by behavioral intentions. This includes habitual and situ-
ational infuences, as long as their impact on behavior is mediated by behavioral intentions. It is
characteristic of highly involving decisions. Another form of belief-controlled choice occurs in
low-involvement situations when choice is due to weak object beliefs (often created by repetitive
advertising) in the absence of well-formed intentions. Habit-controlled choice refers to acquisition
behavior that is directly controlled by previous choice behavior. Belk suggests that habits will
infuence intentions most strongly for frequently purchased, low-involvement products, but he
argues that habit-controlled choice can occur in both low- and high-involvement situations. Belk
treats curiosity-controlled choice as the opposite of habit-controlled choice, and he refers to cases
in which the positive effect of habits on acquisition behavior is disrupted or reversed. He suggests
that it is most common for moderately involving choices. Finally, affect-controlled choice refers
to a direct infuence of object affect on acquisition behavior unmediated by behavioral intentions.
Belk suggests that this choice mechanism is “especially likely for high-involvement objects with
affective overtones and limited time for choice” (p. 26) (such as at an auction for art objects).
Sheth and Associates’ Consumption Values
Sheth, Newman, and Gross (1991) proposed a theory of market choice behavior according to
which market choice is a function of fve different kinds of values: functional value, social value,
emotional value, epistemic value, and conditional value. A given choice may be dominated by
one of these values, but usually is infuenced by multiple values.
Functional value denotes a product’s “ability to perform its functional, utilitarian, or physical pur-
poses. Alternatives acquire functional value through the possession of salient functional, utilitarian,
or physical attributes” (p. 18). Attributes commonly used to judge functional value include intrinsic
quality cues such as performance, reliability, and durability. When products lack differentiation on
functional attributes, price may be used to assess functional value. Social value pertains to the perceived
utility of a product because of its congruence with the norms of relevant social groups or its ability to
project a desired social image. Products whose consumption is socially visible are particularly likely
to possess social value. Sheth, Newman, and Gross summarize research in the areas of social class,
consumption symbolism, reference groups, conspicuous and compensatory consumption, the norma-
tive component of attitudes, and opinion leadership and diffusion of innovation that is consistent with
the role of social value in product choices. Emotional value refers to a product’s ability to generate
affective states. Impulse purchases, entertainment choices, decisions about products affecting one’s
PURCHASE BEHAVIOR AND A PROPOSAL FOR A NEW TYPOLOGY 17
self-image, and the selection of food products are often based on emotional value. Under emotional
value, the authors also subsume motivation research, personality research, work on nonverbal process-
ing and hemispheral brain lateralization, and studies of subliminal perception. Epistemic value deals
with a product’s “ability to arouse curiosity, provide novelty, and/or satisfy a desire for knowledge.
Alternatives acquire epistemic value through their capacity to provide something new or different” (p.
21). Risky product choices, innovativeness, variety seeking, and exploratory information seeking are
commonly attributed, at least in part, to a desire for epistemic value. Finally, conditional value refers to
temporary functional or social value due to particular situational circumstances. Frequently, it involves
deviations from planned purchase behavior because of contextual contingencies. Examples include
purchases made in an emergency situation, seasonal demand for certain products (such as Christmas
cards), and products bought to take advantage of a sale.
Consumers’ Decision-Making Styles
Sproles and Kendall (1986) suggest that consumers can be characterized in terms of how they
approach purchase tasks and that these decision-making styles are like personality traits in the
consumer domain (see also Sproles and Sproles 1990). Based on a review of the literature, they
identifed eight fundamental consumer decision-making characteristics and constructed an instru-
ment (called the Consumer Styles Inventory) to measure these characteristics. Brief descriptions of
the eight styles follow. Perfectionistic, high-quality conscious consumers make careful purchases
and try to buy the best quality products. Brand conscious, “price equals quality” consumers have
a preference for well-known national brands, use price as a signal of quality, and like shopping
in nice department and specialty stores. Novelty-fashion–conscious consumers are interested in
style, variety, and exciting new products. Recreational, hedonistic consumers enjoy going shop-
ping. Price-conscious, “value for money” consumers buy as much as possible on sale and are
concerned with getting the best value for their money. Impulsive, careless consumers often buy
on impulse and sometimes make careless purchases. Confused by overchoice consumers fnd it
hard to choose between brands and stores and often experience information overload. Habitual,
brand-loyal consumers have their favorite brands and stores and stick with them.
Summary of Categorical Typologies
It seems fair to say that the categorical purchase typologies have not had a strong infuence on
thinking about buying behavior. They are not well known in the marketing feld, and empirical
research has been lacking. The various typologies focus on the factors that can control choice in
a given situation (product-related beliefs, habits, affect, and so forth), or the types of value that
consumers derive from products, and they incorporate some elements of the unidimensional ap-
proaches discussed earlier, but supplement them with particular buying motives that are deemed
relevant (such as curiosity). However, because they are not derived from underlying dimensions, it
is not clear how exhaustive the typologies are and how the purchase behaviors distinguished in the
typologies are related to each other. Finally, it remains to be seen whether decision-making styles
can be treated like personality traits, which are supposed to be stable across situations and time.
A New Typology of Purchase Decisions
None of the previously suggested dimensional typologies of purchase decisions is comprehensive
enough to unambiguously accommodate the wide variety of purchase behaviors that are encoun-
18 HANS BAUMGARTNER
tered in practice. Furthermore, there are inconsistencies in how certain purchase behaviors are
classifed, which suggests that one or two dimensions of variation may not be suffcient to ac-
commodate all purchase decisions. Although several of the categorical approaches fare better in
terms of comprehensiveness, they have the disadvantage that it is not obvious how the different
categories are related. Finally, a common shortcoming of all typologies is that they seem to be
based on conceptual discussions of how different purchase decisions are related to each other and
that few empirical tests of the proposed categorizations are available.
In the remainder of this chapter we will report three studies that were designed to develop and
validate a new typology of buying behaviors based on the wide variety of motives that may stimulate
purchases. Our assumption was that even though the reasons for making a purchase are numerous, it
should be possible to come up with a new typology of purchase decisions based on a limited number of
underlying dimensions that parsimoniously describes the buying behaviors commonly encountered in
practice. As shown below, this assumption proved correct, and we will propose a new typology called the
purchase cube, which distinguishes eight purchase behaviors based on three underlying dimensions.
Study 1: Development of the New Typology
Method
Participants. A total of 306 undergraduate marketing students participated in the study to fulfll
a course requirement. The data were collected in twenty-three sessions, with 3 to 24 people par-
ticipating at any one time. Approximately 51 percent of the participants were female, and 298
respondents provided complete data.
Materials and Procedures. Participants were given a short questionnaire that contained the instruc-
tions and the stimuli to be classifed. The instructions stated:
On the next page you will fnd a table listing reasons that consumers mentioned for why they
bought certain things. These reasons refect different motivations for making a purchase, and
we will refer to them as purchase behaviors for short. We would like you to read through
this list and then classify the purchase behaviors into groups according to how you think
they belong together. You can form as many or as few groups as you think appropriate.
There are no right or wrong answers. Classify all purchase behaviors into groups, and put
each behavior into only one group.
An example dealing with the categorization of four different vegetables was provided to clarify
the task. Participants were reminded to read through the entire list before starting the classifcation,
and to take their time and classify all purchase behaviors carefully.
On the second page there was a list of forty-four different purchase behaviors. The list was as-
sembled based on an extensive review of the academic literature dealing with different types of
purchase decisions and various consumer behavior textbooks. Table 1.1 on page 20 lists the purchase
behaviors alphabetically by their acronyms, which will be used later. In the questionnaire the behaviors
were arranged in random order. Participants were told to classify the purchase behaviors by putting
the same number in front of each behavior that they thought belonged in the same group.
Analysis. The similarity between each pair of purchase behaviors was computed as the proportion
of respondents who placed the two behaviors into the same category. The resulting 44 by 44 matrix
PURCHASE BEHAVIOR AND A PROPOSAL FOR A NEW TYPOLOGY 19
of similarities was then submitted to a nonmetric multidimensional scaling (MDS) analysis and
average linkage clustering. The data were also analyzed with metric MDS and a cluster analysis
based on Ward’s minimum variance method, which yielded similar results.
MDS solutions in 1 to 4 dimensions produced the following badness-of-ft measures (Kruskal’s
stress formula 1): 0.39, 0.18, 0.08, and 0.05. The three-dimensional solution ft the data well and led
to an interpretable solution, so it was chosen as the most appropriate representation of the data.
Results
Table 1.2 on page 21 reports the coordinates of the forty-four purchase behaviors on the three
dimensions emerging from the MDS analysis. For ease of interpretation, the purchase behaviors
are ranked separately from low to high on each dimension. Interpreting the three dimensions is
relatively straightforward. Dimension 1 separates functional purchase behaviors in the negative
domain (for example., making a replacement purchase, buying something because the purchase
solves a problem, making a purchase based on functional or utilitarian reasons, making a purchase
based on objective, logical criteria) from psycho-social purchase behaviors in the positive domain
(for example, buying something because it’s currently fashionable, making a purchase for emotional
reasons, buying something because it meets with social approval, buying something because of the
status it confers upon you). Dimension 2 may be interpreted as a low- versus high-involvement
continuum. At the low-involvement end are buying something because of habit, making a routine
purchase, buying something that you usually buy, and buying something because you’ve bought
it in the past; and at the high-involvement end are making a purchase based on a careful compari-
son of the available products, buying something because the price is good, making a purchase
based on the quality of the available products, and buying something because it provides the best
value. Dimension 3 distinguishes purchase behaviors that occur spontaneously (such as buying
something out of curiosity, making an unplanned purchase, making purchases more or less ran-
domly, buying something to try it out) from purchase behaviors that are undertaken deliberately
(for example, buying a particular product because of the brand name, buying a brand to project a
certain image, buying a particular product because of the reputation of the brand, buying a brand
because of its style).
The frst two dimensions are similar to those used in the FCB or Rossiter, Percy, and Dono-
van grids. The third dimension is new, although it bears some semblance to Howard and Sheth’s
(1969) dimension of familiarity with the product class or the brands within the product class, and
to Bagozzi’s (1983) dimension of extent of prior learning (which he sees as distinct from degree
of involvement). The third dimension can be seen as introducing an additional dimension of varia-
tion into each quadrant of the FCB grid. To simplify the presentation, this dimension has been
dichotomized in Figure 1.1 (on page 23), and the left-hand grid shows the spontaneous purchase
behaviors and the right-hand grid the deliberate purchase behaviors. Although this obscures dif-
ferences in the extent to which purchase behaviors are spontaneous or deliberate, it simplifes the
graphical presentation of the fndings and enables an explicit comparison with the well-known
FCB grid. In Figure 1.1, ellipses have been drawn around purchase behaviors that are grouped
together in the cluster analysis.
Figure 1.1 suggests a distinction among eight different purchase behaviors, corresponding to
the eight cells of a 2 × 2 × 2 design obtained by dichotomizing the three dimensions of the MDS
analysis into functional versus psycho-social purchases, low versus high purchase involvement,
and spontaneous versus deliberate purchases. We will refer to this scheme as the purchase cube
(see Figure 1.2, page 24 and Baumgartner 2002).
20 HANS BAUMGARTNER
Table 1.1
Alphabetical Listing of Forty-four Purchase Behaviors by Acronym
Brand name Buying a particular product because of the brand name
Change Buying something for a change of pace
Comparison Making a purchase based on a careful comparison of the available products
Convenience Buying something out of convenience
Curiosity Buying something out of curiosity
Emotion Making a purchase for emotional reasons
Familiarity Buying a brand because you’re familiar with it
Fashion Buying something because it’s currently fashionable
Feel good Buying something because it makes you feel good
Fun Buying something just for the fun of it
Habit Buying something because of habit
Image Buying a brand to project a certain image
Impulse Buying something on impulse
Liking Buying something because you just like it
Logic Making a purchase based on objective, logical criteria
Loyalty Buying a brand because you’re loyal to it
Mindless Buying something mindlessly
Past purchase Buying something because you’ve bought it in the past
Performance Buying something because of its superior performance
Personality Buying something because the product expresses your personality
Preference Buying a brand because of a strong preference for it
Price Buying something because the price is good
Problem solving Buying something because the purchase solves a problem
Quality Making a purchase based on the quality of the available products
Random Making a purchase more or less randomly
Replacement Making a replacement purchase
Reputation Buying a particular product because of the reputation of the brand
Routine Making a routine purchase
Sale Buying something because it’s on sale
Satisfaction Buying a brand because you’ve been satisfed with it in the past
Self-esteem Buying something because it makes you feel good about yourself
Senses Buying something because of the way it looks, sounds, feels, tastes, or smells
Social approval Buying something because it meets with social approval
Status Buying something because of the status it confers upon you
Style Buying a brand because of its style
Thoughtless Buying something without thinking much about it
Time pressure Making a purchase under time pressure
Trial Buying something to try it out
Unplanned Making an unplanned purchase
Usual Buying something that you usually buy
Utilitarian Making a purchase based on functional or utilitarian reasons
Value Buying something because it provides the best value
Variety Buying something because of a desire for variety
Want Buying something because it is what you want
PURCHASE BEHAVIOR AND A PROPOSAL FOR A NEW TYPOLOGY 21
Table 1.2
Placement of the 44 Purchase Behaviors Along the 3 MDS Dimensions (Study 1)
Dimension 1 Dimension 2 Dimension 3
Replacement –1.60 Habit –1.39 Unplanned –1.93
Problem solving –1.60 Routine –1.32 Curiosity –1.93
Utilitarian –1.48 Usual –1.27 Random –1.89
Logic –1.47 Past purchase –1.23 Trial –1.88
Comparison –1.36 Thoughtless –1.19 Time pressure –1.80
Quality –1.11 Loyalty –1.19 Impulse –1.79
Value –1.06 Familiarity –1.08 Variety –1.59
Routine –0.98 Satisfaction –1.03 Change –1.58
Past purchase –0.91 Mindless –1.02 Fun –1.56
Usual –0.87 Liking –0.84 Mindless –1.40
Habit –0.86 Preference –0.82 Sale –1.26
Price –0.81 Convenience –0.70 Convenience –1.17
Convenience –0.79 Want –0.59 Thoughtless –0.80
Performance –0.78 Random –0.50 Price –0.68
Satisfaction –0.77 Replacement –0.41 Replacement –0.45
Familiarity –0.69 Impulse –0.41 Problem solving –0.24
Time pressure –0.62 Brand name –0.28 Emotion 0.15
Sale –0.59 Unplanned –0.20 Value 0.16
Loyalty –0.58 Self-esteem –0.20 Liking 0.20
Preference –0.48 Feel good –0.17 Want 0.28
Thoughtless –0.19 Personality –0.05 Habit 0.33
Mindless 0.08 Fun –0.05 Comparison 0.34
Reputation 0.11 Time pressure –0.04 Routine 0.38
Random 0.22 Emotion 0.04 Utilitarian 0.51
Unplanned 0.30 Reputation 0.23 Quality 0.54
Liking 0.41 Trial 0.26 Logic 0.55
Want 0.42 Curiosity 0.27 Usual 0.55
Brand name 0.47 Style 0.33 Past purchase 0.59
Impulse 0.55 Change 0.38 Senses 0.62
Curiosity 0.74 Image 0.40 Self-esteem 0.85
Senses 0.79 Status 0.49 Personality 0.85
Trial 0.84 Performance 0.57 Familiarity 0.86
Variety 0.91 Variety 0.62 Feel good 0.86
Feel good 0.91 Social approval 0.62 Satisfaction 0.89
Change 1.05 Fashion 0.63 Loyalty 0.90
Fun 1.12 Senses 0.73 Fashion 1.04
Image 1.14 Utilitarian 0.88 Preference 1.11
Self-esteem 1.15 Problem solving 1.11 Performance 1.17
Style 1.19 Logic 1.27 Social approval 1.25
Personality 1.27 Sale 1.28 Status 1.30
Status 1.35 Value 1.35 Style 1.31
Social approval 1.51 Quality 1.39 Reputation 1.44
Emotion 1.52 Price 1.51 Image 1.46
Fashion 1.55 Comparison 1.61 Brand name 1.47
22
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PURCHASE BEHAVIOR AND A PROPOSAL FOR A NEW TYPOLOGY 23
Starting with the spontaneous half of the purchase cube, purchases that are based mostly on
functional considerations and demand a fair amount of purchase involvement are called promo-
tional purchases. Buying something because the price is good and buying something because it’s
on sale represent this type of purchase behavior. Purchases that are psycho-social in nature and
above average in purchase involvement are called exploratory purchases. Variety-seeking behav-
ior, purchases motivated by curiosity, and trial purchases are classifed in this category. Buying
something just for the fun of it is also included in this group in the cluster analysis, although it
Low purchase
involvement
High purchase
involvement
Functional
purchases
Psycho-social
purchases
Spontaneous purchases
Deliberate purchases
Spontaneous purchases
Promotional
purchases
Exploratory
purchases
Casual
purchases
Impulsive
purchases
Deliberate purchases
Extended
purchase
decision
making
Symbolic
purchases
Repetitive
purchases
Hedonic
purchases
Figure 1.2 The Purchase Cube: A Three-Dimensional Typology of Purchase Behaviors
Note: Based on Baumgartner (2002).
24 HANS BAUMGARTNER
is also close to impulse purchases in Figure 1.1 and may be considered an example of hedonic
purchases (to be discussed later). Functional, uninvolving purchases are called casual purchases.
They include mindless purchases, purchases motivated by convenience, and purchases made
under time pressure, although the latter are more involving than purchases that are given little or
no thought. Finally, psycho-social purchases that are below average on purchase involvement will
be referred to as impulsive purchases. Besides unplanned purchases, this category also includes
purchases that are made more or less randomly, which is consistent with the often capricious
nature of impulsive buying behavior.
Turning to the deliberate half of the purchase cube, high-involvement purchase behavior based on
functional criteria is called extended purchase decision making. In addition to purchases for which
utilitarian and logical considerations are important, this group includes purchases that entail a careful
comparison of alternatives, purchases that necessitate problem-solving activities, and purchases that
involve an evaluation of the performance, quality, and value of the available alternatives. Functional
purchases that are low in involvement are called repetitive purchases. Based on the cluster analysis
results, two subgroups can be distinguished. One group includes purchases of products that the
consumer knows and likes, and thus buys with some degree of loyalty. The other group includes
habitual or routine purchases. Purchases that are made for psycho-social reasons and are somewhat
higher in involvement are called symbolic purchases. Again, two categories of purchase behaviors
can be distinguished. One deals with social motivations for buying things. This includes buying a
brand to project a certain image, making a purchase because of the status it confers or because it
meets with social approval, buying products that are fashionable or in style, and purchasing brands
because of their name or reputation. The other taps more psychological purchase motives, such as
buying a product because it expresses your personality, making a purchase for emotional reasons,
or buying something because it makes you feel good about yourself. Sensory purchases are also
included in this latter category. Finally, psycho-social purchases that are relatively low in involve-
ment are called hedonic purchases. This includes buying something because you like it and buying
something because it is what you want. Purchase behaviors such as buying something because it
makes you feel good and buying something because of the way it looks, sounds, feels, tastes, or
smells would also seem to belong in the hedonic group, and in fact in the cluster analysis solution
based on Ward’s method, the psychologically motivated symbolic purchase behaviors (feel good,
self-esteem, personality, emotion, and senses) are grouped together with the two hedonic purchase
behaviors. However, in the MDS solution this more inclusive category of hedonic purchases is not
well separated from the socially motivated symbolic purchase behaviors.
Some additional comments are in order to illuminate the meaning of the purchase behav-
iors distinguished in the purchase cube. First, one strength of the proposed typology seems
to be that it clarifes the differences between symbolic purchases, exploratory purchases,
hedonic purchases, and impulsive purchases, although additional empirical research is
called for to substantiate these differences. Symbolic purchases and exploratory purchases
are similar in that psycho-social motives are the primary motivators and both are relatively
high in involvement. However, they differ in whether the purchase is made deliberately or
spontaneously. The same is true for hedonic and impulsive purchases, which are stimulated
by psycho-social motives and are relatively low in involvement, but differ in whether they
are made deliberately or spontaneously. It should be noted that hedonic is used in a specifc
sense in the present context, referring not simply to purchases made for psycho-social reasons
(which is one meaning of hedonic), but more specifcally to purchases that are also deliberate
and relatively low in involvement.
Second, promotional purchases are similar to purchases made through extended purchase
PURCHASE BEHAVIOR AND A PROPOSAL FOR A NEW TYPOLOGY 25
decision making, but a good price or a sale can turn an otherwise deliberate purchase into a more
spontaneous one, which seems consistent with actual practice. Third, exploratory purchases (includ-
ing purchases motivated by a desire for variety) are not made randomly or thoughtlessly and with
a minimum of involvement (and if they are made that way, they are not exploratory purchases in
the sense used here). Instead, they involve some effort and care because the goal is to complicate
an otherwise routine buying process.
Finally, at frst sight it might seem odd that purchases can be high in involvement and spontane-
ous, or low in involvement and deliberate. However, a somewhat similar distinction is also made by
Bagozzi (1983), who uses degree of involvement and extent of prior learning in his classifcation
of consumer choice processes. A buying decision may be low in involvement (because it requires
little effort and care), yet it is made deliberately based on prior experience with the product or
brand. On the other hand, a purchase may be highly involving although the buying decision is
made relatively spontaneously. More detail concerning the distinction between the two dimensions
will be provided in the third study.
Study 2: Validating the New Typology
In the second study we attempted to validate the fndings of Study 1 by using a different task.
Participants were given a specifc product category and were asked to rate how well each of
the forty-four purchase behaviors (reasons for purchasing things) described the purchase of the
product in question.
Method
Participants. The respondents who participated in Study 1 completed a second task, and these data
were used to validate the new purchase typology. As in the frst study, 298 participants provided
complete data.
Materials and Procedures. Respondents were asked to rate to what extent each of forty-four
different reasons for purchasing things accurately described the purchase of a certain product.
Participants were told that, if possible, it might be helpful to think of a time or times when they
had purchased the product in question. A fve-point rating scale ranging from “does not describe
it at all” to “describes it very well” was used to collect the data.
Forty different products were used in the study. They were selected from Figure 1.1 in Ratchford
(1987), such that ten products represented each of the four quadrants of the FCB grid: think versus
feel, and low versus high involvement. An attempt was made to choose products that spanned both
dimensions of the FCB grid and that were meaningful to undergraduate students. The products
are listed in Table 1.3. Participants responded to only one product, so that each product was rated
by seven or eight people.
Analysis. Two sets of analyses were performed on the data. First, multidimensional scaling (MDS)
was used to investigate whether the classifcation of purchase behaviors proposed in Study 1 would
emerge again. To this end, the data of respondents rating the same product were averaged and
correlations were computed between each of the forty-four purchase behaviors across the forty
products. These correlations were then converted to Euclidean distances using the transformation
U − , and the resulting matrix of dissimilarities was submitted to nonmetric MDS. The badness
of ft measures in one to four dimensions were .43, .13, .07, and .05, and the corresponding cor-
26 HANS BAUMGARTNER
relations between the actual and ftted distances were .66, .95, .98, and .99. The three-dimensional
solution was again judged to be the best representation of the data.
Second, a confrmatory factor analysis was conducted on respondents’ ratings of each product
across the forty-four purchase behaviors. Eight factors were specifed a priori, and each purchase
behavior was initially hypothesized to load on only one factor based on Figure 1.1 (that is, the
circles are the eight factors, and the purchase behaviors within each circle are assumed to load
on the factor). Based on goodness-of-ft considerations, the model was subsequently respecifed
slightly as described in more detail below.
Results
MDS Results. Using oblique Procrustes rotation, the initial three-dimensional MDS solution was
rotated to make it maximally congruent with the three-dimensional MDS solution from Study 1.
After rotation, the corresponding dimension coeffcients from the two solutions correlated
0.91, 0.77, and 0.86 for functional vs. psycho-social purchases, low vs. high purchase involvement,
and spontaneous vs. deliberate purchase behaviors, respectively. The highest correlation between
noncorresponding dimensions across the two studies was 0.23, and the correlations between the
dimension coeffcients in Study 2 were -.02, -.09, and .27 (the highest correlation being between
purchase involvement and deliberateness of the purchase). These fndings indicate that, overall, the
MDS solutions from the two studies are quite similar and that the three-dimensional representation
of purchase behaviors uncovered in Study 1 could be replicated using a different task in which
respondents were not explicitly asked to classify reasons for purchase.
Figure 1.3 displays the results of Study 2 graphically. As in Figure 1.1, the fndings are presented
separately for spontaneous and deliberate purchase behaviors. The four types of spontaneous
purchase behavior are generally situated in the hypothesized quadrant, except that exploratory
purchases (particularly trial purchases and curiosity-motivated purchases) are too low in involve-
ment so that they are not well separated from impulsive purchase behavior. Furthermore, problem-
solving purchases and routine purchases are not deliberate enough and are thus classifed with
the spontaneous purchase behaviors. The four types of deliberate purchase behavior also occupy
the hypothesized quadrant. The only discrepancies with Study 1 are that brand name purchases
Table 1.3
Products Used in Study 2
High-involvement
think products
High-involvement
feel products
Low-involvement
think products
Low-involvement
feel products
Auto insurance Sports car Insecticide Inexpensive watch
Console TV Expensive watch Suntan lotion Greeting card
Stereo component Wallpaper Salad oil Pizza
Portable TV Hair coloring Dry bleach Deodorant soap
35 mm camera Perfume Insect repellent Peanut butter
Instamatic camera Wine for dinner party Regular shampoo Magazine
Motor oil Complexion/face soap Liquid bleach Diet soft drink
Headache remedy Coffee Non-disposable razor Regular soft drink
Washer/dryer Eyeglasses Disposable razor Salty snack
Economy car Jeans Paper towel Regular beer
27
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28 HANS BAUMGARTNER
and purchases based on the reputation of the brand are situated in the functional half of the grid,
and that purchases based on a strong preference for the brand, sensory purchases, and purchases
motivated by fun are classifed as hedonic purchases. The latter result is actually more in line
with a priori expectations than with the fndings of the frst study. Overall, the results of Study 1
are replicated well.
Confrmatory Factor Analysis Results. The initial confrmatory factor model did not ft the data
well (χ
2
874
= 2830.53, p < .0001, RMSEA = .087, CFI = .73, TLI = .70). The model was respeci-
fedbysplittingtherepetitivepurchasefactorintotwosubfactors—loyaltypurchases,consisting
of preference, satisfaction, familiarity, past purchase, loyalty, reputation, and brand name; and
habitualpurchases,consistingofusual,routine,andhabit—andrelaxingthirty-sevennon-target
loadings. Of these, eighteen were below .3. The resulting solution achieved an acceptable ft (χ
2
829

= 1611.83, p < .0001, RMSEA = .056, CFI = .89, TLI = .88), and the matrix of factor loadings is
shown in Table 1.4. The loadings of items defning a particular factor are shown in boldface. The
results are very similar to the MDS solution and for the most part consistent with the results of
Study 1. The following discrepancies are apparent. First, buying something because it provides
the best value loads most highly on the promotional purchase factor. This is consistent with one
ofthemeaningsofvalueidentifedbyZeithaml(1988)—valueasthebestpriceavailable.Buying
something under time pressure has the highest loading on the impulse purchase factor, which also
includes unplanned and random purchases. Making a replacement purchase loads about equally
strongly on extended purchase decision making and habitual purchase behavior, which is consistent
with its placement between these two purchase types in Figure 1.1. It is also consistent with the
ambiguous nature of replacement purchases, because for infrequently bought, high-involvement
products, a replacement purchase may entail extended decision making, while for frequently
purchased, low-involvement products, replacement purchases are probably more habitual. Buying
something because of the reputation of the brand and purchasing a brand because of its name load
most strongly on the loyalty purchase factor, and sensory purchases have the highest loading on
hedonic purchase behavior. Both fndings are consistent with the MDS results.
Although repetitive purchase behaviors are split into two subfactors, they are fairly highly cor-
related at .70. Several other interfactor correlations are substantial as well; impulsive and casual
purchase behaviors are correlated .81, impulsive and exploratory purchases .66, symbolic purchases
and exploratory purchases .66, and loyal purchases and extended decision making .61.
Study 3: Validating the Interpretation of the Three Dimensions of the New Typology
The three dimensions of the new typology of purchase behaviors were interpreted as functional
vs. psycho-social purchases, low- vs. high-involvement purchases, and spontaneous vs. deliberate
purchases. This interpretation was largely based on intuitive grounds and on what is known about
the different types of purchase behaviors. In the case of functional vs. psycho-social purchases, the
name chosen for this dimension is probably least controversial. Previous authors have frequently
distinguished purchases that are motivated either by utilitarian considerations such as quality,
price, familiarity, and convenience, or by nonfunctional concerns about how a product makes one
feel or how it makes others feel about oneself. Since many of the purchase behaviors that respon-
dents classifed directly refect these underlying motivations, it was relatively straightforward to
interpret the frst dimension.
The interpretation of the remaining two dimensions is not nearly as clear cut. First, what does
involvement in a purchase really mean? Does it refer to the personal relevance or importance of
PURCHASE BEHAVIOR AND A PROPOSAL FOR A NEW TYPOLOGY 29
Table 1.4
Confrmatory Factor Analysis Results
F1 F2 F3 F4 F5 F6 F7 F8 F9
Price 0.75
Sale 0.77
Value 0.54 0.21
Convenience 0.26 0.54
Mindless 0.79 –0.20
Thoughtless 0.92 –0.32
Variety 0.64
Change 0.78
Curious 0.91 –0.39
Trial 1.04 –0.54
Fun 0.74
Unplanned 0.69
Impulse 0.18 0.88
Random 0.73
Time pressure 0.14 0.65 0.20 –0.33
Comparison 0.67 –0.24 0.25
Quality 0.17 0.62
Logic 0.93 –0.47
Problem solving 0.34 0.45 –0.45
Utilitarian 0.38 0.96 –0.53 –0.32
Performance 0.68
Preference –0.17 0.55 0.19 0.35
Satisfaction 0.72
Familiarity 0.81
Past purchase 0.78
Loyalty .22 0.64 0.20
Reputation –0.29 0.68 0.32
Name 0.59 0.27
Usual 0.19 0.63 0.15
Routine –0.40 1.12
Habit 0.77
Replacement 0.48 –0.44 0.53
Fashion 0.82
Social approval 0.73
Status 0.80
Image 0.77
Style 0.14 0.78
Emotion 0.21 0.58
Feel good 0.77
Personality –0.13 0.81
Self-esteem 0.86
Want 0.19 0.78
Liking 0.86
Senses 0.27 0.48
Note: F1—promotional purchase behavior; F2—casual purchase behavior; F3—exploratory purchase behav-
ior; F4—impulsive purchase behavior; F5—extended purchase decision making; F6—loyalty purchase behavior;
F7—habitual purchase behavior; F8—symbolic purchase behavior; F9—hedonic purchase behavior.
30 HANS BAUMGARTNER
a purchase in general, the riskiness of a purchase more specifcally (as suggested by Rossiter,
Percy, and Donovan 1991), or the amount of care required by a purchase and the degree of effort
expended on it? Second, is the interpretation of the third dimension as spontaneous vs. deliberate
purchases appropriate, and what other aspects of purchase behavior (such as previous experience
with purchasing the product, prior planning of the purchase) can be used to characterize such
purchases? Third, how do high-involvement purchases differ from deliberate purchases? In the
frst validation study, high-involvement products selected from Ratchford’s work on the FCB grid
were also products that were purchased deliberately, so the issue of discrimination arises.
To answer these questions and, more generally, to validate the interpretation of the three MDS
dimensions uncovered in Studies 1 and 2, we conducted another study in which respondents
were asked to rate the forty-four purchase behaviors on a number of specifc scales. The scales
were selected to represent different meanings of the three presumed MDS dimensions in terms
of functional vs. psycho-social purchases, purchase involvement, and spontaneous vs. deliberate
purchases.
Method
Participants. A total of seventy-seven undergraduate marketing students participated in the study
to fulfll a course requirement. Seventy-fve respondents, 56 percent of whom were female, pro-
vided complete data.
Materials and Procedures. Participants were asked to rate the forty-four purchase behaviors from the
previous two studies on seventeen scales. Since collecting seventeen ratings for each of forty-four
purchase behaviors was thought to be too tiresome, the purchase behaviors were split in half and
each respondent was randomly assigned to rate one of the halves. For one of the groups, “buying
something compulsively” was added to the list of purchase behaviors. This purchase type was omitted
in the earlier studies but was thought to be relevant to the classifcation of purchase behaviors.
The seventeen scales used to characterize the purchase behaviors were: rational-emotional, thinking-
feeling, unexciting-exciting, not fun-fun, not pleasurable-pleasurable, boring-interesting, says nothing-
something about me, does not require-requires care, effortless-effortful, unimportant-important, not
personally-personally relevant, not risky-risky, spontaneous-deliberate, does not follow-follows a script,
unintended-intended, little-lot of previous experience, unplanned-planned. Respondents were asked to
rate whether purchases of a given type tended to be rational or emotional, involved thinking or feeling,
and so forth. A seven-point scale was used to collect the ratings.
Analysis. Property ftting was employed to determine how well each of the seventeen scales
described the dimensions identifed in the previous two studies. Specifcally, for each purchase
behavior, we computed the average value of a purchase type (for example, buying a particular
product because of the brand name) on a given scale (for example, rational-emotional) across all
respondents who rated that purchase behavior. These average scores were then regressed on the
dimension coeffcients from Studies 1 and 2. The results can be interpreted like a loading matrix
in factor analysis to interpret the meaning of each dimension in an MDS analysis.
Results
The property ftting results are shown in Table 1.5. High loadings of a dimension on a given scale
have been highlighted to aid in the interpretation of the solution. The fndings are very similar
31
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32 HANS BAUMGARTNER
for the dimension coeffcients from the two studies, so we will focus on the fndings from the
frst study.
The adjective pairs rational-emotional and thinking-feeling are most closely related to the frst
dimension, which confrms the interpretation of this dimension as contrasting functional (think-
ing) psycho-social (feeling) purchases. The adjective pairs unexciting-exciting, not fun-fun, not
pleasurable-pleasurable, and boring-interesting are also substantially related to the frst dimension.
This indicates that functional purchases are rated as relatively unexciting and boring, and as low
in fun and pleasure. Contrary to expectations, says nothing-something about me does not describe
the frst dimension and in fact is not strongly related to any dimension.
Dimension 2 is mostly associated with the two items does not require-requires care and effortless-
effortful. It does not have a strong relationship with unimportant-important and not personally-
personally relevant. Interestingly, the regression coeffcients for the item not risky-risky indicate
that both psycho-social purchases and spontaneous purchases are thought to be risky. Riskiness is
not related to involvement, so the meaning of involvement in the present case is somewhat differ-
ent from the way it is usually conceptualized. Involvement in the present usage refers specifcally
to the degree of care required by a purchase or the amount of effort expended on the purchase.
It does not refer to importance or personal relevance in general or the riskiness of a purchase. In
other words, purchase involvement is not systematically related to the importance or relevance
of the product per se (that is, even a high-involvement product may require little purchase effort
if strong prior attitudes guide the purchase). In a similar way, riskiness of the purchase is not
a systematic correlate of purchase involvement, because even though a high-risk product may
require a more careful purchase process, not devoting much effort to the buying decision also
makes the purchase risky.
Dimension 3 is closely related to spontaneous-deliberate, does not follow-follows a script,
unintended-intended, little-lot of previous experience, and unplanned-planned. Thus, as hy-
pothesized, this dimension captures differences in deliberateness, prior planning, and previous
experience. The slight negative correlations of these items with the frst dimension indicate that
there is some tendency for deliberate purchases to be functional or, conversely, for spontaneous
purchases to involve feeling.
Discussion and Conclusion
A classifcation of forty-four different purchase behaviors refecting various purchase motives
yielded a typology of eight distinct types of purchase behavior based on three underlying dimensions
(functional vs. psycho-social purchases, low vs. high purchase involvement, and spontaneous vs.
deliberate purchases). The typology was replicated using a task in which respondents rated how well
the forty-four different purchase behaviors described the purchase of forty different products, and
the interpretation of the three underlying dimensions was validated by assessing the correspondence
between the placement of the forty-four purchase behaviors along the three dimensions and direct
ratings of the purchase behaviors on hypothesized descriptors of the three dimensions.
It is instructive to contrast the purchase types on opposite poles of the diagonals through the
purchase cube. There are four different contrast pairs: extended purchase decision making vs.
impulsive purchase behavior, symbolic purchase behavior vs. casual purchase behavior, repetitive
purchase behavior vs. exploratory purchase behavior, and hedonic purchase behavior vs. promo-
tional purchase behavior. All four pairs differ on all three underlying dimensions. For example, while
extended purchase decision making is functional, high in purchase involvement, and deliberate,
impulsive purchase behavior is psycho-social, low in purchase involvement, and spontaneous. Prior
PURCHASE BEHAVIOR AND A PROPOSAL FOR A NEW TYPOLOGY 33
research has emphasized the contrast between repetitive purchase behavior (habit) and exploratory
purchase behavior (variety seeking), particularly in the modeling literature (e.g., Kahn, Kalwani,
and Morrison 1986). The contrast between extended purchase decision making and impulsive
purchase behavior is at least implicit in some of the literature on impulsive buying behavior (Puri
1996). The contrast pairs symbolic purchase behavior vs. casual purchase behavior and hedonic
purchase behavior vs. promotional purchase behavior are less well established, and more detailed
study of these pairs might shed light on the categories of casual and promotional purchase behav-
iors, which are probably the least clearly defned purchase types in the purchase cube.
The next step in further developing the proposed typology of purchase behaviors would be
to delineate each type in greater detail, review what we already know about each kind of buying
behavior, and identify opportunities for future research. At present, discussions of the purchase
process in consumer behavior textbooks are focused too much on extended purchase decision
making, which characterizes only a small portion of the purchases that consumers actually make.
Development of mini-theories for all eight types of purchase behaviors would seem to be a promis-
ing avenue for the construction of a more comprehensive theory of buyer behavior.
Acknowledgments
The author acknowledges helpful comments on previous versions of this chapter by Lisa Bolton,
Kunter Gunasti, Meg Meloy, Bill Ross, and participants of the marketing proseminar at Penn
State.
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37
chaptEr 2
MEASURING CUSTOMER LIFETIME VALUE
Models and Analysis
siddharth s. siNGh aNd dipaK c. JaiN
Abstract
This chapter focuses on the literature related to customer lifetime value (CLV) measurement. It
frst discusses the issues related to the context of CLV measurement and presents a contextual
framework for understanding and categorizing models of CLV. The chapter then reviews some
prominent models for measuring customer lifetime value in different contexts and discusses the
strengths and weaknesses of each. Finally, the chapter discusses the key issues that need to be
addressed to advance the literature.
Introduction
The last few years have seen an explosion of research into customer lifetime value (CLV).
1
This
has followed the increased focus of frms on customer relationship management (CRM), where
frms consider their interactions with customers over the entire duration of the customer-frm re-
lationship, also called customer lifetime, to improve proftability. To evaluate strategies in CRM,
frms need to measure their impact. This is where CLV enters the picture. It is used as a metric to
evaluate actions of the frm (Borle, Singh, and Jain 2008; Gupta and Zeithaml 2006).
2
Defnition of Customer Lifetime Value (CLV)
The literature has generally defned CLV in ways that differ subtly. For example, Dwyer (1997)
defnes lifetime value as the present value of the expected benefts (for example, gross margin) less
the burdens (for example, direct costs of servicing and communicating) from customers. Kumar,
Ramani,andBohling(2004)defneCLVasthesumofcumulatedcashfows—discountedusing
theweightedaveragecostofcapital—ofacustomeroverhisorherentirelifetimewiththefrm.
Berger and Nasr (1998) quote Kotler and Armstrong (1996) to defne a proftable customer as “a
person, household, or company whose revenues over time exceed, by an acceptable amount, the
company costs of attracting, selling, and servicing that customer.” They refer to this excess as
customer lifetime value.
Although they appear to be similar at frst glance, it is important to note the differences in the
defnitions. In the frst, by Dwyer (1997), expected benefts from a customer can be interpreted
38 SIDDHARTH S. SINGH AND DIPAK C. JAIN
broadly to include both direct benefts through direct revenues from the customer and indirect
benefts such as through word-of-mouth effect. Also, since this defnition considers only the
expected benefts and costs, it ignores the past (such as cost of customer acquisition and realized
revenues from a customer). While the defnition by Kumar, Ramani, and Bohling (2004) focuses
on the cash fows from a customer and does not consider costs, that of Berger and Nasr (1998)
does consider costs, including the cost of customer acquisition.
As far as benefts from a customer are concerned, the CLV models developed so far generally
focus on the revenue stream from a customer and do not account for the network benefts. The
next step in the development of these models has to consider important factors such as word-of-
mouth and other network effects (such as participation in customer communities) in valuing a
customer. It is well recognized in the literature and the popular press that such network effects
due to a customer add to the value of a customer and are part of CLV (e.g., Lee, Lee, and Feick
2006). While some researchers have attempted to deal with this issue by separating CLV from the
network effects such as the word-of-mouth effect (Kumar, Petersen, and Leone 2007), this only
underscores the issue that we raise here. Since word-of-mouth and other network effects impact
the value of a customer to the frm, these should be part of CLV.
ThedifferencesinthedefnitionsofCLV—thebasicfoundationofthisliterature—highlight
the need for developing clear defnitions of key terms. We believe that the defnition by Dwyer
(1997) is broad enough to include important factors such as the word-of-mouth effect. Therefore,
in this paper we will consider the CLV defnition according to Dwyer. In case of prospects (that
is, potential customers), we recommend using the term prospect lifetime value (PLV) instead of
customer lifetime value (CLV), where PLV includes all the factors considered in CLV in addition
to the cost of customer acquisition. In this chapter however, for simplicity we will henceforth use
the term CLV to include both CLV and PLV.
Measurement of CLV
For CLV to be effectively used as a metric, frms need to measure it. Therefore, as a logical next
step in the development of this literature, many researchers have focused on developing models to
measure CLV. These models provide a way to estimate CLV given the nature of the customer-frm
relationship and the data available. The models incorporate factors that affect CLV to the extent
possible for an accurate measure. However, this is a challenging task. Figure 2.1 shows the main
factors that infuence CLV, underscoring the complexity underlying CLV and the challenges in
measuring it accurately.
To aid the users of CLV models, there is a need to categorize these models (or methods for
estimating CLV) more clearly based on some reasonable criteria that can be used to easily choose
between the alternative methods for any specifc application. Understanding the strengths and
limitations of each method within a proper context allows a user to apply them intelligently.
We will discuss the contexts where some of the key proposed models can be used, the strengths
and limitations of each model, and the challenges that lie ahead in further developing this literature.
The chapter is organized as follows. The second section discusses various contexts of the customer-
frm relationship and why an understanding of these contexts is important for the measurement
of CLV. It also presents a contextual framework to organize the literature in a meaningful way.
The following section discusses some prominent models proposed for measuring CLV in different
contexts and the strengths and limitations of each. The fourth section discusses some important
issues that need to be addressed in order to take the literature to the next level, and the fnal sec-
tion summarizes the chapter.
MEASURING CUSTOMER LIFETIME VALUE 39
Context of Customer Lifetime Value Measurement
A review of the customer lifetime value literature (Borle, Singh, and Jain 2008; Fader, Hardie, and
Lee 2006a; Venkatesan and Kumar 2004; Reinartz and Kumar 2000 and 2003; Bolton 1998; Bhat-
tacharya 1998) soon reveals that the context of CLV measurement plays a key role in the methods
proposed for measuring CLV and the issues that become important both from a modeling point
of view and the managerial point of view. By context, we mean the context of the customer-frm
relationship that generated the data to be used for estimating CLV. From a modeling perspective, the
context defnes the data available to estimate a CLV model, and from a managerial perspective, the
context defnes the issues that become important in managing customer proftability. The importance
of the context of customer-frm relationship for modeling CLV, however, is not well understood
by either managers or educators, as is evident commonly both in the use and teaching of CLV
(Fader, Hardie, and Lee 2006a). We feel that this lack of understanding is a signifcant roadblock
to providing prescriptions for use of different models in different managerial situations.
To understand the importance of context, consider the following examples: (a) grocery purchases
from a retail outlet, (b) purchases from a direct marketing catalog, (c) child-care services, and
(d) subscription services (for example, magazine and cable television). In most contexts such as (a)
and (b), the frm does not know when a customer defects. After purchasing, if a customer does not
purchase for a long time, what does that mean? Is the customer still “active,” or has the customer
defected? One key implication of this uncertainty is that the frm has to manage both customer
retention and purchases to enhance the lifetime value of a customer. The lack of knowledge of
customer defections (that is, customer lifetime duration) also makes modeling CLV in this context
more challenging.
In contexts such as (c) (child-care services) the frm would know with certainty when a customer
defects. Also, the frm knows that all customers will defect at some point in a few years time no
matter what it does to retain them, because children grow up and do not require child-care services.
Therefore, the focus of the frm is more on up-selling/cross-selling (for example, selling additional
services). Similarly in contexts such as (d) (subscription services) a frm would know when a customer
defects. Here longer customer lifetime implies higher lifetime value. Therefore, the primary focus of
frms is on managing customer retention. In both (c) and (d), knowledge of customer lifetimes makes
it relatively easier to estimate CLV. Note that customers have to be acquired before a frm can sell to
them and retain them. Therefore, customer acquisition is always an important issue.
Figure 2.1 Factors Impacting CLV
Customer Lifetime
Interpurchase Time
Purchases
Returns
Marketing Activities of
Firm
Network Effects (e.g.,
Word-of-Mouth)
Discount Rate
Cost of Customer
Acquisition
Cost of Customer
Retention
Cost of Returns
Cost of Marketing
Activities
Customer
Lifetime Value
(CLV)
Customer Lifetime
Interpurchase Time
Purchases
Returns
Marketing Activities of
Firm
Network Effects (e.g.,
Word-of-Mouth)
Discount Rate
Cost of Customer
Acquisition
Cost of Customer
Retention
Cost of Returns
Cost of Marketing
Activities
Customer
Lifetime Value
(CLV)
40 SIDDHARTH S. SINGH AND DIPAK C. JAIN
Let us now consider the revenue stream from customers in these example contexts. The revenue
stream from a customer in the grocery purchases context (a) or direct marketing catalog purchase
(b) is likely to be stochastic from the frm’s point of view, and therefore customer lifetimes and
proftability relationship are not known to the frm. In the child-care (c) and subscription context
(d), the revenue stream is more predictable. Thus, longer customer lifetime implies higher CLV.
3

Clearly, the context dictates the type of data available to the researcher/frm (for example, whether
completed lifetimes are known or not) and the issues that become important.
Despite the importance of context in CLV research, there has been little systematic study of
the contexts. Various researchers have attempted to divide the context into categories that conve-
niently suited their purpose. The three most common context classifcations are: lost-for-good and
always-a-share, membership and nonmembership, and contractual and noncontractual.
Lost-for-Good and Always-a-Share
Conceived by Jackson (1985) (see also Dwyer 1997), this categorization of industrial buyers
proposes that in a lost-for-good case customers remain in business with the frm until they defect,
andoncetheydefect,theyneverreturn—theyarelostforgood(suchasintelecommunication
system purchases where buyers typically select one vendor). In the always-a-share case, custom-
ers might do business with multiple vendors. Therefore, even if a customer temporarily does
not do business with a frm, he or she has some probability of doing it in future (for example,
purchase of offce supplies).
Dwyer (1997) explains the essence of this categorization and applies it to other businesses,
suggesting that in an always-a-share case, customers can generally evaluate products, adjust their
purchase volume, try new vendors relatively easily, and buy heavily even after periods of inactivity.
An example of this case is catalog buying. In the lost-for-good case, on the other hand, more complex
products are involved and buyers are looking for solutions to complex problems through the purchase.
These customers also depend upon high quality and level of services that come with the purchase.
It suggests that settings involving signifcant resource commitment on the part of the customer or
contracts such as fnancial services and magazine subscriptions are examples of lost-for-good cases.
Customers who defect return to the pool of prospects for possible reacquisition in future.
Although this categorization has been used by researchers (e.g., Rust, Lemon, and Zeithaml
2004; Pfeifer and Carraway 2000; Venkatesan and Kumar 2004), it has limitations and has not
been developed beyond what was presented by Dwyer (1997). For example, consider product
categories such as music, books, and packaged foods that can be purchased commonly through
numerous retail outlets as well as through several music clubs, book clubs, and purchase clubs
such as Sam’s Club. In the latter case, the nature of these products still implies an always-a-share
situation, but there is a contract involved. Thus while the product characteristics suggest putting
them in an always-a-share context, the contract and service characteristics suggest that they belong
to a lost-for-good context, underscoring the limitations of this categorization.
From the perspective of modeling CLV, when a frm has data only on its interactions with its
own customers, which is a very common scenario, the usefulness of this categorization is not clear.
When data concerning customer purchases from multiple vendors is available (such as survey data,
panel data), an always-a-share case can be modeled using something akin to the brand-switching
matrix commonly used in marketing. An example of such a model for estimating customer equity
is Rust, Lemon, and Zeithaml (2004). Hazard rate models can be used to model lifetimes and
subsequently CLV in a lost-for-good case. The important highlight in this categorization is the
consideration of competition that is ignored in other classifcation schemes.
MEASURING CUSTOMER LIFETIME VALUE 41
Membership and Nonmembership
Thisclassifcationputseachcontextintooneofthetwocategories—membershipandnon-mem-
bership. In the membership category, customers have to join a frm as a member before purchasing
from the frm or making use of its services. The other contexts fall under the non-membership
category. Examples are club memberships such as purchase clubs (such as Sam’s Club and Costco),
health clubs (for example, LA Fitness), and direct marketing clubs (such as book clubs or music
clubs). Examples of studies in marketing focusing on the membership context are Borle, Singh,
and Jain (2008), Bhattacharya (1998), and Bhattacharya, Rao, and Glynn (1995).
Although sometimes useful, this categorization has issues that make it less useful than others
because it is based on neither clear customer behavioral differences that have signifcant implica-
tions for measuring CLV nor information that a frm has about its customer that could be used
to estimate CLV. For example, membership is a form of contract; however, all contracts are not
memberships. Does a customer-frm relationship in a membership context lead to different customer
purchase behavior than similar nonmembership contexts where a purchase contract between a
customer and frm exists? Consider a health club that requires membership (a membership context)
and a newspaper subscription (a non-membership context). These are similar in many respects as
far as measuring CLV is concerned. In both cases, the frm knows when a customer defects and it
is relatively easier to make an accurate forecast of the revenue stream from customers. A context
categorization that ignores such similarity is less useful.
Contractual and Noncontractual
This is the most popular categorization of contexts in the CLV literature (e.g., Fader, Hardie, and
Lee 2005a and 2005b; Venkatesan and Kumar, 2004; Reinartz and Kumar, 2000 and 2003). Re-
inartz and Kumar (2000) defne a contractual context as one in which the expected revenues can
be forecast fairly accurately and, given a constant usage of service, increasing cumulative profts
over the customer’s lifetime would be expected. Noncontractual contexts are those in which the
frm must ensure that a relationship stays alive because customers typically split their category
expenses among several frms, for example, department store purchases or mail-order purchases in
the catalog and direct marketing industry. The article further says that customer lifetime analyses
have been conducted typically in contractual settings such as magazine subscriptions and cellular
telephone services.
The characteristics that defne these categories are not clear. For example, the sharing of a
customer’s business by multiple vendors is considered a typical characteristic of a noncontractual
context, but nothing is said about this sharing in a contractual context. It seems that the categoriza-
tion as proposed in its early development is loosely modeled after always-a-share and lost-for-good
context categories, where the former is similar to the noncontractual category and the later is similar
to contractual. One can easily fnd situations (such as a purchase club, for example, Costco or
Sam’s Club) in which the customer-frm relationship possesses characteristics of both categories.
A customer could be a member of multiple purchase clubs that sell similar items.
Other studies that have used this classifcation have attempted to refne it further. Reinartz and
Kumar(2003)saythat“areasinneedofresearcharenoncontractualrelationships—relationships
between buyers and sellers that are not governed by a contract or membership. . . . Given that
switching costs are low and customers choose to interact with the frms at their own volition, this is
a nontrivial question for noncontractual relationships.” Thus this article considers a noncontractual
relationship as one where there is (a) no contract or membership involved, that is, frms do not
42 SIDDHARTH S. SINGH AND DIPAK C. JAIN
observe customer defection; (b) switching costs are low; and (c) customers choose to interact with
the frms as and when they desire. Again we can see that a noncontractual context is considered
similar to an always-a-share context.
Fader, Hardie, and Lee (2005b) say “ . . . noncontractual setting (i.e., where the opportunities
for transactions are continuous and the time at which customers become inactive is unobserved),”
and Venkatesan and Kumar (2004) consider the issues that become important for frms in differ-
ent contexts and say that in contractual contexts managers are interested in predicting customer
retention, while in noncontractual contexts the focus is more on predicting future customer activity
and the predicted contribution margin from each customer because there is always a chance that
the customer will purchase in the future. Therefore, implicitly Venkatesh and Kumar consider a
contractual context where longer customer lifetime implies higher customer value. Borle, Singh,
and Jain (2008) point out this lack of clarity in context categorization in the literature and attempt
to summarize the defnition of contractual and noncontractual contexts based on articles in the
literature. However, they dwell on this issue just enough to highlight the unique characteristics of
the data and do not attempt to provide a better classifcation scheme.
As we can see, researchers have not defned contractual and noncontractual contexts very
clearly, and this classifcation needs further refnement. This is perhaps because no article has
focused primarily on the context issue itself except Fader, Hardie, and Lee (2006a), which we
discuss later. The defnitions of contexts in each paper have been provided on an ad hoc basis just
to defne the parameters of the particular study, leading to the lack of clarity that we have found.
Based on several articles in the CLV literature, we can summarize the defnition of contractual
and noncontractual contexts as follows.
In a contractual context, the frm knows when a customer defects; thus the lifetime of each
customer is known with certainty once that customer defects. The buyer-seller relationship is
governed by a contract or membership. The duration of the customer-frm relationship is closely
tied to the revenue stream from the customer; thus customer lifetime is related to the CLV such that
longer customer lifetime means higher CLV for the frm. Therefore, customer retention becomes
the frm’s primary focus in managing customer relationships. Examples of such contexts would
be utilities, insurance services, cable television, magazine and newspaper subscription services,
some cellular services, and some club memberships. Studies in contractual contexts include Borle,
Singh, and Jain (2008), Thomas (2001), Bolton (1998), Bhattacharya (1998), and Bhattacharya,
Rao, and Glynn (1995).
A noncontractual context is one in which a frm does not know when a customer defects, and
the relationship between customer lifetime and purchase behavior is uncertain (for example,
retailing, catalog purchases, and charity fund drives). Therefore, any model that measures CLV
or investigates the factors driving CLV has to make some assumption about customer lifetime
with the frm. A common approach is to assume exponential customer lifetime distribution (e.g.,
Schmittlein, Morrison, and Colombo 1987; Schmittlein and Petersen 1994; Fader, Hardie, and
Lee 2005a), which may be restrictive in many situations. Another alternative is to assume a fxed
time horizon for CLV prediction. However, such a judgment is likely to vary from one situation
to another, leading to biases in estimation of CLV.
Are the contractual and noncontractual categories as defned in the literature so far adequate?
We fnd this not to be the case. Note that there is heterogeneity in contexts within each category
that has signifcant implications for estimating CLV. For example, within the contractual context,
one can have situations such as a newspaper subscription or a cable TV subscription (where lon-
ger customer lifetime implies higher customer lifetime value) as well as membership contracts
(such as purchase clubs) where customer spending has an unknown relationship with customer
MEASURING CUSTOMER LIFETIME VALUE 43
lifetime duration. Therefore, there is a need for further refnement of the categories to address
these issues.
Fader, Hardie, and Lee (2006a) attempt to refne this categorization by considering contexts along
two dimensions: “continuous time and discrete time” and “contractual and noncontractual.” They
defne the notion of “continuous time” where the customer-frm transaction can occur at any time,
and “discrete time” where transactions can occur only at discrete points in time. And they defne
a contractual case as one in which the time when a customer becomes inactive is observed, and a
noncontractual case as one in which the time when a customer becomes inactive is not observed
by the frm.
4
Based on these two dimensions (that is, types of relationship with customers), they
classify the customer base as shown in Table 2.1.
Although this categorization takes a signifcant step forward by using two dimensions, it can be
refned further. It considers opportunities of transactions and customer defections because variations
in customer behavior and the data available with the frm along these dimensions have signifcant
implications for measuring CLV and the issues that become important for managers. However, spend-
ing by customers during a purchase occasion that is equally important has not been considered.
In Table 2.1 let us focus on the discrete-noncontractual cell, in which are both prescription reflls
and charity fund drives. However, for the frm involved in each case, the issues that are meaningful
are not the same. In a charity fund drive, an organization soliciting funds has to make an attempt to
get funds, and get more of them. The amount donated can vary signifcantly from one occasion to
another and across donors. In the prescription refll case, generally the amount remains the same or
more predictable for any customer and similar to other customers with same illness. From a model-
ing point of view as well, a model of CLV in the case of charity fund drive is likely to include more
complexity to deal with the uncertainty in the amount raised from a donor. The prescription refll case
can do with a much simpler approach for modeling the spending component of the CLV model.
We believe that an adequate context categorization can result from a “bottom-up” approach
that considers all the main drivers of CLV, namely, customer lifetime, purchase time, and spend-
ing. While the classifcation in Table 2.1 considers lifetime via the contractual-noncontractual
dimension, and purchase time via the continuous-discrete dimension, it ignores the third critical
dimension, which is customer spending. Let us consider the money spent by a customer during
each purchase occasion as falling into one of the following two categories: Fixed and Variable. In
the Fixed category, the amount spent on each occasion is predictable easily, that is, it is either the
same or attains one of a few possible discrete values and thus can be predicted relatively easily.
Table 2.1
Context Categorization Proposed by Fader, Hardie, and Lee (2006a)
Opportunities for Transactions Noncontractual Contractual
Continuous Grocery purchases Credit card
Doctor visits Student meal plan
Hotel stays Cell phone usage
Event attendance Magazine subscriptions
Discrete Prescription reflls Insurance policy
Charity fund drives Health club
Source: As proposed by Fader, Hardic, and Lee 2006.
44 SIDDHARTH S. SINGH AND DIPAK C. JAIN
For example, a magazine subscriber pays the same amount per time period for the magazine. In
the Variable spending category, a customer can spend any amount.
For the frm in a context with Fixed spending, the issues of focus are the timing of purchase
(purchase time) and/or customer defection (customer lifetime), whereas a frm in the Variable spend-
ing category needs to focus on customer spending as well. From the point of view of estimating
CLV, the Variable spending category poses more challenges. Examples of studies where spending
falls in the Variable category are Borle, Singh, and Jain (2008) (where spending per transaction
for each customer is modeled as Lognormal) and Fader, Hardie, and Lee (2005a) (where spending
per transaction is modeled as gamma-gamma).
Table 2.2 represents our refnement of the categorization in Table 2.1. Our aim is to propose a
customer-frm relationship framework that adds to the existing framework in a meaningful man-
ner and is reasonably comprehensive. It is noteworthy that a customer-frm transaction might not
be monetary. For example, a cell phone is used all the time, which is a nonmonetary transaction;
however, payments for the phone service happen at fxed intervals. In developing the framework,
we have focused on the monetary transactions as the key transactions of interest. This is reason-
able because the timings of customer spending, as opposed to the timings of product usage,
5
have
a bearing on CLV.
The context categorization presented in Table 2.2 is useful in understanding and prescribing
models for use in a specifc situation. Generally, it is most challenging to develop an accurate
CLV model for context (B) and (D), where both the spending and purchase times are variable.
Between these two, (B) presents a higher degree of diffculty due to lack of information about
customer defection.
It is noteworthy that the two broad categories of the customer lifetime dimension (contractual
and noncontractual) are the most interesting for modeling CLV. The other two components of
a CLV model (spending and purchase time) can be suitably modeled relatively easily given the
signifcant work in the general marketing literature on revenues from a customer and interpurchase
Table 2.2
Proposed Context Categorization
Customer Lifetime Dimension
Noncontractual Contractual
Customer Spending Dimension Customer Spending Dimension
Purchase
Time
Dimension Fixed Variable Fixed Variable
Continuous (A) (B) (C) (D)
Offine movie rental Grocery purchases Student meal plan Credit card
Hotel stays Purchase clubs
Air travel
Discrete (E) (F) (G) (H)
Event attendance Charity fund drives Magazine subs Cell phone/
Prescription reflls Insurance policy PDA payments
Health club
Note: The examples in each cell are for illustration only and represent only the cases that are appropriate for
the cell. Within each example, such as student meal plan, there could be examples that fall in another cell.
MEASURING CUSTOMER LIFETIME VALUE 45
time. Therefore, in presenting the models for CLV, we focus on this lifetime dimension only.
Any model proposed for a contractual or a noncontractual context can be modifed for use in any
subcategory within these respective categories.
Models for Measuring Customer Lifetime Value
In the general marketing literature, signifcant work has been done to investigate and forecast
drivers of CLV such as customer lifetime, customer spending, interpurchase time, promotions,
and so on (e.g., Bolton 1998; Chintagunta 1993; Allenby, Leone, and Jen 1999; Bhattacha-
rya 1998; Jain and Vilcassim 1991). As a result, numerous possibilities exist for combining
models for different drivers of CLV to get its estimate. In this section, we do not consider the
individual models for a specifc driver of CLV. Our focus here is on the prominent models
proposed for estimating CLV. The CLV models that we discuss contain component models
(or submodels) for the drivers of CLV considered. These submodels in turn are based on the
extant research in the general marketing literature as mentioned earlier. Therefore, the CLV
models discussed here have already considered the numerous possibilities for the component
submodels, which justifes our focus on these models while ignoring the numerous other ad
hoc possibilities.
We use the framework in Table 2.2 as a guide. To facilitate the descriptions, we categorize
the models into two broad categories based on the context discussed earlier, namely, models for
contractual and noncontractual contexts. The models for each context can be modifed suitably
for use in any subcategory within the context. Table 2.3 presents the models that we discuss in
this section, beginning with models for contractual contexts and followed by models for noncon-
tractual contexts.
Models for Contractual Contexts
In this context, frms know the time of customer defections. While a customer is in business with a
frm, it also has information on the realized purchase behavior of the customer. Donkers, Verhoef,
and de Jong (2007) provide an excellent comparison of CLV models in a contractual context. Our
discussion adds to their work. We frst discuss the basic structural model of CLV.
Table 2.3
Models of CLV Discussed
Contractual contexts
1 Basic Structural Model of CLV (Jain and Singh 2002; Berger and Nasr 1998)
2 Regression/Recency, Frequency, and Monetary (RFM) Models (e.g., Donkers, Verhoef, and
de Jong 2007)
3 Hazard Rate Models (Borle, Singh, and Jain 2008)
Noncontractual contexts
1 Pareto/NBD (Schmittlein, Morrison, and Colombo 1987)
2 Beta-Geometric/NBD or BG/NBD (Fader, Hardie, and Lee 2005b)
3 Markov Chain Models (Pfeifer and Carraway 2000; Rust, Lemon, and Zeithaml 2004)
4 Markov Chain Monte Carlo (MCMC) Data Augmentation Based Estimation Framework
(Singh, Borle, and Jain 2008)
46 SIDDHARTH S. SINGH AND DIPAK C. JAIN
Basic Structural Model of CLV
The basic model for CLV of a customer is (see Jain and Singh 2002):

( )

= −
+

=
Q
L L
L L
G
& 5
&/9


, (1)
where i = the period of cash fow from customer transaction, R
i
= revenue from the customer in
period i, C
i
= total cost of generating the revenue R
i
in period i, and n = total number of periods
of projected life of the customer. Several variations of this basic model and their details can be
found in Berger and Nasr (1998).
Using the basic structural model, one simple way to estimate CLV is to take the expected
customer lifetime, the average interpurchase time, and dollar purchase amounts observed in the
past and use them to predict the present value of future customer revenues assuming these aver-
age values for the inputs in the CLV model. Such a heuristic model would be a quick and useful
method to calculate CLV in the absence of any better model (Borle, Singh, and Jain 2008).
Although the basic model (and its variations) is useful to understand the essence of CLV, there are
several issues with this formulation that relate to the assumptions it makes about customer purchase
behavior. For example, it assumes fxed and known customer lifetime duration, revenues (both times
and amounts), and costs of generating revenues. These restrictive assumptions make the model unat-
tractive in most cases. Examples of situations where this model can be useful are newspaper or magazine
subscriptions where the revenues from a customer are known and occur at fxed known times. The
length of the subscription, that is, customer lifetime, is the only unknown variable. The frm could use
someruleofthumbforthislength—suchasafxedtimeperiodof,say,threeyears—ortaketheaver-
age subscription period for its past customers to get this time. Such simplistic measures will be biased,
but the low cost of applying this model might justify its use in the right situation.
To develop more accurate models, one has to consider modeling customer lifetime to better
refect its variation across customers. A good method would be to use hazard rate models (Helsen
and Schmittlein 1993), which can provide more accurate information about the expected lifetime
of each existing customer. This lifetime in turn can be used in the CLV models along with the
revenues and cost information to get an estimate of the lifetime value of each customer. The models
discussed so far in this section are most suitable for cases that fall in cell (G) in Table 2.2. In other
situations within the contractual context, the assumptions of fxed revenues and costs cannot be
justifed. Therefore, researchers have developed ways to make the basic model more fexible or
to fnd alternatives to it.
Regression/RFM Models
The regression/RFM methods are commonly used techniques to score customers for a variety of
purposes (such as targeting customers for a direct mail campaign). An RFM framework uses in-
formation on a customer’s past purchase behavior along three dimensions (its recency, frequency,
and monetary value) to “score” customers. Regression methods can use these and other variables
to score customers as well as estimate CLV of each customer. The scores are related to the ex-
pected potential customer purchase behavior and hence can be considered as another measure of
customer value to the frm. Scores generally serve a similar purpose as the CLV measure. These
methods have been used in noncontractual contexts as well; see, for example, Borle, Singh, and
MEASURING CUSTOMER LIFETIME VALUE 47
Jain (2008), Donkers, Verhoef, and de Jong (2007), Malthouse and Blattberg (2005), Reinartz and
Kumar (2003), and Colombo and Jiang (1999).
Hazard Rate Models
Jain and Vilcassim (1991) and Helsen and Schmittlein (1993) provide a good introduction of hazard
rate models in marketing. Hazard of an event means the risk of its occurring. Here, the event is cus-
tomer defection or purchase. These models are well suited to model the risk of customer defection
and the risk of purchase happening when data about these events is available. The estimates from
these models in turn provide the expected duration of customer lifetime and interpurchase time.
Depending upon the characteristics of customer spending, a suitable model can be used for its esti-
mation. The estimates from these three submodels (lifetime, interpurchase time, and spending) can
provide estimates of CLV. A prominent example of this approach in a contractual context is provided
in Borle, Singh, and Jain (2008); it is henceforth referred to as the BSJ 2008 model.
The BSJ 2008 Model. This hierarchical Bayesian model proposed by Borle, Singh, and Jain jointly
predicts a customer’s risk of defection, risk of purchase, and spending at each purchase occasion.
This information is then used to estimate the lifetime value of each of the frm’s customers at
every purchase occasion. The frm can use this customer lifetime value information to segment
customers and target them. Borle, Singh, and Jain develop and apply the model to data from a
direct marketing company. They test the model and show that it performs signifcantly better in
both predicting CLV and targeting valuable customers than a simple heuristic model, an advanced
RFM model proposed by Reinartz and Kumar (2003), and two other models nested within the
proposed BSJ 2008 model.
The BSJ 2008 model is a joint model of the three dependent drivers of CLV, namely the in-
terpurchase time, the purchase amount, and the probability of leaving, given that a customer has
survived a particular purchase occasion (that is, the hazard rate or the risk of defection). The model
for each of these three quantities is specifed along with a correlation structure across these three
submodels, leading to a joint model of these three quantities. In the model, the interpurchase time
is assumed to follow a NBD process, the amount expended by a customer on a purchase occasion
followsalognormalprocess,andthehazardoflifetime—thatis,therisk of customer defection
inaparticularinterpurchasetimeperiod—ismodeledusingadiscretehazardmodel.Themodel
also incorporates time-varying effects to improve the predictive performance.
CLV Models for Noncontractual Contexts
In this context, frms do not know whether a customer has defected or intends to remain in
business with the frm. Since knowledge of customer lifetime is essential to estimate CLV, this
becomes a challenging context for CLV measurement. Some users deal with this challenge by
considering a future time period of a fxed duration, say three years, and estimating the net
present value of the profts from a customer during this period. Regression models can be used
to estimate future timing and amount of spending by the customer during this period. Past pur-
chase behavior and customer characteristics are some of the variables that can be included as
explanatory variables in the regression model. Such methods can be applied in many ways (e.g.,
Malthouse and Blattberg 2005). It is noteworthy that such ad hoc approaches are best suited
for forecasting an outcome during the next time period. As the forecasting horizon increases,
these methods produce more error.
48 SIDDHARTH S. SINGH AND DIPAK C. JAIN
The following discussion focuses primarily on stochastic models of CLV that assume some
underlying customer purchase behavior characteristics. These models assume that the observed cus-
tomer purchase behavior is generated due to these latent customer characteristics. Such models have
advantages over other approaches, as discussed in detail in Fader, Hardie, and Lee (2006a).
The Pareto/NBD Model
The Pareto/NBD model, developed by Schmittlein, Morrison, and Colombo (1987), uses observed
past purchase behavior of customers to forecast their likely future purchase behavior. This outcome
is then used as input to estimate CLV (e.g., Reinartz and Kumar 2000 and 2003; Fader, Hardie,
and Lee 2005a; Singh, Borle, and Jain 2008).
When customer defections are not observed, the Pareto/NBD model is a very elegant way of
getting the probability of a customer’s activity in a relationship with a frm. This model can be
used to estimate (a) the number of customers currently active, (b) how this number changes over
time, (c) the likelihood of a specifc customer’s being active, (e) how long a customer is likely
to remain active, and (f) the expected number of purchases from a customer during a future time
interval. The model assumptions are as follows:
1. While the customer is active in a business relationship with the frm, he/she makes
transactions with the frm that are randomly distributed in time with customer–specifc
rate λ. Therefore, the number of transactions X made by a customer in a time period of
length t is a Poisson random variable.
2. A customer has an unobserved lifetime duration represented by τ, which is an exponential
random variable. Customers drop out or defect from the frm randomly according to a
rate µ.
3. The transaction rate λ follows a Gamma distribution across customers with parameters
r, α > 0. The mean purchase rate across customers is E[λ] = r/α and the variance is r/α
2
.
4. The dropout rate µ follows a Gamma distribution across customers with parameters
s/β > 0. The mean dropout rate is E[µ] = s/β and the variance is s/β
2
.
5. The purchase rate λ and dropout rate µ vary independently across customers.
For a customer, the expected number of transactions made in T units of time following an
initial purchase is

( )
]
]
]
]

J
J
J
·
'
'
(
|
+

@ >
V
7 V
U
7 V U ; (
β
β
α
β
β α
. (2)
For α > β, the probability that a customer is still active, given an observed purchase history of X
purchases in time (0,T) since the initial purchase with the latest purchase happening at time t, is
( )
( ) ( )
( ) ( )


+
|
|
|
|
|
|
|
|
|
|
|
|
¦
|
]
]
]
]
]
]
]

J
J
·
'
(
|
+
+

J
J
·
'
(
|
+
+
J
J
·
'
(
|
+
+
+ +
+
7 ] F E D )
7
7
W ] F E D )
W
7
W
7
V [ U
V
7 W [ ; V U $OLYH 3
V
V [ U
α
β
α
β
α
α
β α
, (3)
MEASURING CUSTOMER LIFETIME VALUE 49
where a
1
= r + x + s; b
1
= s + 1; c
1
= r + x + s + 1; z
1
(y) = (α-β)/(α+y). For cases when α = β and
α < β, see Schmittlein, Morrison, and Colombo (1987).
Extended Pareto/NBD Model. Schmittlein and Petersen (1994) empirically validate the Pareto/NBD
model and propose an extension to it by incorporating dollar volume of purchase. The key assumption
here is that the distribution of average amount spent across customers is independent of the distribu-
tion of the transaction rate λ and the dropout rate µ. The expected future dollar volume per reorder is
provided in Schmittlein and Peterson. Note that for the estimation of CLV, the output of the Pareto/
NBD model is used along with the output from a suitable model for customer spending.
Despite the signifcant merits of the Pareto/NBD model, it imposes strong assumptions on the
underlying customer purchase behavior that might not be suitable for many situations (Borle, Singh,
and Jain 2008; Singh, Borle, and Jain 2008). In addition, it is somewhat diffcult to estimate as
recommended, thus restricting its usage in practice. Several researchers have attempted to gener-
alize the Pareto/NBD model and/or suggest alternatives that are easier to estimate. For example,
Abe (2008) extends the Pareto/NBD model using a hierarchical Bayesian (HB) framework by
relaxing the independence assumption of the purchase and dropout rates.
The BG/NBD Model
Proposed by Fader, Hardie, and Lee (2005b) as an “easy to estimate” alternative to the Pareto/
NBD model, the Beta-Geometric-NBD (BG/NBD) model makes slightly different assumptions
about the underlying customer purchase behavior that make it signifcantly easier to implement
and yet allow the user to obtain similar benefts. If ease of estimation is desired, the BG/NBD
model is an excellent alternative to the well-known Pareto/NBD model.
The assumptions underlying the BG/NBD model are as follows:
1. While active, the number of transactions made by a customer follows a Poisson process
with transaction rate λ. Therefore, the time between transactions follows exponential
distribution.
2. λ follows Gamma distribution across customers with parameters r and α.
3. After any transaction, a customer defects (becomes inactive) with probability p. Therefore
the customer dropout is distributed across transactions as a (shifted) geometric distribu-
tion.
4. p follows a beta distribution with parameters a and b.
5. λ and p vary independently across customers.
Note that assumptions (1) and (2) are identical to the Pareto/NBD model. While the Pareto/
NBD model assumes that customers can defect at any time, the BG/NBD model assumes that
defections occur immediately after a purchase. Using these assumptions, the expression for the
expected number of transactions in a future time period of length t for an individual with observed
past purchase behavior is obtained as
( ) ( )
[ U
[
[
[ U
[
W
7
[ E
D
W 7
W
[ E D [ E [ U )
W 7
7
D
[ E D
E D U 7 W [ ; W < (
+
>
+
J
J
J
·
'
'
(
|
+
+
− +
+
]
]
]
]

J
J
·
'
(
|
+ +
− + + + + J
J
·
'
(
|
+ +
+


− + +

α
α
δ
α α
α
α

, (4)
50 SIDDHARTH S. SINGH AND DIPAK C. JAIN
where
( )
( )
( ) ( )

> − −

=
− − − −

E F

GW ]W W W
E F E %
] F E D )
D E F E
is the Euler’s integral for the Gaussian
hypergeometric function, x is the number of transactions observed in time period (0,T), and t
x
(0
< t
x
≤ T) is the time of the last transaction.
See Fader, Hardie, and Lee (2005b) for more details of the BG/NBD model. The article also compares
the forecast of future purchasing using the BG/NBD model with that from the Pareto/NBD model and
fnds that both the models are accurate (at both the individual customer level and the aggregate level).
Just as in the case of Pareto/NBD model, the outcome from the BG/NBD model in combination with the
outcome from a suitable customer spending model can be used to estimate CLV of each customer.
MCMC-Based Data Augmentation Algorithm by Singh, Borle, and Jain (2008)
The Pareto/NBD and the BG/NBD models discussed so far in this section have several advantages
over the earlier-used RFM scoring methods. The key advantages accrue as a result of the behavioral
story underlying these models, where the observed transactions are considered a manifestation of
underlying latent customer characteristics (see Fader, Hardie, and Lee 2006a). The problem is that
the “story” underlying the modeling approach so far has been limited to strict assumptions imposed
on customer characteristics such as the purchase behavior. For example, the Pareto/NBD model
assumes that individual customer lifetimes and interpurchase times follow different exponential
distributions. This is a restrictive assumption that might not be supported in many situations. In
addition, the model assumes that the outcomes of lifetime, interpurchase time, and spending are
independent of each other. Since these outcomes belong to each customer, the assumption of
independence between these outcomes is also restrictive. Finally, the estimation of these models
(except the BG/NBD model) is challenging. The Markov Chain Monte Carlo (MCMC)-based
data augmentation framework proposed by Singh, Borle, and Jain (2008) (henceforth referred to
as the SBJ framework for simplicity) addresses these issues successfully.
The SBJ framework has at its core a data augmentation algorithm for estimating CLV models
in noncontractual contexts and is not a specifc model. Therefore it is fundamentally different
from the models proposed so far in the literature. The SBJ framework can be used to estimate all
the models discussed so far in addition to many different models with varying distributional as-
sumptions for the underlying customer behavior. In fact, any standard statistical distribution can
be used for the underlying customer characteristics generating the data. Therefore the user is not
restricted to assuming that the interpurchase times and lifetimes follow exponential distributions.
The algorithm then allows the forecast of future purchase transactions and the CLV using these.
Both the Pareto/NBD and the BG/NBD models assume that the underlying drivers of CLV
(customer lifetime and interpurchase time) are independent. Also, when these models are used
for estimating CLV by adding a model for customer spending, spending also is assumed to be
independent of these other behaviors. In reality, this independence is very hard to justify, as these
outcomes are for the same customer. The SBJ framework allows for the estimation of correlation
between the defection, purchase, and spending outcomes. See Singh, Borle, and Jain (2008) for
applications of the framework including the estimation of the extended Pareto/NBD model, the
BG/NBD model, and a number of other models that use different underlying distributions for
customer lifetime and purchase behavior. The authors fnd that the assumptions of more fexible
distributions for the underlying customer behavior yield more accurate forecasts. Some models
compared yield signifcantly better performance than the Pareto/NBD and the BG/NBD, under-
scoring the value of the framework. It is noteworthy that such fexibility in modeling of CLV in
noncontractual contexts was not available to the users earlier. The advantages of the SBJ frame-
MEASURING CUSTOMER LIFETIME VALUE 51
work over existing alternatives are very signifcant, and we recommend its usage for forecasting
customer purchase behavior in this context.
We now describe the key algorithm in the SBJ framework using the example of the Pareto/NBD
model. If we assume that customer purchase behavior follows the assumptions underlying the
Pareto/NBD model and use the SBJ framework to estimate the Pareto/NBD model, the assumptions
and the simulation/data augmentation steps involved are as shown in Tables 2.4 and 2.5.
To estimate CLV, a model for customer spending is required as well. See Singh, Borle, and Jain
(2008) for more details regarding estimating CLV using the framework, and modeling of covari-
ates and correlations between the outcomes. The authors also show many other applications of
the framework using different distributional assumptions for the drivers of CLV.
Markov Chain Models
Markov chain models have been used in marketing for years to model brand switching (e.g.,
Kalwani and Morrison 1977). Their fexibility and ability to model competition allows their use
in modeling CLV as well. Suitable modifcations of these models can be used both in a contractual
and noncontractual context. An early use of this class of models for modeling CLV can be found in
Pfeifer and Carraway (2000), who illustrate the relationship between Markov chain models and the
commonly used recency, frequency, and monetary (RFM) framework. Rust, Lemon, and Zeithaml
(2004) present a relatively sophisticated version of a Markov chain model to model CLV.
Customer Equity Model of Rust, Lemon, and Zeithaml (2004)
When data on customer purchase behavior from multiple vendors is available, this model is a very
nice option for modeling the lifetime value of customers for specifc brand/vendor. The fexibility
of the model allows estimation of the impact of several drivers of customer lifetime value on the
total lifetime value of a frm’s customers as well as that of its competitors. Another advantage
of the model is that it can be estimated using cross-sectional survey data as well as longitudinal
panel data.
Table 2.4
Notation Used in the Framework (using Pareto/NBD assumptions)
Notation Explanation
h A particular customer.
T
h
The total time for a customer h from the initial purchase occasion until the current time.
t
h
The time from the initial purchase occasion until the last observed purchase occasion
for customer h (therefore t
h
≤ T
h
).
X
h
The total number of purchases made by customer h since the initial purchase in time
period T
h
, with the latest purchase being at time t
h
.
IPT
hi
The interpurchase time between the i
th
and the (i–1)
th
purchase for customer h.
totLIFE
h
Total lifetime of customer h from the initial purchase occasion until the customer de-
fects. This is a latent variable, that is, unobserved by the frm.
totLIFE
h
(old)
Intermediate variables used in the simulation of the latent variable totLIFE
h
.
totLIFE
h
(new)
52 SIDDHARTH S. SINGH AND DIPAK C. JAIN
Using individual-level data from a cross-sectional sample of customers and combining
it with purchase or purchase intentions data, each customer’s switching matrix is modeled.
The individual choice probabilities in the switching matrix, that is, the probability that in-
dividual i chooses brand k given that brand j was most recently chosen, is modeled using a
multinomial logit model. Therefore, each customer i has a JXJ switching matrix, where J is
the number of brands.
The lifetime value of customer i to brand j is then calculated using these probabilities, the average
purchase rate per unit time, the average purchase volume for brand j, and the per unit contribution
margin for brand j. The other details can be found in Rust, Lemon, and Zeithaml (2004).
Key Issues in Modeling CLV
The literature on CLV models has exploded in the past few years. So far, the models proposed to
estimate CLV have generally considered the revenue stream from customers and some obvious
costs involved. Underlying this revenue stream are many complex and important factors that have
generally not been considered in depth while modeling CLV. In addition, there are other factors
related to the customer that are still not well understood and that can beneft the frm (such as
network effects).
Table 2.5
Simulation/Data Augmentation Steps Involved in Estimating the Pareto/NBD Model
Using the SBJ Algorithm
Simulation Step Description
Step 0 Initialization Initialize: totLIFE
h
= T
h
(or any number ≥ t
h
).
Initialize: totLIFE
h
(old)
= totLIFE
h
(new)
= totLIFE
h
.
Initialize: The parameters (r,α) and (s,β).
Step 1 Draw totLIFE
h
(new)
(such that totLIFE
h
(new)
≥ t
h
) from the Pareto distribution with
the current parameters (s,β).
Step 2 Calculate two likelihoods for each customer—like
h
(old)
is the likelihood of the
interpurchase time data for customer h conditional on the lifetime of h be-
ing totLIFE
h
(old)
, and like
h
(new)
is the likelihood of the interpurchase time data
for customer h conditional on the lifetime of h being totLIFE
h
(new)
drawn in the
previous step.
Step 3 Assign totLIFE
h
= totLIFE
h
(new)
with probability


ROG
K
QHZ
K
QHZ
K
K
OLNH OLNH
OLNH
SURE
+
=
, or assign totLIFE
h
= totLIFE
h
(old)
Step 4 Estimate the Pareto distribution parameters (s,β) and the NBD distribution
parameters (r,α) conditional on the total lifetime of the customer h being
totLIFE
h
. That is, update NBD parameters (r,α) and Pareto parameters (s,β).
Step 5 Set totLIFE
h
(old)
= totLIFE
h
.
Step 6 Go to Step 1.
Source: Singh, Borle, and Jain (2008).
MEASURING CUSTOMER LIFETIME VALUE 53
Consider revenues from a customer. These revenues might come from purchases in multiple
categories, and customer purchase behavior with respect to each category might vary. They might
come in response to promotions with varying costs and effectiveness. Examples of such factors
that can impact CLV are cross-selling, word-of-mouth effect, returns, and marketing actions
and their impact on the revenues from different sources. To estimate CLV, one could potentially
forecast the revenues directly using some sort of model for total revenues or one could model
the revenues due to each underlying factor, such as purchases in each category, and build up the
forecast for the total revenues.
Some other areas in marketing have focused on many of these underlying customer-level fac-
tors to understand and forecast them better (e.g., Hess and Mayhew 1997). However, within the
CLV measurement literature, models proposed so far have generally explicitly or implicitly made
assumptions about many of these factors to deal with them. These assumptions take various forms,
such as a factor having no impact (that is, when it is ignored) or a factor having the average value
for all customers (e.g., Kumar, Ramani, and Bohling 2004). To take the CLV literature forward,
bridges have to be built between the research on the drivers of CLV (and the factors that impact
these drivers) and the literature on CLV measurement models such that the CLV measurement
models can be refned further to provide better understanding of the effect of various factors on
CLV and to forecast CLV more accurately. We now discuss some of the key issues that need to be
considered in models of CLV to advance the CLV measurement literature.
Cost of Customer Acquisition
In analyzing the return on investment in customer relationships, how much a frm spends on ac-
quiring a new customer is an important consideration. Acquiring customers at a price more than
their lifetime value (that is, acquiring customers with negative PLV) would obviously result in a
loss. It is common to see the popular press talk about the average cost of acquiring a customer in
a specifc industry (e.g., Schmid 2001); however, such average fgures could be misleading. The
experience of many direct marketing companies suggests that while some customers are quick
to start business with the frm, others are reluctant and need many solicitations before they do.
Clearly, then, the cost of acquiring different customers can be different. Once acquired, how does
the purchase behavior (and subsequently the lifetime value) of these customers differ?
Research suggests that the value of customers acquired through different channels can vary
(Villanueva, Yoo, and Hanssens 2008; Lewis 2006). For example, Villanueva, Yoo, and Hans-
sens, using Web hosting company data, fnd that customers acquired through costly but fast-acting
marketing investments add more short-term value, and customers acquired via word of mouth add
nearly twice as much long-term value to the frm. Some other studies have linked acquisition and
retention (e.g., Blattberg and Deighton 1996; Thomas 2001; Reinartz, Thomas, and Kumar 2005);
however, to our knowledge no one has considered the total cost of individual customer acquisition
(for example, cost attributable to the channel of acquisition and promotions for acquisition) with
the subsequent customer purchase behavior and CLV. The heterogeneity in the cost of acquiring
different customers needs more research and should be accounted for in evaluating prospects.
Cost of Customer Relationship Management
Once a prospect has been acquired as a customer, frms spend resources for managing their re-
lationship with the customer and selling to him/her. These resources involve costs that can be
complex and hard to pinpoint. For example, while the cost of manufacturing a product or the costs
54 SIDDHARTH S. SINGH AND DIPAK C. JAIN
associated with promotions are relatively easy to obtain, the cost of employee time on an activity
or the cost of managing returns is diffcult to estimate. Since information about costs is generally
not available to a researcher easily, most models of CLV make assumptions about these costs.
For example, Venkatesan and Kumar (2004), while discussing cost, say that “the discounting
of cost allocations is straightforward if we assume that there is a yearly allocation of resources
(as is the case in most organizations) and that the cost allocation occurs at the beginning of the
year (the present period).” The issue is that many organizations have aggregate cost fgures, and
allocating them in any model for individual customers without considering the variation in costs
across them is likely to provide biased CLV estimates. Research suggests that such average cost
allocation might not be appropriate, as the cost of serving a customer might be different for dif-
ferent customers (e.g., Reichheld and Teal 1996).
Some studies focus on net revenues from customers and ignore the cost part altogether due to
lack of availability of cost data. For example, Borle, Singh, and Jain (2008) propose a sophisti-
cated model for measuring CLV in a contractual context. Due to unavailability of cost data, they
use spending by customers to apply their model. Although their approach can be modifed easily
to include cost data, application of their model without such cost data can reduce the accuracy of
the model forecasts.
The cost of managing customer relationships and selling to them has several different sources.
Some of the key sources that need consideration include:
Cost of Customer Retention
Firms take various initiatives such as loyalty programs to retain customers. The cost of such
programs has yet to be adequately considered in models for CLV. This cost includes the cost
of designing the program, launching it, and managing it in an ongoing fashion. While the frst
two components are part of the fxed cost of such programs and can be ignored, the cost of
managing the program could be variable and should be considered if appropriate in evaluat-
ing customers. Within these cost components is the cost of physical and employee resources
expended. Given that CLV is a customer-level measure, how does one allocate these costs to
an individual customer? Should it be allocated equally, or should some other factor such as the
frequency of product usage, the time spent with a customer service representative, or a combi-
nation of these form the basis of cost allocation? To our knowledge, these questions have not
been considered in the literature.
Cost of Marketing Activities
Marketing activities are commonly used as explanatory variables in models for measuring CLV.
The cost of such activities, however, is generally ignored. This cost might vary across custom-
ers, and a model has to account for this variation to accurately forecast CLV (Kumar, Shah, and
Venkatesan 2006). For example, while some customers would be sent many promotions before
they make a purchase, others might require just one.
Cost of Returns
Returns by customers has generally been ignored in developing CLV models. Given its importance,
we discuss it in greater detail here. Return of purchased product by a customer is an undesirable
activity for both the customer and the frm. Customers return an estimated $100 billion worth of
MEASURING CUSTOMER LIFETIME VALUE 55
products each year. The reasons for this trend include the rise of electronic retailing, the increase
in catalog purchases, and a lower tolerance among buyers for imperfection (Stock, Speh, and
Shear, 2002). Hess and Mayhew (1997) suggest that in direct marketing, the fact that customers
do not physically evaluate a product before purchasing increases the risk of returns. Further, direct
marketers should expect 4–25 percent of their sales returned. It is clear that returns are important,
but this importance is not refected in the research output related to product returns.
In the CLV literature, some researchers have used returns as an explanatory variable in a
model for a specifc driver of CLV (e.g., Venkatesan and Kumar 2004; Reinartz and Kumar 2003),
however, returns have not been incorporated in CLV measurement models directly despite be-
ing one of the key drivers of CLV. Demonstrating the value of returns for measuring CLV, Singh
and Jain (2008a) use data from a direct marketing company to segment customers on the basis
of purchases and returns. They then estimate segment level CLV frst while ignoring returns and
then while accounting for returns by individual customers. They fnd that consideration of returns
signifcantly alters CLV. One segment of customers that is very attractive when returns are ignored
becomes highly unattractive when returns are accounted for. The impact of returns on CLV var-
ies signifcantly across segments, underscoring the need for considering returns at the individual
customer level in modeling CLV.
Cross-selling
Many businesses such as retailers (for example, Amazon.com), consumer products companies
(for example, Johnson & Johnson), banks (such as Citibank), and insurance companies (Allstate,
for example) attempt to sell different types of products and services to their existing customers.
Consider a woman who purchases a digital camera from Amazon.com. As soon as she purchases
the camera, she gets personalized promotions of accessories such as a camera bag from Amazon.
com. These cross-selling opportunities to a customer are an important reason for frms to invest
in customer retention. If a company acquires a customer who buys from one division, the frm has
information about the customer and her purchase behavior that can be used to its advantage by
more effectively selling other products/services to her. Further, cross-selling enhances customer
retention due to higher switching costs for customers who purchase multiple products and services
from a frm (Kumar, George, and Pancras 2008). This implies that cross-selling to customers is
likely to increase revenues and reduce the cost of customer retention. Therefore, for the frm, part
of the customer value lies in the potential for cross-selling.
The importance of cross-selling to customer value is well recognized by researchers (Kumar,
George, and Pancras 2008; Verhoef and Donkers 2005; Ngobo 2004; Venkatesan and Kumar 2004;
Reinartz and Kumar 2003; Blattberg, Getz, and Thomas 2001; Verhoef, Philip, and Hoekstra 2001;
Kamakura, Ramaswami, and Srivastava 1991). However, how to measure and incorporate the
cross-selling potential of a customer (which is likely to vary across customers) into CLV models
remains a research question.
Word-of-Mouth Effect
Word of mouth represents informal communication between customers/consumers about a frm
and/or its product and services (Tax, Chandrashekaran, and Christiansen 1993). Such communi-
cation can be both positive and negative. The value of customer word of mouth for a frm is well
recognized (Zeithaml 2000; Harrison-Walker 2001; Helm 2003; Rogers 1995; Danaher and Rust
1996; Herr, Kardes, and Kim 1991; Walker 1995; Murray 1991; Buttle 1998). The importance
56 SIDDHARTH S. SINGH AND DIPAK C. JAIN
of customer referrals for new customer acquisition is also recognized by researchers (Mangold,
Miller, and Brockway 1999; Rogers 1995). The popularity of referral reward programs and viral
marketing programs in practice refects the value that frms place on word-of-mouth effects. While
some researchers have attempted to estimate word-of-mouth effects, the research is still in its early
stages due to the complexity involved (e.g., Helm, 2003; Hogan, Lemon, and Libai 2004 ). Kumar,
Petersen, and Leone (2007) use data from a telecommunications company and fnancial services
frm to estimate the value of customer referrals and conclude that a frm’s best marketers may be
worth far more to the frm than the most enthusiastic customers, thus highlighting the importance
of word of mouth in evaluating customers.
Despite the importance of word-of-mouth effects, it is only recently that these and other network
effects (such as participation in customer communities) have started getting the attention of research-
ers in CLV (e.g., Lee, Lee, and Feick 2006; Kumar, Petersen, and Leone 2007; Hogan, Lemon, and
Libai 2004). It is obvious that these factors have an impact on customer value. What is not obvious
is how to incorporate these factors in the model for measuring CLV, given the signifcant challenges
inmeasuringthem—relatedtotheavailabilityofappropriatedataandthemodelforestimatingthem.
So far, to our knowledge, these effects have not been incorporated adequately in the mainstream
models for CLV. But this is an obvious direction for the literature to develop.
Competition
Most of the models proposed for measuring CLV use a frm’s database of past transactions with
its customers for estimation. Since information on customer purchases from competitors is not
available in such databases, competition has been ignored in modeling CLV. If CLV is to be used
as a metric for making strategic decisions, then a frm needs to understand the impact of its actions
on both its own CLV and that of its competitors. Lemon (2006) suggests that for CLV models to
be really useful, they need to incorporate competition through share of wallet or the probability
of purchasing from the competition in the future.
Although desirable, competition cannot be incorporated into CLV models until relevant data is
available. What should a frm do in the absence of such data? Should it not use the CLV metric? It is
important to remember that CLV models are just a tool toward an end. CLV measures provide just one
input into decision making by managers. Just as in conducting traditional marketing research we fnd
the most useful tool in a given situation, considering given the time and other resource constraints,
we have to consider CLV models in light of the availability of data and other constraints. If data is
available, then incorporation of such information into CLV models is likely to provide very useful
insights. A good example is Rust, Lemon, and Zeithaml (2004) discussed earlier.
Forecasting and Planning
Jain and Singh (2002) present the research on CLV as focusing on three main areas: (1) de-
velopment of models to estimate CLV, (2) customer base analysis, and (3) analysis of CLV
and its implications using analytical models. If we focus on (1) and (2), we can see that frms
might require CLV models for at least two objectives. The frst objective concerns understand-
ing the implications of different marketing actions on CLV. The second concerns estimation
of the lifetime value of each existing customer and prospect to take some action based on the
estimated CLV (such as targeting high-value customers). In the former case, the frm has to
incorporate marketing activities as covariates in the model for CLV. Most models allow this
to be done in some manner. Data on past customer transactions can be used to estimate these
MEASURING CUSTOMER LIFETIME VALUE 57
models to understand the impact of these factors on CLV. Many research articles demonstrate
such applications (e.g., Dreze and Bonfrer 2008).
The second objective of forecasting CLV, however, raises some interesting questions. Malthouse
and Blattberg (2005) examine how accurately future proftability of customers can be estimated.
They use four data sets from different industries to study this issue. Based on the results, they
propose two rules: of the highest 20 percent lifetime value customers, 55 percent will be misclas-
sifed, and of the bottom 80 percent lifetime value customers, 15 percent will be misclassifed. As
this study suggests, CLV forecasting is a risky business, as there is likely to be high error in the
forecasts. Does this mean that it is not useful? We do not think so.
CLV is a forward-looking dynamic concept, since it includes the value of the entire duration
of the customer-frm relationship to the frm. Also, we have seen so far that it depends upon the
frm’s marketing activities, its cost of maintaining the relationship with the customer, and the
customer’s purchase and return behavior. Therefore, in order to accurately forecast CLV, one has
to be able to forecast all the factors that drive CLV accurately in order to include these factors in a
CLV forecasting model. This is an extremely diffcult challenge. For example, Kumar, Shah, and
Venkatesan (2006) assume the direct marketing cost for each customer to be the same for the next
three years. The errors in the forecast of each driver of CLV are likely to add to the forecast error
in the CLV. An alternative in models for estimating CLV is to ignore the factors affecting CLV that
cannot be forecast accurately and consider only those that can be. Another alternative is to consider
just the past purchase behavior and other time invariant factors (such as gender) to estimate CLV.
These considerations will, however, affect the accuracy of CLV estimates obtained.
All these issues raise questions about the use of CLV as a forward-looking metric. In order to
decide which alternative is better, one has to consider the main objective of using CLV metric in
the frst place along with the constraints a frm faces. Adding complexity to a model properly is
likely to improve estimates. The key question is whether adding this complexity, if possible, is
worth the improvement in results obtained. Fader, Hardie, and Lee (2006b) contend that covariates
and competition should be ignored in computing CLV because adding them only adds noise and
complexity. Thus they advocate estimating CLV by considering only the past customer purchases
and some time invariant covariates. What one fnally chooses to do will depend upon the judgment
of the user, as opinions differ on this issue.
Here we want to point out that CLV is important for its use as a metric. This metric is useful
only if it can be measured reasonably well and its estimation can be done with the data that frms
generally possess or can collect. The literature on CLV measurement so far indicates that the
models proposed, such as the Pareto/NBD model, provide an accurate enough forecast of CLV
to be useful in practice. Applications of these models now available in the literature talk about
how these models help a frm achieve better results. Clearly, these applications are proof of their
utility. Fader, Hardie, and Lee (2006a and b) provide a strong defense of the use of probability
models such as the Pareto/NBD and the BG/NBD model based on their performance in rigorous
tests in many studies. Given the strong evidence that these models are useful to frms, we recom-
mend using a suitable model for estimating CLV even if data on competition is not available and
a forecast of key drivers of CLV cannot be done accurately.
Endogeneity of CLV Drivers
The modeling issues related to forecasting the value of customers have been discussed in the
previous section. Here we focus on the modeling issues that relate to the analysis of CLV and the
study of various factors on CLV.
58 SIDDHARTH S. SINGH AND DIPAK C. JAIN
In the extant literature, researchers have segmented customers on the basis of customer life-
times to analyze segment-level CLV while treating customer lifetime as exogenous (Reinartz and
Kumar 2000). Recent research suggests that customer lifetime changes with each customer-frm
interaction and therefore should not be treated as exogenous in analyzing lifetime value (Borle,
Singh, and Jain 2008; Singh and Jain 2008b).
It is common to build up a model for CLV using the key drivers of CLV (e.g., Venkatesan and
Kumar 2004; Fader, Hardie, and Lee 2005a and b). Since these drivers, such as customer spend-
ing, interpurchase time, and customer lifetime, relate to each customer, they should be modeled
jointly to account for the relationship between them (Seetharaman 2006; Borle, Singh, and Jain
2008). Also, values of these drivers that appear as explanatory variables are likely to be endog-
enous. The modeling should account for this potential endogeneity. However, these issues are
either ignored or not adequately addressed. Not accounting for the endogeneity and simultane-
ity of various factors in the model is diffcult to justify and can lead to misleading conclusions.
While these issues are commonly taken care of in other research streams within marketing, the
CLV literature is only now moving in the direction of addressing them (e.g., Singh and Jain 2008;
Borle, Singh, and Jain 2008).
Summary and Discussion
The literature on customer lifetime value (CLV) has reached a junction where numerous models
have been proposed to estimate CLV in different contexts. There is, however, little research on
presenting this literature in a proper contextual framework, which is necessary to provide a user
with easy recommendations for the models to use in any particular situation. Besides the issue of
the context, there are key factors that impact CLV that have not been considered adequately, if at
all, in the models for measuring and analyzing CLV.
This chapter reviews the literature on models/methods proposed to measure CLV to do the
following:
1. Discuss the relevance of the context of CLV measurement and propose a contextual
framework that can be used to understand and classify CLV models better.
2. Describe some prominent models/methods proposed for measuring CLV in different
contexts and discuss the strengths and weaknesses of each.
3. Discuss factors that impact CLV but have not been adequately considered in modeling
CLV. These factors include network effects (such as word-of-mouth effects), returns, cost
of managing customer relationships, and so forth.
In short, this paper takes a pause to review what has been done in the CLV measurement literature
so far and considers what needs to be done now to advance the literature. In addition, it attempts
to sort out some contextual issues to present the literature in a proper contextual framework. The
literature on CLV is expanding fast. We hope that this work will help readers understand it better
and provide them with directions for future research.
Notes
1. The numerous articles related to customer lifetime value address many issues within the feld such as
measurement of customer lifetime value (e.g., Borle, Singh, and Jain 2008; Lewis 2005; Fader, Hardie, and
Lee 2005a; Gupta, Lehmann, and Stuart 2004; Libai, Narayandas, and Humby 2002; Reinartz and Kumar
MEASURING CUSTOMER LIFETIME VALUE 59
2000); study of the drivers of customer value (e.g., Rust, Lemon, and Zeithaml 2004; Magi 2003; Berger,
Bolton, Bowman, and Briggs 2002); customer loyalty programs (e.g., Shugan 2005; Lewis 2004; Kim, Shi,
Srinivasan 2001; Cigliano, Georgiadis, Pleasance, and Whally 2000; Dowling and Uncles 1997); and cus-
tomer acquisition and retention (e.g., Capraro, Broniarczyk, and Srivastava 2003; Thomas 2001; Blattberg,
Getz, and Thomas 2001).
2. Some researchers have also used the total value of a frm’s customers in measuring the value of the
frm (Gupta, Lehmann, and Stuart 2004).
3. In the child care context, customer retention has to be managed until the child “grows up.”
4. Note that in Fader, Hardie, and Lee (2005b), the defnition of a noncontractual context would be the
same as a noncontractual–continuous-time context as defned here.
5. This is not to suggest that the timings of product usage do not affect CLV. Cost of managing customer
relationships, returns, and so forth might occur at times different from the spending by a customer. These
costs, if signifcant and when considered, would lead to further refnement of the categorization. Our purpose
is to propose a categorization that achieves a balance between the most important criteria and parsimony
of the framework.
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63
chaptEr 3
LEARNING MODELS
s. sriraM aNd pradEEp K. chiNtaGuNta
Abstract
Choice models typically assume that agents know with certainty the utility they would derive from
various alternatives. Such an assumption is likely to be violated in instances where (a) the agent
is new to the context or (b) the choice set has new alternatives. Learning models specify a mecha-
nism by which consumers resolve uncertainty regarding products or their characteristics in such
“turbulent” contexts. In this chapter, we provide a critical review of the extant learning literature
in marketing and economics. We also discuss some avenues for future research in this area.
Introduction
The extensive literature on choice models has been built on the premise that consumers derive
utility from the various alternatives in their choice set and choose the alternative that gives them
the greatest utility. Typically, these models assume that consumers know the various components
of this utility with certainty. This would be the case for categories in which (a) consumers make
purchases regularly and (b) there are no new product introductions and consumers have been
participating in the category over an extended period of time. However, if consumers are either
new to the category or if the category experiences several new product introductions, this as-
sumption is likely to be violated. In such instances, consumers would perceive some uncertainty
in the utility they would derive from the various alternatives. Consequently, this would play a
role in their choice decision. Moreover, consumers may try to resolve this uncertainty by learning
about the utility they would derive from the products through various information sources such
as actual purchase and consumption of the product, advertising messages, and word-of-mouth
interactions with other consumers. Learning models specify the mechanism by which consumers
use these various sources of information to resolve their uncertainty. A choice model that formally
incorporates learning behavior would then be able to assess the relative effcacy of the different
information sources in aiding consumer learning.
The literature that considers consumer learning can be broadly classifed into two streams. The
frst consists of reduced-form models that allow for the evolution of a consumer’s brand preferences
and price sensitivity parameter to be a function of her past experience in the category (Heilman,
Bowman, and Wright 2000) or due to her exposure to advertising by these brands (see, for example,
Jedidi, Mela, and Gupta 1999; Sriram, Chintagunta, and Neelamegham 2006; Sriram and Kalwani
2007). Therefore, these models do not provide a structural representation of the learning mechanism.
One criticism of such reduced form models is that they may not be invariant to policy changes (also
known as Lucas Critique). Therefore, they may not be useful if the focus of the researcher is to
64 S. SRIRAM AND PRADEEP K. CHINTAGUNTA
understand the implications of signifcant policy changes. The second stream of literature explicitly
accounts for how consumers update their beliefs regarding components of their utility about which
they are uncertain. The structural nature of such models provides some defense against the Lucas
Critique. Most of these studies assume that consumers update their beliefs in a Bayesian fashion
with the extent of updating being related to their perceived precision of the signals that aid in such
learning. In this chapter, we present a review of this latter stream of the learning literature. While
the above discussion was based on consumers’ learning about the utility they would derive from the
various alternatives, the literature encompasses various other contexts, such as physicians’ learning
about a drug and managers’ learning about the attractiveness of a market.
The rest of the chapter is organized as follows. First, we begin by discussing the basic structure
of learning models. We then discuss the differences between the various learning models in the
marketing and economics literatures in terms of the agent who is learning, the entity that the agent
is uncertain about, and the signals that help in learning. Subsequently, we talk about how the basic
learning model has been extended in the literature. The following section sheds some light on po-
tential avenues for future research, and the fnal section provides some concluding comments.
The Basic Structure of Learning Models
Learning models are typically characterized by the following four aspects: (a) an agent, (b) a
component of the agent’s utility function that she is uncertain about (an unknown entity), (c) sig-
nals that the agent receives about the unknown entity, and (d) a mechanism by which information
in the signal is used to resolve the uncertainty in (b). A common example in marketing involves
consumers (the agents) who are uncertain about the quality of the product they are deciding to
purchase (the unknown entity). Upon purchase and experience of the product, they receive some
information regarding its true quality (the signal). The signal is usually assumed to be “noisy,”
that is, a single purchase or experience usually does not resolve all the uncertainty regarding the
product. In a standard Bayesian learning model (the mechanism), the agent has some prior belief
about the quality of the product. The (noisy) signal the consumer receives from the purchase
and use of the product allows the agent to combine the prior belief with the signal in a Bayesian
fashion to update beliefs about the product’s quality. Usually, researchers assume that the noisy
information that agents receive each period comes from a distribution whose mean equals the true
value of the unknown entity, that is, that the signals are unbiased. Hence, if the agent receives
signals over an extended period of time by making repeated purchases, the updated belief about
product quality will converge to its “true” value. Below, we present a formal discussion of the
model structure in the context of this example.
Consider a market with only one new nondurable product that can be purchased every period.
Consumers in such a market decide on whether to purchase the product or not during each period
t, t = 1, 2, . . . , T. Further, we assume that consumers can make only one purchase during each
period. Let Q be the true quality of the product. In our illustrative learning model, consumers do
not know this true quality. At period 0, all consumers start with a prior belief that the quality of
this product is normally distributed with mean Q
0
and variance s
2
0
, that is,
Prior ~


σ 4 1 . (1)
In period 1, consumers would make their purchase decisions based on this prior belief. If
consumer i, i = 1, 2, . . . I, purchases the product, she can assess the quality of the product from
her consumption experience, Q
Ei1
. If we assume that the consumer always derives the experience
LEARNING MODELS 65
of quality that is equal to the true quality Q
Ei1
 Q,  i, t, then this one consumption experience
is suffcient to assess the true quality of the product. However, in reality, this experienced quality
might differ from the true quality, Q, because of (a) intrinsic product variability (Roberts and Urban
1988) and/or (b) idiosyncratic consumer perceptions (Erdem and Keane 1996). Hence, researchers
typically assume that these experienced quality signals are draws from a normal distribution whose
mean equals the true quality, that is, that these are unbiased signals. Thus, we have
a

4 (LW
4 1 4 σ , , L 7 W = = , (2)
where

4
σ captures the extent to which the signals are noisy. Thus, for learning to extend beyond
the initial purchase, we need

>
4
σ .
Subsequent to the frst purchase (and consumption experience) the consumer has some more
information than the prior she started with. Consumers use this new information along with the
prior to update their beliefs about the true quality of the product in a Bayesian fashion. Specifcally,
since both the prior and the signal are normally distributed, conjugacy implies that the posterior
belief at the end of period 1 would also follow a normal distribution (DeGroot 1970) with mean
L
4 and variance

L
σ such that

(L L L L
4 4 4 ϖ θ + = and (3a)

4
L
σ σ
σ
+
=
, (3b)
where

4
4
4
L
σ σ
σ
σ σ
σ
θ
+
=
+
=
and (3c)

4
4
4
L
σ σ
σ
σ σ
σ
ϖ
+
=
+
=
. (3d)
This posterior belief at the end of period 1 acts as the prior belief at the beginning of period 2. Thus,
when the consumer makes a purchase decision in period 2, she would expect her quality experience
to come from this distribution, that is, a
a

L L L
4 1 4 σ . On the other hand, a consumer who does
not make a purchase in period 1 will use the same prior in period 2 as she did in period 1. Hence, we
can generalize equations 3a, 3b, 3c, and 3d for any time period t, t = 1, 2, . . . , T, as follows:

(LW W L LW
4 4 4 ϖ θ + =

, (3a´)


= −
+
=
+
=
W
4
L
4
LW
LW
LW
,
,

τ
τ
σ σ σ σ
σ
(3b´)
66 S. SRIRAM AND PRADEEP K. CHINTAGUNTA


4 W L LW
4
4
LW
W L
W L
LW
,
,
σ σ
σ
σ σ
σ
θ
+
=
+
=



(3c´)


4 W L LW
W L LW
4
LW
W L
4
LW
LW
,
,
,
,
σ σ
σ
σ σ
σ
ϖ
+
=
+
=



, (3d´)
where I
it
is an indicator variable that takes on the value 1 if consumer i makes a purchase in pe-
riod t and 0 otherwise. Similarly, when the consumer makes a purchase in period t+1, she would
assume that the quality of the product,

a
+ LW
4 , comes from this posterior distribution at the end of
period t, that is, a
a

LW LW LW
4 1 4 σ
+
. Equations 3a´, 3b´, 3c´, and 3d´ imply that as the number of
consumption experiences increases, the consumer learns more and more about the true quality
of the product. As a result, her posterior mean would shift away from her initial prior and move
closer to the true mean quality. Similarly, as she receives more information, her posterior variance
would decrease.
In order to demonstrate how a consumer’s posterior belief would evolve as she receives
these signals, we performed a simulation wherein the true quality of the product, Q, is set at
5. The consumer has a prior belief that the true quality of the product, Q
0
, is 0 with a variance of
5 (

= σ ). The consumer receives unbiased signals around this true quality with a signal vari-
ance of 2 (

=
4
σ
). In Figure 3.1, we plot the evolution of the posterior mean and variance as the
number of purchase occasions increase. As discussed above, the fgure reveals that the consumer’s
posterior belief about the true quality of the product converges to its true value as she receives
more signals. Furthermore, her uncertainty about this belief (posterior variance) falls with each
additional signal and tends to zero asymptotically.
This concludes our discussion of a basic mechanism by which consumers learn about the quality
of a new (to them) product. Later we will discuss other learning mechanisms. Now we turn to a
discussion of the utility function that drives purchases.
Specifcation of the Utility Function
For the sake of simplicity, we defne the utility that the consumer derives from the product at time
t as a function of her quality perception and the price of the product at that time. As discussed
above, when a consumer makes a purchase decision at period t, she still perceives some uncer-
tainty about the quality of the product she would receive. Hence, her utility will also be a random
variable. Specifcally,

LW W LW LW
S 4 I X ε β + =
a

a
, (4)
where
LW
X
a
is the utility that consumer i derives from purchasing the product at time t, p
t
is the
price of the product at time t, β is the price sensitivity parameter, and ε
it
is a consumer and time-
LEARNING MODELS 67
varying idiosyncratic term that is not observed by the researcher.
1
Since the consumer does not
know the true quality and, hence, the true utility, she makes her purchase decision based on the
expected utility,

LW W LW LW W LW LW
S 4 I ( S 4 I ( X ( ε β ε β + = + = @
a
> @
a
> @
a
> , (5)
where E[.] is the expectation operator. The expectation is taken over the prior distribution at the
beginning of that period (or the posterior distribution at the end of the previous period). Since
the error term is perfectly known to the consumer and unknown only to the researcher, it can be
taken out of the expectation operator as in equation 5. Further, if we assume that the deterministic
component of the utility from not purchasing is 0 and the error term ε
it
follows a type I extreme
value distribution, we can write out the probability that consumer i would make a purchase at
time t, Pr
it
as

)|) ; .
~
( | exp( 1
)|) ; .
~
( | exp(
Pr
β
β
W LW
W LW
LW
S 4 I (
S 4 I (
+
=
. (6)
The specifcation of the utility function in equation 4 will have implications for how the posterior
mean and variance enter the expected utility in equation 5 and hence the probability of purchase
in equation 6. For example, if f(.) is a linear function of
LW
4
a
such that

LW W LW LW
S 4 X ε β + + =
a
a
, (7a)

LW W W L
LW W LW LW
S 4
S 4 ( X (
ε β
ε β
+ + =
+ + =

@
a
> @
a
>
. (7b)
Figure 3.1 Change in Posterior Mean and Variance with Number of Purchases
0
1
2
3
4
5
6
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
No. Purchases (Signals)
True Quality Posterior Mean Posterior Variance
68 S. SRIRAM AND PRADEEP K. CHINTAGUNTA
The expression for the expected utility in equation 7b implies that it depends solely on the
posterior mean from the previous period and is independent of the posterior variance. On the
other hand, concave or convex specifcations of f(.) would lead to expected utilities that depend
on both the posterior mean and variance. More specifcally, a concave utility function would
imply that the consumers are risk averse. Consequently, the expected utility would be nega-
tively infuenced by the posterior variance. Likewise, a convex utility function would have the
posterior variance affecting the expected utility positively. In Table 3.1, we present the utility
functionandtheexpectedutilityforthreecommonlyusedfunctionalformsintheliterature—
linear, quadratic, and constant absolute risk aversion (CARA). Note that the term γ in the qua-
dratic and CARA specifcations corresponds to the level of risk aversion, with positive values
corresponding to risk-averse consumers (concave utility) and negative values corresponding to
risk-seeking consumers (convex utility).
Learning Models in Marketing and Economics
We now turn our attention to a discussion of the different applications of learning models in the
marketing and economics literature. Specifcally, we break down the discussion into how these
studies differ in terms of the following three questions: (a) who is learning? (the agent), (b) what
are they learning about? (the uncertain entity), and (c) how do they learn? (the signal). In Appendix
3.1, on pages 82–83, we provide a summary of selected studies on learning. The appendix also
provides details on how these studies differ on these three dimensions.
Who Is Learning? (The Agent)
Broadly, there are three types of agents in the literature: (a) consumers who are making decisions
regarding their own consumption or purchases, (b) physicians making decisions on behalf of their
patients, and (c) managers making decisions on behalf of their frms. As regards the frst group,
consumers, the literature on learning models spans several industries including consumer packaged
goods (see, for example, Ackerberg 2003; Erdem and Keane 1996; Mehta, Rajiv, and Srinivasan
2003, 2004), consumer durables such as automobiles (Roberts and Urban 1988) and computers
(Erdem, Keane, Oncu, and Strebel 2005), and services such as local telephone (Narayanan, Chin-
tagunta, and Miravete 2007) and wireless (Xiao, Chan, and Narasimhan 2007). The choice of the
category has typically been dictated by the nature of data required to infer consumer learning. Since
inference of learning requires us to observe consumer decisions over several time periods, most
of the work has been in the context of frequently purchased consumer packaged goods or services
such as telephone and wireless where consumers are not bound by a contract and therefore have
the option of switching between services during each period. A casual perusal of the appendix
would confrm this. The only exceptions are the studies by Roberts and Urban (1988) and Erdem
and colleagues (2005), set in the context of consumer purchases of automobiles and computers,
respectively. Clearly, if one needs to infer learning in these contexts based on how consumers
modify their purchases over time, it would require data that track the purchases of these consumers
over several purchase occasions. Given the lifetime of these categories (especially automobiles),
we may have to track purchases over several decades to arrive at a reasonably large purchase his-
tory to infer learning. Therefore, in both cases, inference regarding learning is not based on repeat
purchases by consumers. Rather, they use data from consumer surveys to infer how consumers
learn over time. For example, Roberts and Urban investigate how car buyers would learn about a
new car model through word of mouth from current customers. In order to infer this, they collect
69
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0
(
e
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p
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70 S. SRIRAM AND PRADEEP K. CHINTAGUNTA
information from potential buyers of the model regarding their willingness to recommend the
model to other potential buyers.
The second class of agents includes physicians who make decisions regarding the drugs to
prescribe to their patients. Past studies have investigated decisions by these agents in a broad class
of prescription drugs, including those for allergies (Narayanan, Manchanda, and Chintagunta
2005), anti-ulcer medication (see, for example, Coscelli and Shum 2004; Crawford and Shum
2005; Chintagunta, Jiang, and Jin 2008), erectile dysfunction (Narayanan and Manchanda 2009),
and heart disease (Ching 2008). Since the agent (physician) and the end consumer (the patient)
are not the same, this context is vulnerable to the critique that the two players may have different
objectives. However, past research has argued that the fear of malpractice lawsuits would ensure
that the physicians have the same objectives as their patients.
The third category of agents comprises managers making decisions on behalf of their frms.
Typically, the decision revolves around whether they should continue with a product or a service
in a given market. For example, Hitsch (2006) investigates the decision of a manager of a brand
of cereals on whether to continue with a new product or discontinue it. Similarly, Dixit and Chin-
tagunta (2007) consider the decision of discount airlines on whether to exit a city-pair market.
Other researchers such as Balvers and Cosimano (1990) deal with the situation in which rational,
forward-looking frms are uncertain about their true demand and use pricing strategically to gener-
ate more informative quantity observations. Yet another category of research along these lines is
the adoption of an innovation of uncertain proftability by a frm. Here the frm receives signals
on the proftability of the innovation, thereby learning about proftability from them; its decision
problem is in the form of an optimal stopping problem in which the stopping value is the expected
return from adoption, and the value from optimal continuation is the discounted expected value
of the next piece of information (see Jensen 1982). Of the three categories of agents, strategic
decision-making by managers appears to be the least studied in the literature.
What Are They Learning About? (The Uncertain Entity)
The most common entity in the literature that agents learn about is the overall quality of a product.
These studies typically start with the assumption that, at the beginning of the data, the agent is
uncertain about the product’s true quality. As the agent makes a series of decisions (such as pur-
chase and subsequent consumption of the product), she obtains unbiased information regarding
the true value of the unknown entity, which helps in updating her beliefs regarding that value, as
discussed above in the section on the basic structure of learning models. In the basic structure, the
true quality does not vary across agents (see, for example, Erdem and Keane 1996). This basic
structure has been extended along two dimensions. First, researchers have extended the notion of
an overall true quality to accommodate the fact that the product match might vary across agents
(Crawford and Shum 2005). For example, when physicians prescribe drugs to patients, they are
likely to consider the fact that the effcacy of a drug would vary across patients. Therefore, apart
from drawing inferences about the overall quality of a drug, they would also learn about how a
drug matches a particular patient (see, for example, Chintagunta, Jiang, and Jin 2008). Similarly,
agents can have different preferences for consumption that could make some options more attrac-
tive than others. For example, Narayanan, Chintagunta, and Miravete (2007) consider the choice
of fxed-rate or metered calling plans for local telephone service. Given uncertainty about their
true consumption rate or type (due to being only on the fxed-rate plan till the introduction of the
metered plan), the agents (consumers) have to choose a calling plan that would suit their needs best.
As consumers learn about their true types, they would converge on a plan that is the best match
LEARNING MODELS 71
for them. Hence, this bears similarity to the case where physicians infer the patient-drug match
based on patient feedback. In a variant of this extension, Coscelli and Shum (2004) investigate
how physicians learn about the effcacy of a drug in treating different diagnoses.
In addition to extending the basic structure to accommodate differences in match across agents,
researchers have added more dimensions of learning. For example, Mehta, Rajiv, and Srinivasan
(2003) extend the basic learning model of consumers’ learning about quality to also accommodate
consumer price search behavior. Consumers are not fully informed about the price levels of the
products in the category and need to undertake a costly search to uncover these prices. Since they
are assumed to know the distribution of prices for each of the brands, their choice of the size of the
consideration set represents a trade-off between the cost of searching for as many prices as there
are brands in the set with the expected benefts from those products. Thus authors assume that
the consumers follow a fxed sample size search strategy. At the same time, they also assume that
learningaboutthetwoentities–qualityandprice—areunrelated.Therefore,informationregard-
ing the price of a product does not help in updating beliefs about the product’s quality. Recently,
Erdem, Keane, and Sun (2008) have allowed for both price and advertising to infuence consumers’
learning of quality. Similarly, Crawford and Shum (2005) consider two unknown entities in the
context of prescription drugs: symptomatic and curative effects. While the symptomatic effect
corresponds to the effcacy of the drug in relieving symptoms, curative effects relate to the abil-
ity of the drug to cure the patient. As in Mehta, Rajiv, and Srinivasan (2003), they assume that
learning about the effcacy of the drug on one effect does not inform the patient or the physician
about its effcacy on the other effect.
Ackerberg (2003) extends the notion of learning about multiple entities by allowing their sig-
nals to be correlated. In his model set in the context of packaged goods, consumers are uncertain
about (a) the quality and (b) advertising expenditures of different brands in the yogurt category.
The uncertainty about advertising expenditures arises because consumers may not watch all the
advertisements of the different brands. Therefore, based on their viewing patterns, consumers
update their beliefs about the extent to which different brands spend on advertising. Ackerberg
further argues that consumers might view advertising expenditure by a brand as a signal of its true
quality. For example, only brands that have a high enough quality can afford to invest heavily in
advertising. He achieves this by allowing the prior beliefs of the consumers regarding quality and
advertising levels to be correlated. Therefore, unlike in Mehta, Rajiv, and Srinivasan (2003) and
Crawford and Shum (2005), learning about one unknown entity (advertising expenditure) also
helps in learning about another unknown entity (quality).
How Are They Learning? (Signals)
Researchers have considered how agents learn from a variety of signals such as consumption, us-
age, advertising, detailing (in case of physicians), and market demand (in case of managers). As
discussed above in the section on the structure of learning models, the standard assumption in the
literature is that these signals are unbiased (that is, mean = true value of the unknown entity) but
noisy indicators of the true value of the unknown entity. What is the source of the signal noise? In
instances where the signal is in the form of consumption, the noise could be because of the inher-
ent variability in the product (Roberts and Urban 1988). It could also be due to market conditions
(Hitsch 2006; Dixit and Chintagunta 2007) as well as due to the inability of the agents to perfectly
evaluate the true value of the signal. For example, it might take consumers several usage occa-
sions to evaluate the stain-removal property of detergents (Erdem and Keane 1996). In the case
of signals such as advertising and detailing, the noise might refect the level of precision in the
72 S. SRIRAM AND PRADEEP K. CHINTAGUNTA
signal. If the agents view the signal as being less precise, it would take several signals to change
their beliefs about the true value of the unknown entity. Such low-precision signals would have
a relatively high variance. At the other end of the spectrum, one can envision scenarios wherein
the agent realizes the true value of the unknown entity after receiving one signal. For example, it
would typically take only one viewing of a movie to evaluate its true quality. In such instances,
the signal would have no variability. Nevertheless, most applications in marketing and economics
have considered only noisy signals. However, the case of one-shot learning is an outcome that is
nested in such models (that is, precision approaches ∞ asymptotically).
We can classify the signals into two broad groups based on whether or not they are an outcome
of the agent’s decision. We call these intrinsic and extrinsic signals respectively. For example, con-
sumption experience is an outcome of the consumer’s decision to purchase the product. Therefore,
it can be classifed as an intrinsic signal. Similarly, the realization of demand for a new product
is a result of a manager’s decision to keep the product in the market. In the case of a physician,
the feedback signals received from patients regarding the effcacy of a prescription drug are real-
ized as a consequence of his decision to prescribe the drug. On the other hand, when a consumer
receives advertising signals regarding a product, it is not a result of her actively seeking the in-
formation. Therefore, we can classify it as an extrinsic signal. Detailing efforts by pharmaceutical
companies directed at physicians fall in the category of signals that are generated by frms and
not by the direct actions of the physicians (although presumably a physician is detailed based on
his prescription activity).
Extensions of the Basic Learning Model
In this section, we discuss some ways in which the basic learning model discussed in the previ-
ous sections has been extended in the literature to accommodate more realistic decision making
by agents. First, we discuss the extension of the decision horizon for the agent from myopic to
forward-looking wherein they consider the effect of learning in being able to make more informed
decisions in the future. Next, we discuss an extension that accommodates instances where the
agents might not fully retain the information they get from the signals. We conclude the section
with a discussion of a learning model in which the agents learn from the action of other agents
even when these agents do not directly communicate with each other. We discuss this under the
subsection entitled “Silent Word of Mouth.”
Decision Horizon
The basic structure of learning models discussed earlier assumes that the agents maximize only
the current utility, that is, they are myopic. The appendix suggests that most of the work in the
literature of learning models falls in this category. However, one can envision scenarios when the
agents would consider payoffs beyond the current period while making their decisions. To illustrate
this point, consider equations 3a´ and 3b´, which provide the expressions for the posterior mean
and variance. These equations imply the following. First, from equation 3a´ it is clear that the
prior mean belief that an agent has about the uncertain entity for the next period is a function of
the current mean and the information that the agent receives during this period. Furthermore, as
shown in Figure 3.1, when the signals are unbiased, the prior mean of the unknown entity would
asymptotically converge to its true value. Therefore, the agent realizes that as she gathers more
information regarding the unknown entity, her beliefs regarding its mean are likely to be closer to
the true value. Second, from equation 3b´ it is clear that the prior variance is strictly decreasing in
LEARNING MODELS 73
the amount of information gathered. Therefore, if the agent is unlikely to be risk neutral (that is,
have a nonlinear utility function), then the expected utility that she would face at the time of making
her decision will be a function of her prior variance (see Table 3.1). Therefore, information gathered
would also have an effect on the expected utility of the agent in a future period through its effect on
the prior variance in future periods. As a result, she is likely to face a trade-off between the follow-
ing two choices: (a) possibly making a suboptimal decision in the current period (either keeping a
product that has a negative expected current proftability in the market or choosing a product that
has a lower expected utility in the current period) and (b) using the information thus gathered to
make more-informed decisions in the future. If the beneft of making more-informed decisions in
the future outweighs the cost of making a suboptimal decision in the current period, the agent might
deviate from the myopically optimal choice. For example, Erdem and Keane (1996) argue that a
consumer (the agent) might “experiment” by purchasing a product that has a lower expected utility
if she could learn about the product’s attributes from the purchase (and eventual consumption). This
“experimentation” will help her make a more informed decision in future periods.
Hitsch (2006) illustrates this point using a simple example in the context of a manager (the
agent) who has to decide whether or not to keep a new product in the market. The agent’s uncer-
tainty pertains to the profts the new product would generate. Let her belief about the product’s
per-period proftability be 1 with probability q (proftable outcome) and –1 with probability 1 – q
(unproftable outcome). Therefore, the expected net present value of profts the new product would
generate over an infnite horizon would be

β β −

=

− × − + ×

T T T
, (8)
where β, 0 ≤ β ≤ 1 is the discount factor. Based on this expected proft, the agent would keep the
product in the market only if the probability of the proftable outcome q > 0.5. However, this
ignores the possibility that the agent might learn something about the product’s proftability by
keeping it in the market. For example, consider that the agent would learn about the true proft-
ability of the product if she keeps it in the market for one period, that is, the signal is completely
informative. In such a scenario, the product would have an expected proft of 2q – 1 in the current
period (same as above). However, armed with the information regarding the true proftability of
the product, the agent can make the optimal decision in future periods. Therefore, the net present
value of the proft stream when the agent considers the fact that she could learn about the true
proftability of the product would be

β
β

+ −

T
T
. (9)
In the above expression, the frst part, 2q – 1, captures the expected profts in the current
period, and the second part corresponds to the net present value of the expected profts that the
agent would derive after having learned about its true proftability. Under this scenario, the agent
would keep the product in the market as long as
β
β


>

T
. Note that

<


β
β
if β > 0.
Therefore, when the discount factor, β, is greater than 0, the agent could make different decisions
regarding retaining the product in the market depending on whether or not she considers the role
of learning in enabling her to make more informed decisions in future periods. Specifcally, the
decision criteria for keeping the product in the market would differ under the two scenarios for
74 S. SRIRAM AND PRADEEP K. CHINTAGUNTA
values of q that lie in the range

< <


T
β
β
. More intuitively, when the agent considers the role
of signals in helping her make more informed decisions in the future, the criteria for keeping the
product alive are likely to be less stringent.
Despite the strong argument in favor of formulating the agent as a forward-looking decision maker,
most of the research in learning models has focused on myopic decision makers. In some contexts such
as a physician prescribing drugs for a patient, it can be argued that the threat of malpractice lawsuits
might prevent the agent from experimenting in order to learn about the product’s true attributes. In
a specifc empirical context, one can look to the data to get some preliminary evidence regarding
experimentation by the agents. So, for example, when looking at new parents making decisions on
the brand of diaper to purchase for their frstborn child, one can check to see whether we observe a
lot of brand switching along with the purchase of small package sizes soon after birth, with the pat-
tern settling down to infrequent switching and larger package sizes subsequently. Such a purchase
pattern might be taken as some evidence consistent with rational forward-looking behavior on the
part of agents (see also Crawford and Shum 2005). Nevertheless, the dynamic nature of learning
models provides suffcient reason to model the agent as a forward-looking decision maker.
The Role of Forgetting
Learning models in the literature have typically assumed that the agents can perfectly recall the
information accumulated in the past. Mehta, Rajiv, and Srinivasan (2004) invoke the literature on
memory and recall (Anderson 1999; Cook and Flay 1978) to challenge this assumption. Specif-
cally, they use evidence from the social psychology literature to formulate a model wherein an
agent’s evaluation of an unknown entity converges to its prior value as the time between signals
increases. The basic structure of the Mehta, Rajiv, and Srinivasan (2004) model hinges on the
conjecture by Alba, Hutchinson, and Lynch (1991) that consumers (the agent) construct their
quality evaluations of products using (a) the attribute information on the product’s package and
(b) the information retrieved from their memory regarding their quality evaluations of the product
from past consumption experiences. In line with this theory, Mehta and his coauthors divide the
information that the consumers use to evaluate a brand’s quality into two groups: (a) the position-
ing set, which corresponds to the information that the consumer learns about the quality of the
brand from its advertisements and/or brand name and (b) the consumption set, which contains the
cumulative information regarding the consumer’s assessment of the brand’s true quality from her
prior consumption experiences. The consumer’s total evaluation of the brand’s quality would be a
convex combination of the information contained in these two sets. The authors further assume that
while the information contained in the positioning set remains unaltered over time, the information
in the consumption set changes as the consumer makes purchases in the category. Moreover, the
authors assume that the consumer might not be able to perfectly recall her past evaluations based
on the choice set. To accommodate this, they defne the recalled evaluation based on the choice set
as a sum of the past evaluation based on the choice set and a random term that has a zero mean.
The random term implies that the recalled evaluation based on the choice set can be higher or
lower than the actual evaluation. Furthermore, a higher variance of this random term would imply
greater forgetting, while zero variance would imply no forgetting. In order to allow this level of
forgetting to increase with time, they model the variance of the random forgetting term to be a
function of the time elapsed since the previous purchase of the brand. When consumers receive
new signals about the quality of the brand, they update the evaluation in their consumption set in
the typical Bayesian manner with the recalled evaluation taking the role of the prior. The authors
LEARNING MODELS 75
show that the standard learning model without forgetting is a nested version of their model. From
their calibration of the model using consumer purchases in the laundry detergent category, the
authors show that not accounting for forgetting would lead to biased estimates.
2
Silent Word of Mouth
The learning models discussed thus far assume that the agents observe the value of the signals they
receive. As discussed earlier, these signals could be in the form of their own experiences, advertising
exposures, or other marketing activities (such as detailing by pharmaceutical companies). Alter-
natively, the agents could also learn through word-of-mouth communication regarding the signals
received by other agents (Roberts and Urban 1988). In all these instances, the agent observes the real
value of the signals even if the signals themselves may be noisy indicators of the true value of the
unknown entity. Zhang (2006) extends this by allowing agents to observe only the discrete decisions
that other agents make as a result of the signal they receive. However, they would not observe the
signals that the other agents actually received (as would be the case in word of mouth). Zhang calls
this “Silent Word of Mouth.” Under silent word of mouth, the agent has to infer the distribution of
the signals that the other agents would have received based on their actions. Examples of instances
where agents make decisions based on silent word of mouth include choice of restaurants based on
the number of patrons waiting outside or watching movies based on box offce collections.
Zhang develops her model in the context of patients (agents) who are waiting in line for a suitable
kidney for transplantation. At the time of making her decision, a patient receives her own private
signal about the quality of the kidney (the unknown entity) as well as the information that all the
other patients ahead of her in the line have rejected the kidney. Since she doesn’t observe the signals
received by the patients ahead of her in the line, she has to infer their signals based on their decisions
to reject the kidney. In doing so, she also needs to account for the fact that these patients would have
rejected the kidney either because they consistently received bad signals or they employed a more
stringent criterion for accepting one. Zhang shows that an implication of her model is that if two
successive patients receive identical private signals, the decision of the frst patient would have an
effect on the second patient’s evaluation of the kidney’s quality. Specifcally, while an acceptance by
the frst agent would increase the second agent’s expected evaluation, a rejection would decrease it.
As a result, patients toward the end of the line are more likely to turn down the kidney offer. Zhang
notes that, given the shortage of available kidneys for transplantation and the clinically acceptable
quality of most rejected kidneys, this fnding could have implications for policy makers. In particular,
facilitation of word-of-mouth communication between patients and suppression of observational
learning might be two mechanisms to break the sequential nature of the decision process.
Avenues for Future Research
In this section, we discuss several possible extensions of the learning literature. Broadly, we group
them into three categories: (a) biased signals, (b) changing value of the unknown entity, and (c)
integration of Bayesian and alternative learning mechanisms.
Biased Signals
Learning models typically assume that although the signals received by the agents are likely
to be noisy, they are nevertheless unbiased. Therefore, if one were to take the average (across
agents and time) of these signals, it would equal the true value of the unknown entity. This
76 S. SRIRAM AND PRADEEP K. CHINTAGUNTA
assumption is likely to be true when consumers learn about the true quality of a product via
consumption experiences or when managers infer the true attractiveness of a market based on
observed demand. However, this assumption is likely to be violated in instances where the
signal comes from a non-neutral entity. For example, advertising or detailing signals by frms
are likely to place a greater emphasis on the positive aspects of their products. Likewise, infor-
mation reported in news outlets with political leanings are likely to be biased in favor of their
respective ideologies (Gentzkow and Shapiro 2008). It would thus be worthwhile to extend the
literature to accommodate learning in the presence of such biased signals. If agents are indeed
aware of the biased nature of signals, they are likely to discount positive claims and/or place
greater emphasis on the negative ones.
Time-Varying Values of the Unknown Entity
While most of the Bayesian learning literature in marketing has assumed that the value of the
unknown entity remains unchanged over time, one can envision scenarios where this is not true.
One such scenario is when the true value of the unknown entity fuctuates stochastically around
a constant mean (see, for example, Lovett 2008). Under such a scenario, the agent knows that the
true value of the unknown entity varies stochastically from time to time as follows:

W W W
4 4 ς + =

,
a

ς
σ ς 1
W
, (10)
where Q
t
is the true value of the unknown entity at time t and ζ
t
is its stochastic variation at time
t. Since the mean of this stochastic variation is zero, the true value of the unknown entity fuctu-
ates around a constant mean. Note that the agent does not observe the true value of the unknown
entity, Q
t
. However, the consumer knows the temporal fuctuation in the true value of the unknown
entity, a

ς
σ ς 1
W
. The consumer, therefore, observes a noisy measure of the unknown entity
such that

a

4 W (LW
4 1 4 σ
, , L 7 W = = . (2´)
Thus, the only difference between equations 2 and 2´ is that in the latter, the process that
generates the signals varies over time. Therefore, when the agent receives signals that vary
over time, it could be either because of (a) noise in the signal generating process,

4
σ , or (b)
the temporal variation in the signal generating process, ζ
t
. Taken together, equations 10 and 2´
represent the system of equations in a standard Kalman flter (Kalman 1960) with equation 2´
playing the role of the observation (or measurement) equation and equation 10 acting as the
system (or state) equation. Hence, the agent’s updating mechanism can be readily obtained based
on derivation of the standard Kalman flter (see, for example, Hamilton 1994; Meinhold and
Singpurwalla 1983; West and Harrison 1994 for simple exposition of the derivation). In what
follows, we present an intuitive discussion of the implications of this stochastic fuctuation. Once
again, we note that equation 2´ is similar to equation 2, with the exception that the mean of the
process that generates the signals is time varying. An implication of this temporal fuctuation
is that as the agent receives signals and updates her belief about the true value of the unknown
entity, she also needs to consider this fuctuation. As a result, the agent’s posterior belief at the
end of period t–1 and her prior belief at the beginning of period t will not coincide.
3
Since the
mean of the fuctuation is zero, the posterior mean at the end of period t–1 and the prior mean
LEARNING MODELS 77
at the beginning of period t would remain the same. On the other hand, this will not be the
case for the posterior and prior variances. Specifcally, if the posterior variance that the agent
i perceives about the true value of the unknown entity at the end of period t is

_ − − W LW
σ , then her
prior variance at the beginning of period t is


_

_ ς
σ σ σ + =
− − − W LW W LW
.
(11)
Hence, the variance of the stochastic fuctuation,

ς
σ , is added to the posterior variance at the
end of period t–1 in arriving at the uncertainty that the agent perceives about the true value of
the unknown entity at the beginning of period t. The intuition behind the above equation is that
the stochastic fuctuation increases the uncertainty that an agent would perceive about the true
quality of the product. As discussed subsequently, it can be shown that when agents anticipate
such stochastic fuctuations in the true value of the unknown entity, the rate of reduction of the
perceived uncertainty (posterior variance) would be slower than it would be if the true value were
time invariant.
One can augment the temporal evolution discussed above to allow the mean of the true value
of the unknown entity to evolve over time. In a simple extension of equation 10, the true value of
the unknown entity can evolve such that

W W W
4 4 ς γ + =

, a

ς
σ ς 1
W
. (10’)
Thus, if 0 < γ < 1 and Q
t
> 0, then the true value of the unknown entity would decrease sto-
chastically over time. An implication of the temporal variation in the mean is that both the prior
mean and the prior variance at the beginning of period t would differ from their corresponding
posteriors at the end of period t–1. More formally,

_ _ − − −
=
W LW W LW
4 4 γ ,
(12)


_

_ ς
σ σ γ σ + =
− − − W LW W LW
,
(13)
where,
_ − − W LW
4 and

_ − − W LW
σ are the posterior mean and variance at the end of period t–1 and
_ − W LW
4
and

_ − W LW
σ is the prior mean and variance at the beginning of period t. Furthermore, equations 3a´,
3b´, 3c´, and 3d´ can be rewritten as follows:

(LW LW W LW LW W LW
4 4 4 ϖ θ + =
− _ _
,
(3a”)


_

_


4
LW
W LW
W LW
,
σ σ
σ
+
=


,
(3b”)


_

_

_

4 W W L LW
4
4
LW
W W L
W W L
LW
,
,
σ σ
σ
σ σ
σ
θ
+
=
+
=




,
(3c”)
78 S. SRIRAM AND PRADEEP K. CHINTAGUNTA


_

_

_

4 W W L LW
W W L LW
4
LW
W W L
4
LW
LW
,
,
,
,
σ σ
σ
σ σ
σ
ϖ
+
=
+
=



. (3d”)
The above formulation can be extended to accommodate the evolution of the true value of
the unknown entity, Q
t
, as a function of other covariates (see, for example, Akcura, Gonul, and
Petrova 2004).
Notwithstanding the mathematical formulation of the belief updating process, the follow-
ing question arises: how is this evolution identifed? For example, consider the case where
the mean of the unknown entity does not vary over time. Under such a scenario, how can one
separately identify fuctuations in the delivery mechanism of the unknown entity from the
temporal fuctuations in its true value? There are two arguments that favor this identifcation.
First, in the absence of the stochastic temporal variation, the weight that the agent places on
the realized values of the unknown entity, ϖ
it
, would steadily decrease over time and asymp-
totically tend to zero. On the other hand, in the presence of a stochastic fuctuation in the true
value of the unknown entity, the weight would decrease at a slower rate and asymptote to a
value greater than zero. As in Lovett (2008), we plot the evolution of this weight for different
values of s
2
ς
/s
2
Q
in Figure 3.2. From this fgure, it is evident that for the traditional Bayesian
learning model with no stochastic fuctuation in the true value (s
2
ς
/s
2
Q
= 0), the weight, ϖ
it
,
approaches zero. However, as the stochastic fuctuation gets more pronounced and s
2
ς
/s
2
Q

increases, the weight asymptotes away from zero. Therefore, if one had a suffciently large
time series of observations, the extent to which the weight asymptotes away from zero can
be used to infer the variance of the stochastic fuctuation, s
2
ς
. The second argument in favor
of identifcation is based on the fact that if the true value of the unknown entity does not vary
over time, the underlying distribution of an agent’s beliefs should remain unaltered over time
if she does not receive any signals. On the other hand, if the agent expects temporal fuctua-
tions in the true value of the unknown entity, her beliefs would exhibit changes even in the
absence of signals. Hence, to the extent that one observes fuctuations in an agent’s prior
beliefs (variance when there is only stochastic variation, and both mean and variance when
there is both change in mean and stochastic variation) across several periods when she does
not receive signals, the model parameters can be identifed.
Despite the possible richness of a model that allows for temporal variations in the true value
of the unknown entity and the arguments behind identifcation of such a model, there has been
very limited empirical work. It would hence be worthwhile to extend the literature along these
lines. Moreover, it would be worthwhile to construct structural versions of reduced form models
based on the Kalman flter.
Alternatives and Augmentations to Bayesian Learning
While most of the discussion in this chapter has revolved around Bayesian learning by agents,
alternative learning mechanisms as well as augmentations to Bayesian learning are possible. In this
regard, it might be worthwhile to integrate the rich theories in the psychology as well as behavioral
marketing literatures with the extant state of the art in Bayesian learning. We believe that there
are at least three possible avenues to doing this. First, an implication of Bayesian learning is that
an agent’s belief about the entity she is uncertain about does not depend on the order in which
LEARNING MODELS 79
she receives information (or signals). However, experimental evidence suggests otherwise (see,
for example, Hogarth and Einhorn 1992). It would thus be useful to develop alternative learning
models that account for order effects in belief updating. Second, when agents receive signals about
the entity they are uncertain about, these signals can exhibit either positive or negative deviations
from what they expected based on their beliefs. In a standard model of Bayesian updating, both
positive and negative deviations are given equal weight. However, according to prospect theory
(Kahneman and Tversky 1979), agents tend to place a greater emphasis on negative deviations
than they would on positive ones, that is, losses loom larger than gains. Integrating such asym-
metric weighting into a model of Bayesian updating would be a worthwhile extension. Third,
although Bayesian learning has been very popular in the marketing literature, consumers might
use several other heuristics while making decisions as well as in updating their beliefs (Tversky
and Kahneman 1974). Extensions that accommodate these heuristics might be worthwhile addi-
tions to the literature.
Although these extensions will help us better understand the mechanism that agents use to
update their beliefs about an unknown entity, the data requirements to facilitate the identifcation
of such augmented models is likely to be stringent. Most of the alternative learning mechanisms
as well as heuristics used in decision-making have been tested using experimental data. On the
other hand, most of the empirical work on Bayesian learning has used secondary data sources.
Hence, researchers need to be cognizant of the additional data requirements that might be needed
to model alternative learning mechanisms.
Conclusion
In this chapter, we present a critical review of learning models in the marketing literature. We
also discuss some avenues in which the literature can be extended to accommodate more realistic
Figure 3.2 Weight Placed on Current Information Over Time
0.0
0.2
0.4
0.6
0.8
1.0
1.2
1 2 3 4 5 6 7 8 9 10
No. Signals
(ıȢ)sq/ (ıQ)sq=0 (ıȢ)sq/ (ıQ)sq=0.6
(ıȢ)sq/ (ıQ)sq=1 (ıȢ)sq/ (ıQ)sq=1.4
80 S. SRIRAM AND PRADEEP K. CHINTAGUNTA
behavior by agents. Since learning models discussed in this literature are structural in nature, they
provide a basis for examining the effect of structural changes in marketing variables on the behavior
of agents. We believe that this stream of research provides suffcient grounds to conduct future
research that would be interesting to academics and practitioners alike. We hope that this literature
review would provide the basic building blocks and a consolidated overview for researchers who
seek to push the frontiers of knowledge in this area.
Notes
1. Note that in typical random utility models, the presence of the error term ε
it
implies randomness from
the perspective of the researcher and not the consumer. In other words, ε
it
is fully known to the consumer.
2. Gowrisankaran, Ho, and Town (2006) consider the situation where doctors learn about complicated
heart surgery procedures by performing them on many patients. In their model, they allow these doctors to
forget what they have learned over time if they do not practice the procedure. However, their application
does not use a Bayesian learning model.
3. Since the mean of the fuctuation is zero, the posterior mean at the end of period t–1 and the period
mean at the beginning of period t would remain the same.
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84
chaptEr 4
CUSTOMER CO-CREATION
A Typology and Research Agenda
MatthEw s. o’hErN aNd aric riNdflEisch
Abstract
Traditional marketing thought and practice largely view new product development (NPD) as an
internal, frm-based activity in which customers are relatively passive buyers and users. This tradi-
tional paradigm is currently being challenged by a new perspective in which customers are active
co-creators of the products they buy and use. This chapter identifes the origins of this paradigm
shift, presents a conceptual typology of four different types of co-creation activity, and offers an
agenda for future research of this emerging paradigm.
New product development (NPD) is an important driver of corporate growth and proftability
(Sorescu, Chandy, and Prabhu 2003; Wind and Mahajan 1997). Unfortunately, most new products
fail to deliver on their objectives (Christensen 1997). Hence, marketing scholars and practitioners
have duly devoted substantial attention toward improving NPD processes. This attention has led
to several important advances, including the specifcation of the Stage-Gate model (Cooper 1990),
the formulation of sophisticated NPD tools such as conjoint analysis and premarket launch fore-
casting (Rangaswamy and Lilien 1997), and advances in knowledge about how best to organize
and manage NPD teams (Sethi, Smith, and Park 2001).
These core topics of NPD research and practice share an important but often unstated as-
sumption that NPD is essentially an internal, frm-based activity. As recently observed by von
Hippel (2005, p. 19), “The idea that novel products and services are developed by manufacturers
is deeply ingrained in both traditional expectations and scholarship.” Hence, NPD research and
practice largely operate under a frm-centered paradigm in which customers are viewed as having
little active infuence upon NPD activity. While this paradigm may have served academics and
practitioners well in the past, it is currently being challenged by the emergence of empowered
customers seeking greater input and control over NPD activity (Seybold 2006). This challenge
is ushering in a new paradigm in which frms can enhance corporate growth and proftability by
allowing customers to take a more active role in NPD activity (Prahalad and Ramaswamy 2000;
von Hippel 2005).
In this newly emerging co-creation paradigm, customers are central and vital participants in
the NPD process and, in some cases, are capable of creating new products with little help from
frms. For example, many of today’s most successful computer applications, including Apache,
CUSTOMER CO-CREATION: A TYPOLOGY AND RESEARCH AGENDA 85
Linux, and Firefox, are open source projects that are managed by self-organizing communities
of volunteer programmers. As shown in Figure 4.1, the open source movement has experienced
tremendous growth in recent years. Likewise, many computer game modifcations are developed
by players rather than manufacturers (Jeppesen and Molin 2003). Customers are also becoming
actively involved in the creation of traditional manufactured products. For instance, over 120,000
individuals around the world served as voluntary members of Boeing’s World Design Team and con-
tributed ideas and input regarding the design of its new 787 Dreamliner airplane (www.newairplane
.com). Likewise, Arduino, an Italian microcontroller manufacturer, provides open access to its
software and schematics and actively encourages customers to tinker with its product design
(www.arduino.cc). Although the literature on this topic is sparse, the evidence marshaled thus
far suggests that customer co-creation is positively associated with several NPD metrics, includ-
ing increased new product creativity, decreased time to market, and reduced development costs
(Grewal, Lilien, and Mallapragada 2006; Shah 2006; von Hippel 2005).
This new paradigm has attracted the attention of the Marketing Science Institute, which has
identifed customer co-creation as a top research priority (Marketing Science Institute 2008).
Likewise, Vargo and Lusch (2004) recognize customer co-creation as a foundational premise un-
derlying marketing’s new service-dominant logic. Moreover, the importance of encouraging and
utilizing customer-generated solutions has been noted by several leading innovation researchers and
practitioners, including Cook (2008), Evans and Wolf (2005), Prahalad and Ramaswamy (2004),
Seybold (2006), and von Hippel (2005), among others. However, to date, marketing scholars have
devoted scant attention to customer co-creation and, instead, continue to focus on NPD as largely
a frm-based activity. Consequently, little is known about the nature of this phenomenon or its
0
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Source: SourceForge.net.
86 MATTHEW S. O’HERN AND ARIC RINDFLEISCH
implications for marketing thought and practice. To date, the limited body of marketing scholarship
on customer co-creation has largely focused on specifc exemplars of this phenomenon, such as
assembling a store-bought bookshelf (Bendapudi and Leone 2003), modifying a computer game
(Prügl and Schreier 2006), or developing open source software (Grewal, Lilien, and Mallapragada
2006; Rajagopalan and Bayus 2008). Although these studies provide an important contribution
by examining the motives and mechanisms underlying customer co-creation, a focus on specifc
exemplars provides only a narrow look at a complex and multifaceted phenomenon (Cook 2008;
Seybold 2006).
Our research seeks to address this gap by offering a broader examination of various forms
of customer co-creation, which we defne as a collaborative NPD activity in which customers
actively contribute and/or select the content of a new product offering.
1
In accordance with this
defnition, customer co-creation involves two key processes: (1) contribution (that is, submitting
content) and (2) selection (choosing which of these submissions will be retained). Using these two
processes as our foundation, we offer a conceptual typology of four different forms of customer
co-creation as well as an agenda for future research in this domain. We believe that this typology
and agenda have the potential to enhance both marketing scholarship and practice. Specifcally,
we provide scholars with a nuanced understanding of the commonalities and distinctions among
these various types of co-creation while offering practitioners an examination of their payoffs and
challenges. In order to provide a contextual backdrop, our thesis begins with an examination of
the trends fueling the rise of customer co-creation.
The Rise of Customer Co-Creation
Successful NPD requires two essential types of information: (1) information about customer
needs and (2) information about how best to solve these needs (Thomke and von Hippel 2002;
von Hippel 2005). Typically, customers (or users) have the most accurate and detailed knowledge
about the frst type of information, while manufacturers (or providers) have the most accurate
and detailed knowledge about the second type. This disparity creates a condition of information
asymmetry (von Hippel 2005).
Traditionally, frms have attempted to manage this asymmetry by engaging in various forms of
marketing research to obtain better information about their customers’ needs. Under this approach,
“Successful innovation rests on frst understanding customer needs and then developing products to
meet those needs” (Hauser, Tellis, and Griffn 2006, p. 3). Unfortunately, customer needs are often
idiosyncratic and tacit in nature and, hence, hard to accurately measure and coherently implement
(Franke and Piller 2004; Simonson 2005). As suggested by von Hippel (2005), consumers have
deep and complex (“high fdelity”) needs; however, traditional market research methods often
provide managers with only a cursory (“low fdelity”) signal of what customers want or need.
As a result, most new product failures are attributed to a frm’s inability to accurately assess and
satisfy customer needs (Ogawa and Piller 2006).
As recently noted by von Hippel and colleagues (Thomke and von Hippel 2002; von Hippel
2005; von Hippel and Katz 2002), an alternative and emerging means of bridging this asymmetry
is to provide customers with information and tools that enable them to take a more proactive role
in the NPD process. As we detail subsequently, an increasing number of frms are employing
this new approach in various manifestations. This movement toward providing consumers with
greater autonomy over NPD activity has witnessed tremendous growth in recent years due to the
rise of customer empowerment. In the remainder of this section, we briefy discuss these trends
and their implications for co-creation.
CUSTOMER CO-CREATION: A TYPOLOGY AND RESEARCH AGENDA 87
As noted earlier, the traditional NPD paradigm largely views consumers as rather passive
entities who are highly dependent upon frms to help satisfy their needs (Carpenter, Glazer, and
Nakamoto 1994; Simonson 2005). Although many individuals still conform to this traditional role
defnition, recent cultural developments are empowering a growing number of end users to play
a more active role in developing the products they buy and use. One important cultural develop-
ment is consumers’ growing suspicion and distrust of marketing communications. For example,
a considerable body of research suggests that consumers are quite skeptical of marketing com-
munication in general and claims about new product performance in particular (Darke and Ritchie
2007; Obermiller and Spangenberg 1998; Wright 2002).
In recent years, this inherent skepticism, fueled by increased news coverage of corporate scandals
(such as Enron, ImClone), muckraking documentaries of big business (for example, SuperSize Me,
The Corporation), and anticorporate websites (for example, adbusters.org, space hijackers.
org), has ignited more active forms of consumer resistance such as anticorporate blogging,
brand avoidance, and culture jamming (Klein, Smith, and John 2004; Kozinets and Handelman
2004; Thompson, Rindfeisch, and Arsel 2006). Hence, an increasing number of consumers are
engaging in direct action to alter corporate marketing activities that they fnd objectionable. This
increased consumer agency represents a signifcant strategic challenge and has led several large
frms, including Wal-Mart, Nike, and McDonalds, to be more cognizant of and open to customer
input (Kalaignanam and Varadarajan 2006). For example, in order to appease consumer activists,
Nike has taken steps to actively engage customers in many facets of its strategic planning and
execution (Seybold 2006).
In addition to a growing suspicion and heightened activism, consumers also appear to be in-
creasingly less fulflled by the act of consumption itself (Firat, Dholakia, and Venkatesh 1995).
The notion that material objects are unable to satisfy intrinsic psychological needs has been
strongly established by consumer researchers (Belk 1985; Richins and Dawson 1992), and these
fndings have recently been disseminated to the broader public (Kasser 2003; Kohn 1999; Schor
1998). According to cognitive psychology, intrinsic needs are more likely to be met via creative
pursuits (Csikszentmihalyi 1996; Deci and Ryan 1985). Thus, through their creative contributions,
customers may reap psychological benefts they would normally be unable to achieve via con-
sumption alone. Indeed, many of today’s popular television programs glorify the creative process
(for example, American Chopper, Trading Spaces, This Old House), and creative pursuits such
as cooking, crafts, and home improvement are rapidly growing in popularity (Ebenkamp 2005;
Pietrykowski 2003). Recent research on customer-led innovation reveals that users often fnd
this activity highly enjoyable (Lakhani and Wolf 2005; Shah 2006).
2
Spurred by these cultural infuences, an increasing number of consumers are seeking a more
active role in the creation of the products they consume (Handelman 2006; Roberts, Baker, and
Walker 2005). For example, nearly one third of the members of extreme sports communities (such
as sailplaning, canyoning, and snowboarding) engaged in some form of product innovation, and
almost a quarter of these innovations were later incorporated into existing products by manufactur-
ers (Franke and Shah 2003). Moreover, research on the creative potential of brand communities
suggests that consumers are willing and able to introduce new offerings even after a product (for
example, Apple Newton) is long abandoned by the frm that sold it (Muñiz and Schau 2005).
The ability of consumers to take a more active role in NPD has been signifcantly enhanced by
recent technological advances, most notably the development and growth of the Internet. According
to several researchers, consumers have traditionally lacked the technical skills and capabilities that
NPD requires (Christensen 1997; Randall, Terweisch, and Ulrich 2005; Simonson 2005). However,
the Internet has helped ameliorate this defciency and empower customers in at least three ways.
88 MATTHEW S. O’HERN AND ARIC RINDFLEISCH
First, the Internet increases access to knowledge that can enhance consumers’ ability to engage
in creative pursuits. For example, consumers interested in learning how to build an electric car
can fnd several websites that contain detailed technical information and user-friendly tutorials
on this topic (for example, www.evadc.org; www.makezine.com; www.evsupersite.net). Hence,
through these electronic archived data sources, knowledge that was once tacit and remote has now
become codifed and proximate (Jeppesen and Molin 2003).
Second, the Internet also facilitates consumers’ ability to apply their knowledge by provid-
ing access to a variety of online design tools (Prahalad and Ramaswamy 2004; Thomke and von
Hippel 2002). For example, fans of popular computer games such as Half-Life and The Sims can
access Internet-based programs that enable them to create their own modifcations and extensions
to these games. Similar types of online design tools can also be found for website development,
podcasting, and digital audio/video production. According to von Hippel (2005, p. 123), these
tools “are often as good as those available to professional designers,” and research suggests that
they are instrumental in encouraging end users to experiment with and improve their own products
(Prügl and Schreier 2006). As a result, in many felds, an increasing number of consumers are
acquiring skills and knowledge that nearly equal those of a frm’s internal NPD team (Leadbeter
and Miller 2004; Prahalad and Ramaswamy 2004).
Third, in addition to enriching the creative capabilities of individual consumers, the Internet en-
hances collective co-creation by connecting individual consumers with others (both consumers and
manufacturers) in a manner that allows them to participate effectively in a co-creation community
(Moon and Sproull 2001; Prahalad and Ramaswamy 2000; Sawhney, Verona, and Prandelli 2005).
These communities enable consumers to learn from (and teach) other consumer-creators (Prügl
and Schreier 2006) and help form collective knowledge and memory systems that transcend the
information and skills of any single individual (Jeppesen and Molin 2003; Leadbeter and Miller
2004). For example, open source computer software is typically developed via self-organized
communities of thousands of contributors who work in a highly collaborative manner and play
a variety of different roles. This collective information exchange enables these co-creation com-
munities to create offerings that can equal or surpass traditional frm-based NPD activity in terms
of development speed, creativity, and marketplace success (Shah 2006).
In sum, growing customer empowerment appears to be rapidly promoting customer co-creation
by motivating consumers to play a more active role in the NPD process, enhancing their NPD
knowledge and skills, and connecting them with proactive communities of like-minded individuals.
This emerging trend presents an exciting opportunity for marketing researchers and practitioners
to employ co-creation as a potential alternative to the traditional NPD paradigm.
A Typology of Customer Co-Creation
In recent years, the rise of co-creation has garnered considerable attention across a broad range
of felds, including information systems, economics, management, and marketing (e.g., Sharma,
Sugumaran, and Rajagopalan 2002; Etgar 2008; Evans and Wolf 2005; von Hippel and Katz
2002; Pitt et al. 2006; Prahalad and Ramaswamy 2004; Vargo and Lusch 2004). This research has
uncovered a variety of different forms of co-creation, ranging from enhanced customer sensing
techniques embedded within largely frm-driven NPD processes to open source innovation oc-
curring beyond the boundaries of the frm. In this section, we conceptually synthesize this diverse
array of co-creation initiatives into a coherent typology.
As previously noted, a growing number of consumers are seeking increased autonomy and
displaying higher levels of empowerment over the NPD process. According to the organizational
CUSTOMER CO-CREATION: A TYPOLOGY AND RESEARCH AGENDA 89
creativity literature, a high degree of autonomy enhances creativity (Amabile et al. 1996; Velt-
house 1990; Woodman, Sawyer, and Griffn 1993). For example, Amabile and her coauthors
fnd that mid-level managers with substantial autonomy are considerably more likely to generate
creative projects compared to mid-level managers with limited autonomy. The positive effect of
autonomy is largely believed to be due to its ability to cultivate high levels of intrinsic motivation
and psychological ownership, which in turn facilitates creativity by making the creative task more
enjoyable and rewarding (Csikszentmihalyi 1996; Deci and Ryan 1985). A release of control should
have a similar (and perhaps even greater) effect on customer co-creation, as customers (unlike
employees) typically receive little or no direct fnancial compensation for their creative efforts
and, thus, must possess high levels of intrinsic motivation in order to engage in and sustain such
activity (Seybold 2006). Hence, releasing control of NPD activities should, theoretically, lead to
more creative and successful offerings.
Although a few frms are beginning to recognize the potential benefts of releasing NPD con-
trol (Seybold 2006), many are reluctant to enhance customer autonomy due to concerns about
leaking valuable proprietary information, ceding managerial power, and losing control over their
brands (Pitt et al. 2006; von Hippel 2005). For example, Intuit’s chairman, Scott Cook, recently
revealed that upper-level managers at his frm resisted customer co-creation because of its “chal-
lenge to long unquestioned beliefs about the role of management, the value of experts, the need
for control over customer experience, and the importance of quality assurance” (Cook 2008, p.
68). This type of reluctance may be well placed, as the marketing strategy literature suggests that
tight and systematic managerial controls (such as the Stage-Gate model) enhance NPD success
(Cooper 1990; Song and Parry 1997). Consequently, co-creation initiatives display considerable
variance in the degree to which they empower customers by allowing them greater autonomy over
the NPD process, especially at its early stages (that is, fuzzy front end).
The NPD literature suggests that the early stages of developing a new product entail two essential
activities: (1) the contribution of novel concepts and ideas, and (2) the selection of which specifc
concepts and ideas should be pursued (Kahn 2005). In many frms, both of these activities are
closely guarded and typically conducted by a small number of employees (that is, an NPD team)
(Sethi, Smith, and Park 2001; Song and Parry 1997). In most cases, customers are not actively
engaged in either activity. Thus, frms can engage in customer co-creation by releasing control
of either the contributions made to the NPD process and/or the selection of these contributions.
Consequently, the degree of customer autonomy across these two activities forms the conceptual
basis for our typology.
Our typology is depicted in Figure 4.2. As shown in this fgure, we depict contribution and
selection as two distinct NPD activities that vary in the degree to which a frm releases control
and empowers its customers as active participants. Our depiction acknowledges that the balance
between control and empowerment lies along a continuum from low to high. Specifcally, we
suggest that the type and format of NPD contributions can range from being essentially fxed by
a frm to wholly open to customer input and that the selection of these contributions can be either
directed by a frm or directed by customers. When arranged along two dimensions, these activities
allow us to derive four distinct types of customer co-creation: (1) collaborating, (2) tinkering, (3)
co-designing, and (4) submitting, with submitting at one extreme (fxed contribution and frm-led
selection) and collaborating at the other (open contribution and customer-led selection). Although
non-exhaustive, we believe that this typology classifes a considerable body of co-creation activ-
ity.
3
In the remainder of this section, we defne each of these types of co-creation, identify their
key features, provide relevant exemplars, and discuss their benefts and limitations (see Table 4.1
for a summary).
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CUSTOMER CO-CREATION: A TYPOLOGY AND RESEARCH AGENDA 91
Collaborating
We defne collaborating as a process in which customers have the power to collectively develop
and improve a new product’s core components and underlying structure. As shown in Figure 4.2,
we conceptualize collaborating as the form of co-creation that offers customers the greatest power
to contribute their own ideas and to select the components that should be incorporated into a new
product offering.
At present, the best examples of collaborating can be seen in open source software initiatives
such as Linux, Apache, and Firefox. In contrast to commercial software, which places consider-
able restrictions on consumer usage, open source software empowers users to make fundamental
changes to a program’s basic structure (that is, source code). This openness also infuences the
way intellectual property is managed, as many open source licenses dictate that program changes
be made freely available to other users. In recent years, open source applications have gained
widespread adoption and market success. For example, Apache, an open source application,
dominates the worldwide market for web-server software with over a 70 percent market share
(Grewal, Lilien, and Mallapragada 2006). In addition to software development, collaborators
are making important and innovative contributions in several other areas, including agriculture
(www.cambria.org), pharmaceutical products (www.tropicaldisease.org), medical devices (www.
designthatmatters.org) and architecture (www.architectureforhumanity.org).
While many collaborator-based projects are managed by nonproft organizations, the principles
underlying this form of co-creation may be usefully employed by for-proft frms (Evans and Wolf
2005; Shah 2006). In fact, some software frms release the source code for selected commercial
Figure 4.2 Four Types of Customer Co-Creation
CONTRIBUTION ACTIVITY
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Co-designing
Submitting
Tinkering
92 MATTHEW S. O’HERN AND ARIC RINDFLEISCH
products into the open source community in hopes of establishing a dominant technological plat-
form. Sun Microsystems, for example, employed this strategy when it made the source code for
its NetBeans development tool freely available. Today, NetBeans has been downloaded more than
eight million times and enjoys contributions from over 300,000 collaborators around the world
(www.netbeans.org). Similarly, IBM uses collaborating as a key part of its competitive strategy
by employing hundreds of open source programmers dedicated to enhancing the Linux operating
system (Harris 2004). IBM also actively encourages open source development outside the frm by
serving as a founding member of the Open Invention Network, a company that supports open source
innovation by purchasing software patents and making them available on a royalty-free basis.
We suggest that collaborating provides customers with a high degree of latitude to contribute
their own new product improvements and gives them substantial freedom to select the new prod-
uct improvements they fnd most valuable. In the case of open source software development, the
underlying offering is based on open standards that grant all customers (who have the requisite
skills) the ability to fully customize the product to better satisfy their own unique needs (Lakhani
and Wolf 2005; Shah 2006). Hence, collaborating grants customers almost unlimited freedom to
alter the underlying product, thereby transforming customers from passive users to active contribu-
tors (Pitt et al. 2006; Evans and Wolf 2005; von Krogh, Spaeth, and Lakhani 2003). Moreover,
collaborators are often responsible for forming their own project teams. These teams exist outside
the traditional boundaries of the frm, are organized in a non-hierarchical fashion, and rely on a
community-based governance system to evaluate and select the inputs made by fellow collaborators
(Grewal, Lilien, and Mallapragada 2006; Lakhani and Wolf 2005; von Krogh, Spaeth, and Lakhani
2003). Hence, this customer-led selection mechanism stands in stark contrast to traditional NPD
teams in which the selection process is largely confned to a few select employees.
Although some individuals engage in collaborating for extrinsic rewards (such as enhancing their
career opportunities or gaining status or recognition), most collaborators appear to be intrinsically
motivated by a strong philosophical belief in the importance of their work as well as by a deep
enjoyment of contributing their thoughts and ideas (Evans and Wolf 2005; Hertel, Niedner, and
Herrmann 2003; Sharma, Sugumaran, and Rajagopalan 2002). Due to this high level of intrinsic
motivation, collaborating has the potential to generate high levels of co-creator involvement
(Lakhani and Wolf 2005; von Hippel 2005). Moreover, recent research suggests that collaborat-
ing can improve NPD performance by accessing novel sources of customer-held knowledge held
across a diverse set of individual contributors (Grewal, Lilien, and Mallapragada 2006).
By generating a high degree of involvement and accessing diverse knowledge domains, col-
laborating appears to be a highly effective means of generating innovative and successful new
products. For example, the open source–based Firefox web browser competes successfully against
Microsoft’s dominant Internet Explorer and is widely regarded as the most innovative browser
currently available (Vogelstein 2008). In addition to spurring innovation, collaborating can dramati-
cally lower the costs of NPD by using unpaid customers to replace salaried employees. Moreover,
unlike traditional NPD projects, which have fnite start and end dates, collaborating is an ongoing
process. This quality should help frms stay on the leading edge by providing a mechanism for
continuous product improvement and enhance customer welfare by accelerating the pace at which
new innovations can be created and distributed to users (von Hippel 2005).
While collaborating may produce substantial benefts, this form of co-creation also faces a
number of challenges. Most importantly, collaborating appears to best suited for information-
rich applications (for example, software development, medical research, digital graphic design)
and, thus, may be the most challenging form of co-creation for more traditional industries such
as packaged goods or consumer durables. Moreover, in order to drive innovation, collaborating
CUSTOMER CO-CREATION: A TYPOLOGY AND RESEARCH AGENDA 93
requires that at least a small cadre of co-creators obtain a high level of skill and knowledge. This
entry requirement may discourage lower-skilled and less knowledgeable customers (who may
nevertheless have interesting ideas) from fully participating in the innovation process. Moreover,
successful collaboration requires frms to cede managerial authority over NPD and loosen their
control over their intellectual property (Cook 2008). Hence, collaborating may be especially dif-
fcult for frms with highly centralized organizational structures and large investments in proprietary
assets. Thus, frms may be forced to strike a diffcult balance between control and openness. For
example, Shah (2006) fnds that when frms engaged in collaboration initiatives restrict individu-
als’ freedom to alter and share new product improvements, customers’ willingness to contribute
decreases and the risk of customer defections increases.
Tinkering
We defne tinkering as a process in which customers make modifcations to a commercially avail-
able product and some of these modifcations are incorporated into subsequent product releases.
4

Tinkering is similar to collaborating in terms of allowing customers a relatively high (but somewhat
lower) degree of autonomy over NPD contributions. However, frms that employ tinkering usually
retain a considerable degree of control over the selection of these contributions.
At present, tinkering is most apparent in the computer game industry, where user-generated
contributions (that is, modifcations) are not only widely tolerated, but actively encouraged. For
example, many game manufacturers invite users to make alterations ranging from incremental
changes, such as edits to a character’s physical appearance, to more radical innovations, such
as the creation of a completely new computer game. In order to assist tinkerers in making these
changes, several computer game manufacturers provide customers with free or low-cost design
tools that are similar or even identical to those used by their in-house software developers (Moon
and Sproull 2001; Nieborg 2005). This strategy often leads to unexpected and innovative creations,
widespread adoption by other gamers, and marketplace success for the frm that produced the
base game. For example, over 90 percent of the content of the widely successful computer game,
The Sims, is derived from tinkerer-based modifcations (called “mods” in the parlance of gamers)
(Leadbeter and Miller 2004).
The contributions of tinkerers are not, however, limited to computer gaming. Tinkering is also
quite common in other information-based products, such as customized digital music and individu-
ally tailored web-based applications. For example, leading Internet frms such as Google.com and
Amazon.com offer open access to their application program interfaces (APIs). Consumers can
combine these open APIs with data from third parties or self-created content to generate innova-
tive hybrid creations known as “mashups.” One impressive user-generated mashup is the website
Chicagocrime.org, which melds information from the Google Maps API with a database from
the Chicago Police Department (CPD). This co-created website allows users to create their own
customized visual display of reported crimes for any street, neighborhood, travel route, or time
period they wish to select. This mashup is considerably more visually appealing and interactive
than CPD’s traditional database and provides customers with enhanced product functionality and
a more enjoyable online experience. At present, Chicagocrime.org receives over 500,000 hits per
month. Google also directly benefts from the efforts of tinkerers like the creators of Chicagocrime
.org, as the changes they make provide a nearly continuous stream of new content that enhances
product functionality and helps differentiate Google Maps from its competitors.
Like collaborating, tinkering begins with the release of a basic building block (such as base
commercial product and development tools). However, in contrast to collaborators, tinkerers do not
94 MATTHEW S. O’HERN AND ARIC RINDFLEISCH
have unfettered access to a product’s source code. This is an important point, because frm-based
control over the underlying product and its source code limits the scope of the product improvements
that tinkerers can develop. In addition, tinkerers must typically sign end-user licensing agreements.
This means that frms have the power to revoke tinkerers’ rights to use development tools and can
limit tinkerers’ ability to share their creations with other users. Thus, customer-created content
that was once freely available may be restricted after the frm launches a new product release that
includes these customer-led improvements. As a result, tinkering allows a frm to exert substantial
control in determining which new customer-generated product improvements are selected to ap-
pear in its offcial new product releases. These characteristics are depicted in Figure 4.2, which
positions tinkering as exhibiting less openness (compared to collaborating) in terms of customer
contribution and a heavily frm-led selection approach.
Although knowledge regarding the outcomes of tinkering is at a formative stage, it appears
that this type of co-creation may deliver several benefts to frms. In crowded markets with similar
offerings, tinkering may provide a basis for product differentiation. For example, the powerful
development tools included in the Unreal Tournament 2004 (UT 2004) Special Edition DVD
distinguished this product from similar offerings and helped UT 2004 become a highly successful
computer game (Nieborg 2005). Firms may also beneft from the activities of tinkerers in terms of
enhancing customer satisfaction and extending their market reach. By supporting and leveraging
the contributions of tinkerers, frms can assist customers in satisfying their own needs and sharing
their solutions with other customers who may have similar needs.
Firms can also beneft from the actions of tinkerers in terms of enhancing market acceptance
of their in-house NPD efforts. For example, LucasArts allowed images and music from its Star
Wars flms to be incorporated into the customer-led mod Galactic Conquest, even though it was
simultaneously developing its own proprietary Star Wars–themed computer game (Nieborg 2005).
By visiting websites where Galactic Conquest devotees congregated, LucasArts was able to identify
and contact users who downloaded this popular mod and determine which customer-generated
content they found most appealing. This approach provided LucasArts with both direct access to
customer-created innovations as well as a virtual test market for its fedgling commercial product,
which ultimately incorporated many of the mod’s most popular features.
Although tinkering may provide a number of benefts, it also poses several challenges. First,
in most (but certainly not all) cases, the act of tinkering requires a considerable degree of user
knowledge and expertise about the product to be modifed as well as its underlying technology.
However, with the increasing availability of user-friendly development tools, consumers who are
not expert users can readily acquire basic tinkering capabilities with moderate learning costs.
5

Tinkering also presents the risk that high-quality (and freely available) mods may dissuade cus-
tomers from purchasing a frm’s future new releases. Thus, frms that actively encourage tinkering
may fnd that their customers have become a formidable source of competition (Cook 2008). In
this sense, tinkering can raise the NPD bar, as a frm must ensure that new releases surpass both
the functionality of its existing products while also demonstrating superiority over versions that
have been created and made freely available by tinkerers.
It is also possible that the actions of tinkerers can have a negative impact on a frm’s brand
equity. For example, some tinkerers may modify computer games in ways that are especially vio-
lent and/or sexually explicit. Imagine, for instance, the case of a customer transforming a World
War II combat game into a mod set in an American high school, in which players amass points by
gunning down their fellow students and teachers. Most consumers would be appalled by such a
game, and the surrounding media attention would undoubtedly refect very negatively on the frm
that created the base product. Thus, the level of contribution autonomy provided by tinkering may
CUSTOMER CO-CREATION: A TYPOLOGY AND RESEARCH AGENDA 95
be a double-edged sword, as frms that rely heavily on tinkering may be particularly vulnerable
to the negative actions of rogue co-creators.
Co-designing
We defne co-designing as a process in which a relatively small group of customers provides a frm
with most of its new product content or designs, while a larger group of customers helps select
which content or designs should be adopted by the frm. As shown in Figure 4.2, co-designing is
characterized by a relatively fxed contribution approach but a high degree of customer autonomy
over the selection of these contributions.
One of the best examples of co-designing is the online clothing manufacturer Threadless.com.
This frm actively solicits original T-shirt designs from current and potential customers and then
invites its extensive network of online customers to evaluate and select a short list of prospective
new products (Chafkin 2008). Similarly, both the online news service Digg.com (www.digg.com)
and the cable television channel Current TV (www.current.tv) acquire much of their content directly
from their users. In contrast to the standard approach used by commercial news organizations,
Digg.com eschews hierarchical editorial control and instead allows its community of over 300,000
registered reviewers to vote on the stories they deem worthy for display. Likewise, Current TV
provides amateur flm makers with the opportunity to upload their homemade documentaries and
gives viewers the chance to select the clips that air on the network.
6
This co-creation approach
has been utilized across a wide variety of product categories, including sporting goods, household
products, home appliances, and consumer packaged goods (Ogawa and Piller 2006). For example,
Jones Soda (www.jonessoda.com) uses co-designing to differentiate its products by displaying
customer-submitted photographs (which are rated online by its users) on its product labels.
The co-designing process begins when customers create new designs and submit their original
content to a central hub (such as a company website). Next, a network of interested customers
evaluates these submissions and selects (typically via online voting) those they fnd most appealing.
Based on these evaluations, the frm then decides which products it will produce and market.
In contrast to tinkering, where co-creators have considerable latitude in terms of altering the
base product, frms engaged in co-designing usually dictate the precise format that co-created
contributions must follow. For example, contributions to Threadless must be submitted using a
company-issued template, can contain only limited text, and are constrained to eight sanctioned
colors. Due to these mandates, co-designing contributions are considerably more fxed and
constrained compared to either collaborating or tinkering. In contrast, co-designing provides
customers considerable autonomy in terms of the selection process. For example, the contribu-
tions that Threadless selects to print as new T-shirt designs are almost exclusively determined
by ratings provided by its customers. However, at times, Threadless invites particular designers
to submit designs, and thus bypasses its typical selection process. Consequently, it appears that
co-designing entails a level of customer autonomy over content selection that falls somewhere
between collaborating and tinkering.
From the perspective of a frm, co-designing appears to offer several advantages. Most im-
portantly, this approach should dramatically reduce a frm’s cost of developing its own original
designs or creative content, as this function is largely outsourced to customers. In addition, because
customers actively assist a frm by both contributing new content and selecting the content that
should appear in future product releases, frms should reduce their cycle times and launch new
products more quickly compared to traditional NPD processes. For example, Threadless typically
introduces several new T-shirts each week. Moreover, in contrast to collaborating and tinkering,
96 MATTHEW S. O’HERN AND ARIC RINDFLEISCH
co-designing is an approach in which both highly skilled (design contributors) and lower-skilled
(design selectors) customers can freely participate. Thus, by providing its broader customer base
with a strong voice in NPD selection and a sense of collective identity, co-designing should
allow a frm to attain higher levels of customer satisfaction and commitment (Hertel, Niedner, and
Herr mann 2003). In addition, by subjecting designs to prelaunch evaluation by a large network of
customers, co-designing should reduce the risk of product failure, avoid drastic price markdowns,
and minimize inventory holding costs (Ogawa and Piller 2006).
Although the benefts of co-designing are intriguing, there are also substantial challenges in
implementing this approach. First, frms may encounter diffculty in terms of attracting a critical
mass of designers large enough to ensure that they obtain a suffcient amount of high-quality
content (Cook 2008). This challenge may be especially acute for frms whose competitors have
already established co-designing initiatives. In addition, although customers may be initially in-
trigued with this approach, the novelty of being able to submit and vote on designs may quickly
wear off. Hence, a frm may fnd its pool of evaluators shrinking over time. Moreover, because
this approach is relatively easy to imitate, frms that base their value proposition primarily on co-
designing may end up lacking a distinctive core competence as competitors copy their approaches.
To combat these challenges, frms that employ co-designing should establish strong lines of mutual
communication with their co-designers and devote substantial effort toward fostering a collective
sense of community (Cook 2008).
Submitting
We defne submitting as a process in which customers directly communicate ideas for new product
offerings to a frm. Submitting is differentiated from traditional forms of customer inquiry (for
example, focus groups, satisfaction surveys, tracking studies, and so forth) by both the degree
of customer effort required and by the nature of the input that customers provide to the frm. In
contrast to most traditional forms of customer inquiry, which simply ask customers to provide
responses to a set of prearranged queries, submitting requires customers to expend considerable
energy developing (either in isolation or as part of a team) tangible ideas for new product offerings.
In addition, while traditional inquiry approaches typically involve customers solely in concept
ideation and evaluation, submitting often requires customers to translate general ideas into well-
defned processes, detailed graphic depictions, or working new product prototypes. As shown in
Figure 4.2, we conceptualize submitting as the form of co-creation that is characterized by the
least amount of customer autonomy in terms of both NPD contribution and selection. Although
submitting resembles co-designing (that is, both types of co-creation allow customers to directly
contribute their own novel ideas and solutions), it differs from co-designing because in submitting,
the frm retains full control over the NPD selection process.
Firms that employ submitting-based co-creation actively solicit input from either current or
potential customers. This solicitation often (but not always) occurs in the form of online invitations
for customer-generated content. For example, the Swedish appliance manufacturer Electrolux
sponsors an annual submitting competition called “Designlab” in which participants are asked
to submit technical designs and product prototypes for cutting-edge household appliances. This
initiative attracts thousands of entries across dozens of countries. From these, Electrolux selects
a small set of fnalists and invites them to a six-day, company-sponsored retreat, where they
participate in workshops, present their inventions, and compete for cash prizes (www.electrolux.
com/designlab). The Italian motorcycle manufacturer Ducati Motors employed a similar approach
via its recent “Design Your Dream Ducati” contest that encouraged Ducati enthusiasts to submit
CUSTOMER CO-CREATION: A TYPOLOGY AND RESEARCH AGENDA 97
innovative artistic and technical ideas to an executive team, which then selected the winning
contributions (Sawhney, Verona, and Prandelli 2005).
In addition to these frm-sponsored initiatives, submitting can also be brokered by third parties.
For example, InnoCentive (a spinoff of Eli Lilly) is a brokering agent that links frms seeking
solutions to complex scientifc problems to a network of thousands of individual scientists. Firms
anonymously post their NPD problems on the InnoCentive website, and highly trained specialists
from around the world can submit solutions. Successful InnoCentive submitters receive fnancial
compensation that can total tens or even hundreds of thousands of dollars, and their contributions
have led to innovative breakthroughs for a variety of major corporations, including Procter and
Gamble, Boeing, and DuPont.
As described in the above examples, submitting begins when customers contribute detailed new
product ideas, solutions, or prototypes. Based on these inputs, a frm then decides which concepts
to further develop, test, and eventually launch. Compared to the three prior types of co-creation,
submitting represents the lowest level of customer empowerment (as the frm dictates the format
that contributions must follow and also has full power to select which customer contributions to
adopt). In addition, many frms seek to retain control by insisting that submitters release their legal
rights to the product improvements they help develop (Wells 2005). Compared to more traditional
forms of customer input, however, submitting provides consumers with a much stronger voice
in the NPD process and allows them to share their knowledge and creative skills directly with
frm-based NPD teams.
Firms may derive several benefts from submitting. First, case study evidence from large frms
such as Intuit and Procter and Gamble suggests that this approach can result in a signifcant reduc-
tion in the time required to develop a new product and an increase in its degree of innovativeness
(Cook 2008; Huston and Sakkab 2006). Also, because submitting offers customer benefts (for
example, enhanced self-image and increased social status) largely absent from more traditional
customer input methods, this form of co-creation should allow frms to engage in richer dialogues
with customers who would normally be unresponsive to more traditional research inquiries. Thus,
this engagement should result in improved market-sensing capabilities and enhanced customer
relationships.
Like other co-creation approaches, submitting also entails a number of challenges. Compared
to the three other forms of co-creation in our framework, submitting may be least likely to result
in truly innovative products because of its minimal level of customer empowerment. Due to
these conditions, submitters may feel less connected with both the frm and other customers
compared to collaborators, tinkerers, or co-designers, and may lack suffcient intrinsic motiva-
tion to actively cooperate with the frm on an ongoing basis. Consequently, frms interested in
using this approach may experience diffculty in retaining active customer participation. Hence,
it is important that frms duly recognize the contributions of submitters (with, for example,
fnancial rewards, words of praise, explicit recognition). Without this type of reciprocity, it is
possible that submitters may feel exploited and come to view submitting as a one-sided ex-
change (Fournier, Dobscha, and Mick 1998) rather than as a mutually satisfying bidirectional
relationship (Oliver 2006).
Perhaps more importantly, frms seeking to adopt this approach may fnd it quite diffcult to
continuously attract new contributors to their submitting initiatives. Because each customer may
have only a limited number of new product solutions to offer, attracting new submitters may be
even more important than retaining established contributors. Moreover, the successful retention
of existing contributors should also enhance a frm’s ability to identify and recruit new submitters
via positive word of mouth (Mathwick, Wiertz, and De Ruyter 2007).
98 MATTHEW S. O’HERN AND ARIC RINDFLEISCH
Future Research Agenda
As seen in the preceding typology, customer co-creation represents a dramatic departure from
traditional NPD practice both in terms of how customers are viewed as well as the roles they play.
In brief, frms that abide by the traditional paradigm seek to solve NPD’s information asymmetry
problem by frst researching consumer preferences and then using this information to develop new
products in-house. In contrast, frms following the emerging co-creation paradigm seek to solve
this problem by actively soliciting consumer contributions and incorporating selected contributions
into their new product offerings. As evidenced by our many examples, a paradigm shift is cur-
rently under way. While the full ramifcations of this transition for marketing thought and practice
are not yet clear, they are likely to be quite substantial. In the words of Wind and Rangaswamy
(2001, p. 20), the emergence of customer co-creation has the potential to alter “everything we
take for granted in marketing.” In this fnal section, we outline an agenda for future research in
this domain. This agenda focuses on the impact of customer co-creation on six distinct domains
of inquiry: (1) organizational culture, (2) organizational learning, (3) organizational dynamics, (4)
resources and capabilities, (5) customer valuation, and (6) brand communities.
Organizational Culture
Because co-creation is fundamentally different from traditional NPD practice, successful imple-
mentation of this new paradigm will likely require signifcant changes in organizational culture
(Sawhney, Verona, and Prandelli 2005; Vargo and Lusch 2004; von Hippel 2005). According to
Thomke and von Hippel (2002, p. 78), “Turning customers into innovators requires no less than
a radical change in management mind-set.” Specifcally, co-creation’s highly interactive nature
may require frms to adopt an open culture in which their goals, activities, and processes are highly
transparent and collaborative (Ogawa and Piller 2006; Prahalad and Ramaswamy 2004). In par-
ticular, frms seeking to harness the benefts of co-creation may fnd it necessary to relax control
over their intellectual property. For example, in 2005, IBM took the radical step of declaring that
it would not enforce hundreds of its software patents in an effort to stimulate open source innova-
tion and increase the market size for its Linux-based servers (Lohr 2005). This type of openness
should encourage co-creation activity and enable customers to contribute innovative solutions to
help a frm meet its goals and objectives. However, many frms with traditional organizational
cultures are quite reluctant to relax control over their intellectual property (Cook 2008; von Hippel
2005). These frms may be willing to entreat customer contribution but will likely seek to retain
control over the selection of these contributions. Thus, the degree to which the benefts (such as
increased new product creativity, decreased time to market, and reduced development costs) of
customer co-creation depend upon releasing organizational control over each of these two key
processes (contribution and selection) is an important issue for future research.
Along with increased openness, frms seeking to reap the benefts of customer co-creation
will also likely need to adopt a more emergent strategic perspective (Mintzberg 1994). Accord-
ing to Jeppesen and Molin (2003, p. 377), under co-creation, “The management issue is not to
enforce ideas, but to make room for them to emerge and channel them into an innovation.” This
diminished focus on planning, forecasting, and control runs directly counter to the well-planned
logic of the traditional NPD paradigm and, thus, is likely to meet with considerable resistance
from managers who strongly believe in a more traditional approach. Indeed, their resistance may
be well founded, as the substitution of improvisation for planning can be potentially harmful to
NPD success (Moorman and Miner 1998). Of the four types of co-creation identifed in our
CUSTOMER CO-CREATION: A TYPOLOGY AND RESEARCH AGENDA 99
typology, co-designing appears to strike the best balance between improvisation and planning, as
it encourages active customer participation within defned constraints. Future research is needed to
determine the effectiveness of planned forms of co-creation such as co-designing and submitting
versus more emergent forms of co-creation such as collaborating and tinkering.
Organizational Learning
Research on the drivers of innovation success has a long tradition in marketing scholarship (see
Henard and Szymanski 2001, and Hauser, Tellis, and Griffn 2006 for reviews). Historically,
the bulk of this research has focused on internal (that is, frm-based) drivers of NPD success,
such as a frm’s degree of marketing and technological skills, level of market orientation, and
amount of cross-functional integration. In recent years, this research has been supplemented
by a growing number of studies that examine drivers of successful innovation beyond the im-
mediate frm, such as the infuence of acquired entities or alliance partners (see, for example,
Chandy, Prabhu, and Ellis 2005; Rindfeisch and Moorman 2001; Sividas and Dwyer 2000).
This research broadly suggests that the success of these collaborative NPD efforts strongly
depends upon the degree to which a frm is able to acquire, assimilate, and apply information
and know-how from its partners. In sum, collaborative NPD has been largely viewed from the
perspective of a frm’s ability to learn.
Customer co-creation adds a new dimension to this emerging literature by suggesting that NPD
success strongly depends not only on a frm’s ability to learn but also on its ability to teach. Spe-
cifcally, successful co-creation rests heavily upon the degree to which a frm is able to enhance
its customers’ NPD-related knowledge and skills via such actions as allowing access to its source
code, providing toolkits that allow customers to directly alter their products in creative ways, and
engaging in direct, two-way communication with co-creators. This education imperative should
be most important for collaborating and tinkering, as these co-creation approaches typically
require a high level of technical skill. However, co-creation education may also be valuable in
enhancing the quality of the contributions of customers engaged in co-designing and submitting.
The importance of customer education has received some attention within the emerging literature
on customer toolkits (such as Franke and Piller 2004; Prügl and Schreier 2006; Thomke and von
Hippel 2002). However, several intriguing questions remain unanswered. For example, what is
the relative value of educating existing customers versus recruiting new customers who already
possess co-creating skills? Likewise, what types of customer education efforts are most valuable
for each of the four types of customer co-creation identifed in our typology?
Organizational Dynamics
The sense of empowerment that co-creators enjoy, combined with the increased knowledge and
skills they are likely to acquire, may give customers a strong sense of psychological ownership
over their contributions (Pitt et al. 2006; Prahalad and Ramaswamy 2000). In turn, this sense of
ownership may complicate a frm’s internal NPD plans and activities. Because co-creation shifts
tasks that were formerly conducted by managers down to customers, it may blur the boundary
between these two groups (Evans and Wolf 2005; Prahalad and Ramaswamy 2000). Thus, cus-
tomers may begin to see themselves not only as consumers but also as producers. Research on
organizational dynamics (that is, stakeholder theory) suggests that frms that are heavily engaged
in customer co-creation could fnd it more diffcult to quickly alter their product lines or radically
change their NPD processes in order to respond to competitive pressures (Donaldson and Preston
100 MATTHEW S. O’HERN AND ARIC RINDFLEISCH
1995). In essence, co-creation initiatives could create a new class of organizational stakeholders,
many of whom may vigorously oppose NPD-related changes with which they disagree.
These challenges are likely to be especially pronounced for those forms of co-creation that
involve a high degree of customer-led contribution activity (tinkering and collaborating). However,
anecdotal evidence suggests they can also occur in co-designing settings. For example, Threadless
is currently facing a sense of ownership struggle, as several members of its online community are
upset about its selection procedures and the recent opening of a brick-and-mortar store in Chicago
(Chafkin 2008). Future research is needed to shed light on both the positive and negative impact
that empowered co-creator stakeholders have upon NPD performance. In particular, the ability of
these stakeholders to effectively respond to market challenges such as the entry of a new competitor
or the emergence of a discontinuous technological is a topic ripe for empirical investigation.
Resources and Capabilities
The ability of a frm to achieve and sustain a competitive advantage is widely believed to rest
upon its resources and capabilities such as sensing market trends, developing strong customer
relationships, and creating innovative new products (Day 1994; Hunt and Morgan 1995; Moorman
and Slotegraaf 1999). These resources and capabilities have been broadly viewed as assets that
are internal to a frm and reside in its organizational culture, operating procedures, and human
resources. For example, Day (1994, p. 38) suggests that “Capabilities are deeply embodied within
the fabric of the organization.”
The emergence of customer co-creation suggests that this strict focus on internal-based resources
and capabilities ignores an important source of potential competitive advantage: the knowledge
and skills embodied in a frm’s customer base (Jeppesen and Molin 2003; Prahalad and Ramas-
wamy 2000; von Hippel 2005). As suggested by Prahalad and Ramaswamy (2000, p. 80), when
frms adopt co-creation, “consumers become a new source of competence for the corporation.”
In essence, frms that succeed in establishing co-creation can gain access to a rich external source
of NPD-related resources and capabilities that can supplement their internal value creation abil-
ity. Thus, the emergence of customer co-creation suggests that marketing scholars should view
a frm’s resources and capabilities from a broader network-based (embodied) perspective rather
than focusing narrowly on its internal (embedded) assets. As with their internal counterparts,
the value of co-creation–based capabilities is likely to depend upon the degree to which they are
distinctive and non-imitable. These qualities may be especially diffcult to attain via a sharing
approach because this form of co-creation appears to have few barriers to entry. Future research
could make an important contribution by identifying the degree to which our four types of co-
creation possess these desired qualities.
Customer Valuation
Understanding and assessing customer value is currently an extremely important topic of market-
ing scholarship (Marketing Science Institute 2008). To date, research on this topic has primarily
focused on identifying the characteristics of proftable customers based largely upon their pur-
chase behavior over time (for example, Gupta, Lehmann, and Stuart 2004; Reinartz and Kumar
2003; Rust, Zeithaml, and Lemon 2001). This focus refects marketing’s traditional belief that
the transaction itself is the primary mechanism of value exchange (Vargo and Lusch 2004). Ac-
cording to this belief, frms are responsible for creating value, and customers reward this value
by purchasing their products (Srivastava, Shervani, and Fahey 1998). However, this perspective
CUSTOMER CO-CREATION: A TYPOLOGY AND RESEARCH AGENDA 101
seems inconsistent with the logic of co-creation, which suggests that customers are not only tar-
gets of a frm’s value proposition, but also active value creators in their own right (Prahalad and
Ramaswamy 2004; Vargo and Lusch 2004). In sum, it seems as if the boundary between producers
and consumers is clearly shifting.
The emergence of customer co-creation is a prime example of these shifting boundaries, as
consumers provide frms with value in the form of their purchase activity as well as their produc-
tion activity. Thus, it is possible that a customer who is an infrequent and low-volume purchaser,
but a highly active contributor or selector of new product ideas, may be one of the frm’s most
valuable assets. Unfortunately, the worth of this customer would go unrecognized by existing
customer valuation perspectives, which do not account for the productive aspects of customer
behavior. Hence, the emergence of customer co-creation calls for updated and enhanced customer
value metrics that adopt a broader view of consumers and the spectrum of value they bring to the
frm. For example, new metrics that focus on assessing the value of a collaborator’s contributions
using market-based criteria such as the number of times their contributions have been downloaded,
viewed, or further modifed by fellow collaborators would be an important refnement of the exist-
ing customer valuation frameworks.
Brand Communities
Historically, marketing scholars have focused on consumer behavior from the perspective of the
individual. In recent years, however, researchers have highlighted the growing phenomenon of
collective consumer behavior in the form of brand communities (McAlexander et al. 2001; Muñiz
and O’Guinn 2001; Muñiz and Schau 2005). These communities bring together (either physically
or virtually) individuals who share a common affnity for a particular brand such as Apple comput-
ers, Saab automobiles, or Harley Davidson motorcycles. Thus far, this literature has emphasized
the potential of these communities as vehicles for forging deep and enduring customer-brand
relationships. However, they may also serve as especially fertile ground for co-creation activity.
Recent research by Muñiz and Schau touches on this potential by observing that members of the
abandoned Apple Newton community develop applications for this product and actively share their
creations with fellow members. Indeed, the basic features of brand communities (for example, a
collection of dedicated and knowledgeable individuals who exchange information about their be-
liefs, interests, and insights) should provide a means of incubating customer co-creation. Moreover,
because customers may engage in co-creation as contributors as well as selectors, community-based
appeals may resonate with one kind of co-creator but not the other. In the case of Threadless, for
example, customers who regularly engage in selecting T-shirt designs are perhaps more likely
to feel a greater sense of community than those who contribute these designs, because this latter
group may be more self-directed and extrinsically motivated by Threadless’s $2,000 cash reward
and the chance to garner greater professional exposure. Thus, the role of brand communities as a
catalyst for co-creation (and vice-versa) is an intriguing topic for future research.
Conclusion
In today’s highly competitive marketplace, a growing number of frms are placing increased reli-
ance upon innovation as a means of achieving growth and proftability. Unfortunately, most new
products fail because they do not adequately satisfy customer wants or needs. Thus, as a means of
minimizing market failure and enhancing fnancial performance, an increasing number of frms are
empowering customers and allowing them to actively participate in the NPD process. As we have
102 MATTHEW S. O’HERN AND ARIC RINDFLEISCH
shown, this customer empowerment can take a number of distinct forms. Our typology classifes
four emerging forms of co-creation delineated by the degree to which customers are empowered
to contribute and select new product ideas. Although each of these co-creation types has its own
potential benefts and challenges, they all lie outside the boundary of NPD’s traditional worldview
and, hence, are contributing to the emergence of an exciting new paradigm. Millions of empowered
customers around the world have embraced the co-creation ethos. Thus, frms should look beyond
the confnes of their traditional NPD approaches and develop effective strategies for identifying
and harnessing the ideas, skills, and talents of their customers. We hope this typology and research
agenda fosters greater appreciation for and investigation into this important phenomenon.
Notes
1. For ease of exposition, we employ the term “product.” However, we acknowledge that customer co-
creation is highly congruent with marketing’s service-dominant logic, which posits that collaborating with
customers creates value by harnessing the power of customer learning and leveraging the service-based
benefts embedded in products (Vargo and Lusch 2004).
2. Although we make no claim that these creativity-based benefts supersede consumption-based benefts, the
extant literature on customer co-creation nevertheless suggests that benefts that are based on the creative work of
customers can play an important role in enhancing customer satisfaction (Lakhani and Wolf 2005; Shah 2006).
3. Some scholars also identify lead users as a form of co-creation (for example, Urban and von Hippel
1988). Our typology does not explicitly consider lead users as a specifc form of co-creation unto itself. In-
stead, we highlight the role that lead users play in some of the types of co-creation identifed in our typology.
In addition, while a few scholars view mass customization as a form of co-creation (Wind and Rangaswamy
2001), a large number of scholars disagree and feel that mass customization does not suffciently incorporate
customer input into the actual creative process (for example, Jeppesen and Molin 2003; von Hippel 2005).
Thus, our framework does not explicitly consider mass customization as a form of co-creation.
4. Many examples of lead-user alterations (such as the frst homemade windsurfers developed by surfng
enthusiasts) bear a resemblance to tinkering. Although these modifcations may result in creative outcomes,
frms rarely if ever assist end users in making these alterations (Franke and Shah 2003; Luethje, Herstatt,
and von Hippel 2002). In contrast, frms engaged in tinkering actively encourage customers to alter their
products, establish forums for tinkerers to share their creations, and specifcally design their products to
allow for easy customer modifcation.
5. It is estimated that approximately one-third of all computer games offer these types of toolkits to their
users (Jepperson and Molin 2003).
6. Current TV was founded in 2005 by former vice president Al Gore. Its tagline (“The TV network
created by the people who watch it”) nicely refects its co-creation ethos.
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107
chaptEr 5
CHALLENGES IN MEASURING RETURN
ON MARKETING INVESTMENT
Combining Research and Practice Perspectives
KoEN pauwEls aNd davE rEiBstEiN
Abstract
Return on Marketing Investment (ROMI) holds great promise as a metric to increase the ac-
countability for marketing spending. Unfortunately, many organizations experience considerable
roadblocks to fulflling the appealing promise of measuring ROMI and using it to enable better
marketing decisions and higher performance. We discuss ten such roadblocks, give examples, and
critically examine how research has addressed and should further address these issues.
Introduction
Return on Marketing Investment (ROMI) is defned as the incremental margin generated by a
marketing program, divided by the cost of that program at a given risk level (Powell 2002). The
typical formula is displayed in equation 1:
Return on Marketing Investment =
[Incremental Margin – Marketing Investment] / Marketing Investment (1)
Use of this metric promotes accountability for marketing spending, enables comparison across
alternatives to decide on the best action, and furthers organizational learning and cross-functional
teamwork. Unfortunately, managers are struggling to defne and calculate ROMI (Woods 2004),
especially outside the price/promotions domain (Bucklin and Gupta 1999). A survey of over one
thousand C-level managers (CMO Council 2004) revealed that over 90 percent of marketing ex-
ecutives viewed marketing performance metrics as a signifcant priority, but that over 80 percent
were unhappy with their current ability to measure performance. Only 17 percent of marketing
executives have a comprehensive system to measure marketing performance. The companies they
work for outperformed other frms in revenue growth, market share, and proftability. Thus, most
organizations experience considerable roadblocks to fulflling the appealing promise of measuring
ROMI and using it to enable better marketing decisions and higher performance. Since most fnan-
cial decisions in the non-marketing domain are typically based on their return on investment, the
108 KOEN PAUWELS AND DAVE REIBSTEIN
absence of ROI calculations for marketing activities makes it harder to obtain funding for them.
Several reasons underlie these diffculties, from the improper use of the term “return on invest-
ment” for measures that do not include profts/margins or investment costs (Lenskold 2003) to
the lack of research into how return on marketing investment can be measured and how it can be
used to enhance performance (Pauwels et al. 2008). Indeed, while many marketing practitioners
and academics have expressed concern about marketing accountability and return on investment,
the current push has come largely from outside the feld, notably top management and fnance
(Lehmann and Reibstein 2006). Unfortunately, CEOs and CFOs have been disappointed by the
most common responses of the marketing feld, from “it is hard to judge the impact of marketing
spending since so many factors come into play between the spending and the ultimate fnancial
result” (marketing practice) to “we already show it through our sales response functions” (mar-
keting academia). The authors’ experience in recent years demonstrates that such positions are of
little help in bridging the gap between marketing and fnance felds, enabling joint understanding
and trust in ROMI calculations and ROMI-based decisions and building the standing of market-
ing in the C-suite.
Previous authors have already laid the conceptual frameworks for return on marketing invest-
ment (Lehmann 2005; Lehmann and Reibstein 2006; Rust et al. 2004; Sheth and Sisodia 2002;
Srivastava, Shercvani, and Fahey 1998). True to the focus of Review of Marketing Research on
“implementing new marketing research concepts and procedures,” this chapter discusses ten con-
ceptual and implementation issues that complicate measurement and use of return on marketing
investment. First, the “incremental margin” in equation 1 (hereafter “return”) needs to be forecast,
in terms of magnitude but also timing and associated risk. Second, the investment could involve
a combination of marketing actions and must be considered from the point of decision perspec-
tive. Once the components of returns and investment are measured, it is still unclear whether they
should be combined for a focus on impact versus effciency and realized versus potential return
on marketing investment. Finally, acting upon measured return on marketing investment requires
clarity on how to weigh multiple objectives and an understanding of whether high ROMI means
the marketing action should get more or less investment in the future. Often, spending more on
programs with a high ROI will lower the ROI percentage but raise the total return, given that we
are generally at the diminishing-returns stage of the response curve.
Figure 5.1 presents our framework for organizing these issues, while Table 5.1 summarizes
what we already know and what we still need to learn from further research.
The remainder of this chapter discusses all ten challenges in detail, giving examples and criti-
cally examining how research has addressed and should further address these issues.
Ten Challenges to Measure and Act upon Return on Marketing Investment
Challenge 1: ROI Framework Devised for Predictable Timing of Returns
Issue
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predictable years. In contrast, spending on a marketing campaign may extend across multiple
periods and result in the building of brand and/or the value of customer assets with a less predict-
able duration. These are the two biggest assets marketing brings to the frm. The effects of brand
and customer asset building will entail wear-in and wear-out patterns that are hard to measure,
109
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CHALLENGES IN MEASURING RETURN ON MARKETING INVESTMENT 111
especially when tracking the impact of several activities. As a result, the mapping of the return for
any one marketing investment will be very diffcult to establish. Even other marketing investments
that are not necessarily directed at brand or at attracting customers will have varying degrees of
longevity and unpredictable impact on the frm’s return.
Example
An advertising campaign may involve spending the money in the frst month, seeing the execution
in the second and third month, observing initial sales effects in the third month and the peak sales
impact in the ffth month. The same campaign may also have increased the willingness to pay for
the brand, which does not show up immediately, as the company does not raise prices. One year
later, though, the company is able to raise the brand’s price by 3 percent and lose only 2 percent
of unit sales, versus 4 percent of unit sales that would have been lost without the ad campaign.
Current Research
While Little (1970) pointed to the possibility of wear-in times for marketing campaigns, empirical
evidence remains limited to sales effects of advertising, new product introductions, and point-of-
purchase actions. The peak sales effect of advertising occurs relatively fast, typically within two
months (Pauwels 2004; Tellis 2004), while the wear-in times for mindset metrics (such as awareness,
liking, and consideration) are just over two months (Srinivasan, Vanheule, and Pauwels 2010). In
contrast, new product introductions typically take several months or years to take off (Golder and
Tellis 1997). As can be expected, point-of-purchase actions work right away or not at all (Pauwels
2004), with price promotions standing out as the most studied marketing action (Srinivasan et al.
2004). A major gap in the literature is the timing of improvements in distribution, with only Srini-
vasan et al. (2010) reporting it takes an average of 2.1 months for increases in distribution coverage
toreachtheirhighestimpact—thelongestwear-intimeofallstudiedmarketingactions.Further
investigation of this issue is important because distribution stands out as the most effective marketing
action (Bronnenberg, Mahajan, and Vanhonacker 2000; Srinivasan et al. 2010). Finally, we know
very little of the timing of returns to investments in new (electronic) media such as paid search,
banner ads, and word-of-mouth referrals. On the latter, Trusov, Bucklin, and Pauwels (2009) report
that wear-out times are substantially higher for word-of-mouth referrals as compared to traditional
marketing actions for a social networking site. Moreover, Drèze and Bonfrer (2008) calculate the
timing of e-mail returns to optimize e-mail frequency and maximize customer equity.
While considerable work has been done on brand and the value of customers, there has been
little research that refects how spending directly adds to the brand’s value and when the payout will
be realized. More efforts are being made to track the connection between spending and customer
acquisition and the value they bring to the frm (Rust et al. 2004). Even here it is often diffcult to
allocate the proportion of spending that contributes to customers’ acquisition versus retention.
Priorities for Further Research
Empirical generalizations on wear-in and wear-out effects are necessary for managerial advice
in cases where data are (for now) missing (Lehmann 2005). As literature has focused on certain
marketing actions in U.S. markets, we are in need of studies analyzing return timing for investments
in new media and new (emerging) markets. Moreover, the timing of returns may systematically
vary by medium and target audience, which should be taken into consideration when deciding
112 KOEN PAUWELS AND DAVE REIBSTEIN
between campaigns. Considerable research still is required to determine the contribution of mar-
keting spending on a brand’s value and when this value is realized by the frm.
Challenge 2: How to Adjust Projected Returns for Risk?
Issue
While marketing is all about change and risk, marketing managers are reluctant to calculate risk-
adjusted ROI due to a combination of fear of statistics and the perceived need to be a cheerleader
for marketing actions (Marketing NPV 2007). Further, we have few measures of risks. Market-
ers often look at the projected return from alternative programs and select the ones that have the
overall highest projected return. This treats each program as having the same levels of risk in their
projections. Different levels of risk for the same expected return should lead risk-averse managers
to select the action with the lowest risk. In addition, the kind of assets created by certain programs
may reduce the vulnerability of the company in the future (Fornell et al. 2006; Srinivasan and
Hanssens 2009). A typical example is a marketing program that builds customer loyalty. As the
loyalty gets larger, the risk levels are reduced. Hence, the programs could be assessed based on
their short-term ROMI or on the resulting reduction in risk for subsequent sales.
Example
A frm has a history of running price promotions every fall. Their years of experience have shown
there will be a 10 percent lift in sales, resulting in a 15 percent ROMI. A manager suggests the
alternative of running a banner ad on several Internet sites, which are preferred by other frms
claiming sales lifts ranging from 2–30 percent with an average of 15 percent and an expected ROMI
of 20 percent, and a range of –5 to 40 percent. If the frm would invest strictly in the program
with the highest return, it would clearly select the banner ads with the higher expected return.
However, many risk-averse managers would instead prefer to continue running the price promo-
tion. The picture further changes if the proposed new media increases brand equity not captured
in the ROMI calculation. As the brand grows in value, it stabilizes future sales.
Current Research
In academic articles, risk assessment typically involves reporting standard errors around model
estimates and forecast error bands, sometimes noting the caveat that the future is expected to be
like the past. Practitioner-oriented articles (e.g., Dhar and Glazer 2003; MarketingNPV 2007) and
books that speak to both academic and practitioner audiences (e.g., Blattberg, Kim, and Neslin
2008; Jagpal 1999, chapter 6) go beyond these statements to consider how risk should be incor-
porated in marketing decision making. The discount rate applied to returns is key in this respect
and can be determined based on the opportunity cost of capital and as well as on the source of
risk. The former approach holds that the frm should use as a discount rate the rate of return an
investor could make on a project of similar risk, calculated as the weighted average cost of capital
(WACC) (Brealey, Meyers, and Marcus 2004). This number differs per company, depending on
their betas (the ratio of the frm’s return variability over the variability of the stock market) and
the frm’s amounts of debt and equity. For instance, using these data from the 1997–2002 period,
Amazon had a WACC of 16.45 percent, while Pfzer had one of only 6.88 percent (ibid.). Because
it is calculated for the whole company, the WACC is the appropriate discount rate when the frm
CHALLENGES IN MEASURING RETURN ON MARKETING INVESTMENT 113
is considering investing in a marketing campaign similar to its past campaigns. For a very differ-
ent campaign, managers should identify the source of risk (that is, which component has a higher
risk level than that of typical projects), which requires them to consider the reasons for atypically
high risk (and ways to mitigate them). Finally, investing in a portfolio of marketing campaigns
and customer segments may reduce risk through diversifcation, and modern portfolio theory may
help frms balance expected returns and variance (Sharpe 2000).
Priorities for Further Research
Several of the recent advances in fnance (as noted above) have yet to be applied and adapted to
marketing investments. Identifying sources of risk is enabled with tools such as Strengths-Weak-
nesses-Opportunities-Threats (SWOT) analyses, process fows, and contributing factor diagrams
(MarketingNPV 2007). Investing in portfolios of marketing campaigns and customer segments
is a prime area for future research. For instance, the correlation among returns from different
segments should be inspired by academic research on how consumers interact across segments
(with, for example, one segment acting as opinion leader for the others).
Challenge 3: Point of Decision Perspective Needs to Be Captured in
ROMI Approach
Issue
ROI was devised for comparing capital projects in which a given level of investment is made
once. Each new adjustment in spending requires a new ROI assessment of the expected returns
for that investment. The expected returns are adjusted as new information comes in. Similarly,
most marketing investments (for example, ad weight) are divisible (that is, we can spend half of
it now, half of it later) and can be revisited as new information comes in. How should companies
deal with such potentially continuous updating of ROI assessments?
Example from Lenskold 2003
A company launches a new product and is deciding on the marketing support campaign. With a cost
of $200K ($100K for market research, $100K for media buying), the marketing campaign is expected
to generate $600K in extra revenues at 50 percent contribution margin. The company calculates a
ROMI of [$300K–$200K]/$200K = 50 percent and decides to undertake the campaign.
After having spent the $100K on market research, research shows that the campaign will generate
only $360K in extra revenues. Should the company spend the remaining $100K? A retrospective
calculation would now reveal a ROMI of [$180K – $200K]/$200K = –10 percent. However, a
forward-looking calculation would consider the $100K spent on market research as a sunk cost
and thus reveal a ROMI of [$180K – $100K]/$100K = 80 percent and imply the campaign should
go on. Which one is correct?
Current Research
Marketing academic research is largely silent on this issue. From decision-making disciplines, we
know that the forward-looking calculation is right in guiding which course of action to take, as it
takes the correct point of decision perspective. However, the retrospective ROMI calculation is
114 KOEN PAUWELS AND DAVE REIBSTEIN
insightful for the purpose of tracking the precision of revenue forecasts and addressing specifc
shortcomings in this regard.
Priorities for Further Research
It is important to distinguish forward-looking ROMI for making specifc decisions from ROI of the
entire marketing budget (or even marketing department), which includes maintenance marketing
and other costs not attributable to specifc campaigns. Moreover, further research is needed into
the true divisibility of strategic marketing investments to answer tough questions that CMOs face
regarding the required level of investment. Finally, it appears worthwhile to regularly experiment
with new marketing ideas using small investments in limited settings and then to scale up the
successful actions quickly to the rest of the organization (Eechambadi 2005).
Challenge 4: Synergy in Marketing Spending
Issue
Here the issue is one of isolating the impact of any one element of the marketing program. Often,
the goal is trying to identify which components of the program are working and producing the
greatest return on the marketing investment. As such, it would be possible to eliminate the com-
ponents that are less effcient. However, the components are often interdependent, which occurs
in two different forms: multi-collinearity and interactions. Multi-collinearity is where two or more
variables or programs are run in conjunction with each other, and as such it is diffcult to assess
which of the programs is really causing the result: is it one, the other, or really only when done
in conjunction. If it is really just one of the programs that is causing the effect, yet it is hard to
assess which is the driver of the result, this is not really synergy, but it poses the same problem
of assessing which is the critical expenditure that is yielding the result. The case of interaction is
really one of synergy. The two components combined have a much greater impact than the one
alone. In this situation, it is diffcult to assess the impact of a single program, as it has an impact
beyond its direct effect. The entire notion of an “integrated marketing program” is built on the
premise that there is a synergy among the various different marketing activities.
Example
Once a year, Bloomingdale’s runs a special price promotion for its credit card holders. It stays open
late for an exclusive shopping evening at reduced prices. To do this without letting their credit card
holders know of the event would be foolish, so the store sends out several special mail pieces to
all of their credit card holders. The net result is a huge boost in sales for that evening. It is diffcult
for the store to tell if the sales hike is the result of the later than usual hours, the reduction in price,
or the special mail pieces that were sent out. It could be merely the result of multi-collinearity,
and because these three activities always happen in conjunction, it is impossible to assess which
is the real causal factor for the sales spike.
Current Research
Integrated Marketing Communications enjoys a long history in practitioner-oriented literature,
but relatively few academic papers have demonstrated marketing synergy. Those that do typically
CHALLENGES IN MEASURING RETURN ON MARKETING INVESTMENT 115
fnd large synergy effects (Naik and Raman 2003; Srinivasan et al. 2009). For one, advertising
is nine times more effective when paired with a new-to-the world car introduction versus paired
with an existing car model (Srinivasan et al. 2009).
Priorities for Further Research
The above-cited papers provide models to demonstrate and quantify synergy based on past data.
However, perfect collinearity among marketing actions in these past data (as in our example)
prohibits a model from distinguishing such effects. In that case, the best way to assess the impact
of the individual components of the marketing program would be to run an experiment or test
market. Taking the Bloomingdale’s example above, it would be possible to try an evening with
extended hours and test the impact. Similar isolation of the effects could be run for the other two
components of the program. In this manner it would be possible to test the effect of each as well
as to assess the synergistic impact.
Challenge 5: ROMI Depends on the Reaction of Competitors and
Other Market Players
Issue
The return on marketing investment is infuenced by the reaction of competitors, other market
players (such as retailers), and by employees of the company itself (for example, through decision
rules that favor repeating past successes (Dekimpe and Hanssens 1999). As a result, marketing
managers are urged to consider the net long-term impact of their decisions, which includes dynamic
response of such market players (Chen 1996; Dekimpe and Hanssens 1999; Day and Reibstein
1997; Jedidi, Mela, and Gupta 1999). This makes it very diffcult to know what the return will
be on any proposed marketing spending prior to knowing all important reactions. To complicate
matters, managers often have little insight into their own company’s decision rules (for example,
supporting a new product with advertising and price cuts) or its inertia (an initially successful
action gets prolonged and/or repeated). Marketing literature has so far focused on estimating
customer and competitor response to marketing actions, instead of the response of other players
in the market system.
Examples
The absence of a signifcant post-promotion sales dip in several empirical studies is mostly due to the
fact that prices do not return to their regular levels for several weeks (Pauwels 2004, 2007; Srinivasan
et al. 2004). A plausible reason for such prolonged company action, as confrmed in experiments, is
the managerial tendency to weigh past prices when setting future prices (Krishna, Mela, and Urbany
2000; Nijs, Srinivasan, and Pauwels 2007). Second, advertising may fail to affect sales due to its
inability to generate consumer response for established brands (Abraham and Lodish 1990), or due
to competitive retaliation campaigns that cancel any demand gain (Bass and Pilon 1980).
Current Research
Research is abundant as to competitive reaction, including its nature (aggressive, accommodating,
or neutral), its speed, and absence due to competitor’s unawareness or inability to react (Chen 1996).
116 KOEN PAUWELS AND DAVE REIBSTEIN
Recent studies have begun to assess the importance of competitive reaction on the return on the initial
marketing investment and report small effects on average, including both positive and negative im-
pact (Steenkamp et al. 2005). Pauwels (2007) fnds that competitor reaction lowers price promotion
benefts by 10 percent. Only a few papers have focused on company decision rules, and they have
consistently found that their impact on the net performance effects of price promotions dominates
that of competitive reaction (Horváth, Leefang, and Wittink 2001; Pauwels 2004, 2007). Similarly,
the reaction of retailers is most often analyzed in the context of price promotions (pass-through) and
new product introductions (retailer adoption and shelf space allocation). As for other market players,
recent research has focused on analyzing investor reaction to product innovation, price reductions, and
advertising (e.g., Pauwels et al. 2004; Joshi and Hanssens 2004; Srinivasan and Hanssens 2009).
Priorities for Further Research
The reaction of market players can be assessed by dynamic system modeling in data-rich
environments (e.g., Pauwels 2004) and by role play in data-scarce environments, such as
one-shot negotiations (Armstrong 2001). Marketing researchers have become fascinated
with the reaction of fnancial markets to marketing actions, as evident from the attention of
the Marketing Science Institute and the Journal of Marketing in a forthcoming special issue
on marketing and fnance. Further research is needed to assess whether investors react ap-
propriately to marketing actions and thus how valuable the information of investor reaction
is for marketing decision making.
A key research priority is to go beyond documenting a reaction and toward understanding
the impact of that reaction on the return on investment of the initiating action. For marketing
mix actions, is it really the case (Pauwels 2004) that the majority of the net sales impact derives
not from customer reaction but from support from other marketing actions (for advertising and
new products) or from prolonging the initial action for several weeks (in the case of feature and
price cuts)? For strategic marketing actions, how does one assess likely competitive reaction in
deciding on location, product quality, and regular price level (for example, start or avoid starting
a price war)?
Challenge 6: Intervening Variables Mask the True Impact of Marketing for the Firm
Issue
Several factors intervene between marketing actions and when the customer ultimately buys the
product, as well as the true impact on the value of the frm. Supply disruptions (especially critical
in emerging economies) can lower the fnancial returns to marketing actions, even when suffcient
consumer demand was generated. Macro-economic changes, such as the recent credit crunch and
fnancial meltdown, can wreak havoc on carefully planned and executed campaigns. Consumer
trends concerning diet habits can change as a result of specifc media exposure. Such interven-
ing factors appear especially important for products with a long sales cycle, as considerable time
passes from awareness to interest to consideration to preference to purchase, assessment, and
ultimately repurchase. Moreover, information on such intervening factors typically comes from
non-marketing datasets (such as government or industry sources), raising the issue of how to
merge different data sets with different periodicity. As a result of intervening factors, it becomes
diffcult to directly assess the impact of the marketing actions and spending on the value of the
frm, even if there is a highly positive impact created by the spending.
CHALLENGES IN MEASURING RETURN ON MARKETING INVESTMENT 117
Example
As in the example in Challenge 1 above, advertising spending occurs in the frst month. In the second
month, the economy takes a downturn, and operations has trouble shipping the product in a timely
manner. The question is, what would have been the resulting sales had these other factors not occurred?
Sales may even be down, yet in order to assess the return on the marketing investment, the real ques-
tion is, how much more would the sales have been down had there been no marketing effort?
Current Research
When the intervening factors are known and measurable, researchers prefer to include them as
variables in their models. For instance, Pauwels and his coauthors (2004) included the S&P 500
index, the construction cost index, and the dollar–yen exchange rate in their analysis of the U.S.
performance impact of product innovation for Japanese car manufacturers. If historical data are
unavailable, managers can assess the likelihood of intervening factors and their impact on the return
on marketing investment, for instance through scenario building (Armstrong 2001; MarketingNPV
2007). Combining such managerial judgment with estimates from past data offers a promising
way to get the best out of model and manager (Blattberg and Hoch 1990).
Priorities for Further Research
A key research goal is to assess the impact of marketing, separating out all of the extraneous and
intervening factors. If there are varying regions or time periods in which there were no or at least
different intervening factors, by running a cross-sectional or time series analysis and including the
intervening variables as other variables in the model or as co-variants, it should be possible to isolate
themarketingeffects.This,ofcourse,assumestwothings—theinterveningfactorsareindependent
of the marketing efforts, and there are suffcient observations of these factors. Unfortunately, often
these two conditions do not exist. For example, when we run a promotion or an advertisement, if
sales boom, then running out of stock is directly correlated with the promotion or marketing. This
would clearly understate the true potential impact of the marketing effort. As for the number of
observations, many times the extraneous factors are episodic and are one-time events, such as a
labor strike, and would be hard to build into a model with such limited observations.
The other alternative is to run an experiment or test market. In a tightly controlled experiment
in a limited geographic area, it would be possible to avoid such intervening factors. Here the
challenges are twofold: 1) running the experiment for a suffcient time period for measuring the
long-term effects, and 2) avoiding the intervening variables that result from the expenditures, such
as advertising and stock-outs. This way, the internal validity would be high in showing the effect
of marketing on performance in the absence of intervening factors. Of course, such experiment or
test market would have limited external validity: in the real world, managers do have to anticipate
and account for key intervening forces.
Challenge 7: Impact vs. Effciency of Marketing Spending
Issue
Even with consensus on measuring the return and investment components of marketing spending,
it is unclear whether they should be combined to measure effective spending versus effcient spend-
ing. Normally, when we refer to return on marketing dollar or ROI, it is in reference to effciency.
118 KOEN PAUWELS AND DAVE REIBSTEIN
With effciency as the goal, it almost always results in a reduction in budget, as the way to increase
the effciency of the total marketing spending is to eliminate those programs that are less effcient.
Instead, the frm may be more interested in the effectiveness (impact) of a marketing action, which
may be better expressed as [return – investment], without dividing by the investment as indicated
by the ROI formula. As an illustration, compare two mutually exclusive projects, with returns of
respectively $100M and $10M and investment costs of respectively $80M and $2M, at the same
level of risk. The frst project has the larger net return [$20M > $8M], but the second project has the
larger return on investment [25 percent < 400 percent]. Which project should a manager prefer?
Example
IBM once had a supplies division, in which it offered a variety of services. In order to maximize
their effciency, they starting looking at each service and eliminating them from the portfolio.
Not surprisingly, the size of the division continued to shrink until they decided they did not have
critical mass to warrant the division. So, while it was effcient, they lacked enough effectiveness
in what they were providing to keep the business.
Current Research
This issue has not been much debated in academic articles, but more so in books and practitioner-oriented
publications. Lenskold (2003) argues that the goal should be effciency, that is, to maximize the return
per dollar spent. In contrast, Ambler (2003) argues that impact (effectiveness) is more important: it is
most closely related to Net Present Value, Discounting Cash Flow, and Economic Value Added metrics
and focuses the organization on maximizing long-term frm value instead of short-term effciency.
Priorities for Further Research
Research could analyze the conditions under which an organization would and should focus on impact
versus effciency goals. For instance, growing, cash-rich frms in boom times favor impact goals,
while cash-strapped (small) frms in recession times favor effciency goals. In general, though, there
should be a balance between effectiveness and effciency goals. For instance, Diageo displays market-
ing actions on a 2 by 2 matrix juxtaposing their impact (on defned objectives) and their effciency
(ROMI). Actions without suffcient impact are likely to be canceled, no matter how high their ROMI,
while impactful but ineffcient actions are reexamined to improve effciency in the future. Probably
there should be some threshold, perhaps the cost of capital, that marketing spending should exceed,
and all programs that exceed this threshold should be supported. Research could investigate what
these thresholds for impact and effciency should be. As this chapter indicates, measuring the effec-
tiveness or the effciency is not an easy task. The point is that it is not only important to measure the
percentage return of any spending amount but also the magnitude. The goal should be to maximize
the total impact once a certain threshold is achieved, even if that reduces the overall effciency.
Challenge 8: Realized ROMI vs. Potential ROMI
Issue
While sophisticated companies like Procter and Gamble have a good feel for the return on invest-
ment of their actions (“realized ROMI”), they have yet to fnd how much return they could have
CHALLENGES IN MEASURING RETURN ON MARKETING INVESTMENT 119
had (“potential ROMI”). This is the spirit behind the Pioneering Research for an In-Store Metric
(PRISM) project: by tracking aisle-specifc traffc and conversion (or “closing rate”), companies
get a better feel for how much extra revenues they could have obtained. Indeed, most companies
do not invest in promising marketing actions until diminishing returns set in: history (non-zero
budgeting, conservative bias) and modesty prevent this.
Example
When focus groups revealed that its target customers loved ice cream, Unilever wanted to fll store
freezer doors with ads for its new Sunsilk hair care product (Neff 2008). However, PRISM data
revealed that only 10 percent of the target market (young women age 18–24) actually go down
the ice cream aisle during a shopping trip. Instead, end-aisle and hair care shelf ads reached a
much larger portion of the target group. In contrast to ice cream, some categories obtain high aisle
traffc but low conversion. Butter, yogurt, cereal, and coffee are examples. How can we explain
such patterns, and how can companies capture some of this potential?
Current Research
Research on marketing potential has focused on customer relationship management, that is, identify-
ing how specifc customers can be upgraded to higher usage and retention (e.g., Neslin et al. 2006).
Using only frm-specifc records, next-product-to-buy models attempt to infer the current share
of requirements and thus quantify the potential for increasing revenues from a customer (Knott,
Hayes, and Neslin 2002). Du, Kamakura, and Mela (2007) augment these internal records with
insights into customers’ relationships with competing frms to estimate the size of each customer’s
wallet and the frm’s share of it. Finally, hidden Markov models have been applied to estimate
household life cycles and their impact on budgetary allocation (Du and Kamakura 2006).
Priorities for Further Research
Marketing could gain a “better seat” in the boardroom if CEOs and CFOs understood how much
money they left on the table by under-investing in marketing and marketing skills (such as optimal
pricing). Based on models of customer requirements and the frm share of wallet (static focus) or
life cycle and next-product-to-buy models (dynamic focus), researchers could calculate “underin-
vestment quotients” to quantify this. Companies can then set up a system at the highest level that
includes metrics allowing experiments and scaling them up. For example, provided with better
in-store metrics, researchers can analyze which vehicles have the biggest impact on aisle traffc
and shopper conversion to capture the full potential of that aisle traffc.
Challenge 9: How to Deal with the Multiple Objectives?
Issue
Besides profts, managers at different levels of the organization care about a multitude of objec-
tives, including stock price/market capitalization, sales volume, the share of a specifc market,
market share, brand equity and other customer mindset metrics, retailer equity, and so forth. How
do these objectives relate to each other? Should they be incorporated into an “integrative” ROMI
calculation, and how much weight should be given to different objectives?
120 KOEN PAUWELS AND DAVE REIBSTEIN
Example
Natter and his coauthors (2007) optimized dynamic pricing and promotion planning for a retailing com-
pany, having agreed to optimize profts. When they recommended higher prices to increase company
revenues, they met with substantial resistance from the purchasing managers, whose supplier discounts
depend on sales volume, and from local branch managers, who insisted on keeping a market share
leadership position in their city. After further discussion, they decided to combine profts, total sales
volume, and local market share objectives in an overall goal function for the model to optimize.
Current Research
With the exception of the work of Natter and his colleagues (2007), we know of little academic
research on this issue. Forrester research reports and academic work in progress does focus on
the measurement of new media, such as user-generated content and blogs. A big question here is
what the objectives of the organization should be.
Priorities for Further Research
Bridging market perspectives across functional and geographical boundaries is an important
objective of marketing in general (e.g., Jaworski and Kohli 1993) and marketing dashboards in
particular (Pauwels et al. 2008). Eliciting these opinions and furthering consensus are underdevel-
oped areas in research and practice. Moreover, research could investigate the “optimal” weighting
of objectives based on hard performance measures, similar to combining model and managerial
judgment (Blattberg and Hoch 1990).
Challenge 10: Invest More or Less in High ROMI Actions?
Issue
If a frm is able to assess the return on their marketing dollars, how should they use this informa-
tion for future budgeting decisions? It is not as simple as shifting dollars to the actions with the
highest past ROMI. Just because this is how the dollars produced in the past does not mean this
is how they will in the future. Further, that a certain level of return was obtained does not mean
this is the optimal level; that is, perhaps better performance could be achieved if a different level
of spending or different implementation was employed.
Example
As Harrah’s implemented their dashboard and determined the effciency of their marketing spending,
they reallocated their dollars to spend only on more productive programs. One might speculate that
with greater productivity around their marketing spending, they would be more likely to spend more.
That was not the case, however (Reibstein et al., 2005). At least, they did not decrease their marketing
spending, but rather felt they could get more done with the same overall marketing budget.
Current Research
Empirical generalizations on sales response functions provide some guidance as to optimal spend-
ing rules (Mantrala, and Zoltners 1992).
CHALLENGES IN MEASURING RETURN ON MARKETING INVESTMENT 121
Imagine a frm with a sales response function as shown in Figure 5.2. What is shown is the sales
response resulting from a certain level of marketing “stock.” This “stock” refects the impact of
current spending plus whatever impact there is from the previous years’ spending. In other words,
advertising’s impact accumulates. Part of the “stock” that has been built by past spending erodes
each year and is added to with each new level of spending. A couple of issues arise:
1. The implication of stock is if the same amount of money was spent in the same way this
year as last, the results will probably be different, even if all other conditions were the
same, since the frm would be at a different level of “stock.”
2. Looking at the “X” on the graph, what is clear is the frm could have had a higher return had it
spent more, although at a lower level of ROMI, since it is past the second infection point.
Priorities for Further Research
If a frm would measure its response function and knew where it was on that function, it would
be in a better position to know whether to be spending more or less than in previous years. The
alternative would be to run experiments to assess alternative levels of expenditure and different
programs and their resulting impact.
Beyond the ten challenges from the framework in Figure 5.1, multinational companies face sev-
eral additional issues, such as global versus local branding and ROMI measurement. For instance,
Samsung has successfully revamped their entire marketing effort to refect a global optimization
of resources, while Avaya has standardized ROMI measurement globally but encourages local
branding and marketing actions.
Conclusion
It is critical to measure the return on marketing investments. In order to get budgeting support,
marketing will fnd it necessary to make the case that investments into marketing programs war-
rant the expenditure, relative to other opportunities facing the organization.
Figure 5.2 Sales Response Function
Sales
Marketing Stock
122 KOEN PAUWELS AND DAVE REIBSTEIN
Unfortunately, the estimate of ROMI is faced with many challenges, as outlined above. Perhaps most
critical is the time delay between when the marketing dollars are spent and the actual and residual results.
Making the direct association between marketing spending and sales results is all the more diffcult
because of the numerous other factors that change due to the marketing investment. Sales are refected in
the number of units sold, but there also is the impact of the marketing spending on the margins that are
commanded. Are the incremental unit sales or the added margin the result of the marketing spending,
or are they coming from the research and development dollars that enhanced the quality of the product
or service? Did the R&D spending get its insights and direction from the marketing research that was
done and was honed to the customers’ needs during the new-product development process?
These factors and others cited above make the problem of estimating ROMI exceedingly dif-
fcult. That said, it should not be an excuse for estimating the return. Comparable issues face other
investment opportunities facing the organization. When one invests in plant and equipment, one is
never fully certain how long the equipment will actually last and how productive the new facilities
will be, or even when they will be completed. Yet estimates are made. When investing in fnancial
instruments or foreign currencies, an estimate is made of the likely return, but this is always done
with uncertainty. The same holds for estimating the return of marketing dollars.
In this chapter we have specifed the types of research that could be done to help reduce some of
the uncertainties and help in ROMI estimation. These steps will not eliminate the uncertainty but
should help in estimating the likely return. In this way, marketing expenditures can be compared
with the other choices facing the organization.
Acknowledgments
We thank Sunil Gupta, Dominique Hanssens, Scott Neslin, Shuba Srinivasan, and Russ Winer for
most excellent comments on a previous version. All remaining errors are our own.
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125
chaptEr 6
SERVICE-DOMINANT LOGIC
A Review and Assessment
stEphEN l. varGo, roBErt f. lusch,
MElissa archpru aKaKa, aNd yi hE
Abstract
The emergence and evolution of service-dominant (S-D) logic (Vargo and Lusch 2004a) has drawn
increasing attention toward the integration of resources, especially intangible and dynamic re-
sources and interdependent processes that drive the creation of value. The core of this developing
mindset fundamentally shifts the focus of marketing and, more generally, business away from the
production and distribution of goods (goods-dominant logic) toward service, the application of
operant resources (knowledge and skills), as the basis of exchange. S-D logic’s advancement is
driven by the collaboration and contributions of marketing and non-marketing-related (and other)
disciplines. Currently, evidence of this joint effort can be found in a variety of journal special is-
sues and conference special sessions, a number of journal articles and other presentations, several
dedicated conferences, and one book with ffty contributing scholars.
This review consolidates the S-D logic writings of Vargo, Lusch, and their coauthors, as well
as the related work (and viewpoints) of other scholars, to examine the implications of the S-D
logic mindset for marketing. It (1) explores the need for S-D logic and summarizes its current state
of development, (2) provides an S-D logic perspective of the market and marketing, (3) clarifes
major theoretical misconceptions, (4) reviews the extension of S-D logic and its integration with
existing marketing knowledge , (5) provides an assessment of the role of S-D logic in the evolution
of academic marketing, and (6) offers directions for future research.
Introduction
What has become known as service-dominant (S-D) logic was introduced by Stephen Vargo and
Robert Lusch (2004a) in a Journal of Marketing (JM) article titled, “Evolving to a New Dominant
Logic for Marketing.” However, in a very real sense, its beginning was much earlier and more
deeply rooted in marketing and marketing-associated literature. S-D logic is intended to capture
and extend a convergence of apparently diverse thought that has been shifting the dominant logic
of marketing and economic thought away from a primary concern with tangible resources, output
in the form of frm-created value (goods), and transactions. It points toward a revised logic for
126 STEPHEN L. VARGO, ROBERT F. LUSCH, MELISSA ARCHPRU AKAKA, AND YI HE
marketing based on the application of often intangible, dynamic resources, inputs for co-created
value, and relational economic and social processes. As the title of the original article implies,
S-D logic represents an evolution, rather than a revolution, in marketing thought.
The central tenet of S-D logic is that reciprocal service, defned as the application of compe-
tences for the beneft of another party, is the fundamental basis of economic exchange. That is,
service is exchanged for service.
The discussion and debate about S-D logic was initiated by the simultaneous publication of
“Evolving . . .” (Vargo and Lusch 2004a) and the commentaries of seven renowned marketing
scholars invited by Ruth Bolton, the editor of JM at that time. In her introduction to the com-
mentaries, Bolton (Bolton et al. 2004, p. 18) observed that “the new dominant logic has important
implications for marketing theory, practice, and pedagogy, as well as for general management and
public policy. . . . The ideas expressed in the article and commentaries will undoubtedly provoke
a variety of reactions.” It appears her foresight was correct. The original article and commentaries
have stimulated a lively and ongoing worldwide discussion about the nature of the market and
marketing within the discipline and beyond.
Interestinandevidenceofthiscontinuingdiscussion—aswellasevidenceofthespiritofcol-
laborationandknowledgegenerationinwhichS-Dlogicisgrounded—canbeseeninthenumber
and variety of publications, special issues, conferences, and conference special sessions with an
S-D logic focus that have followed the publication of the original article. The “Otago Forum on
Service-Dominant Logic” (organized by David Ballantyne) was held in November 2005 to dis-
cuss and further codevelop S-D logic and its challenge to marketing’s dominant, goods-centered
paradigm and was followed by “Otago Forum II” in December 2008 to focus on moving the
theoretical foundations of S-D logic into marketing and marketing-related practice. Both forums
weretiedtospecialissuesofjournals—Marketing Theory and Industrial Marketing Management,
respectively. About the time of the frst Otago forum, The Service-Dominant Logic of Marketing:
Dialog, Debate, and Directions (Lusch and Vargo 2006a) was published. This book brought to-
gether insights from ffty top marketing scholars from around the world and represented various
viewpoints and positions in relation to S-D logic.
Since the 2004 article, there have also been special sessions on S-D logic at the American
Marketing Association (AMA) summer and/or winter conference every year to date (2004–2008).
Additionally, S-D logic has been the focus of special sessions at the 2004 Academy of Market-
ing Science (AMS) Cross-Cultural Conference held in Mexico, the 2007 AMS World Marketing
Congress in Italy, the 2005 European Marketing Academy Conference (EMAC), the 2005 Australia
and New Zealand Marketing Academy Conference (ANZMAC), and the 2008 Global Marketing
Conference in Shanghai (coordinated by the Korean Academy of Marketing Science), as well as
a joint ANZMAC/EMAC symposium in 2007 that resulted in a special issue of the Australasian
Marketing Journal (2007). Also in 2008, an S-D logic Doctoral Colloquium was held in conjunc-
tion with the Logic and Science of Service (also known as the Art and Science of Service), which
focused on S-D logic–related topics. Moreover, S-D logic is the central topic of a special issue
of the Journal of Academy of Marketing Science (2008), which received approximately seventy
submissions. Further evidence of the impact of and continuing dialogue about S-D logic can be
found in a Google search for “Vargo and Lusch” on the World Wide Web, which reveals hundreds
of forums, journal publications, conference presentations, books and book chapters, and marketing
course syllabi, as well as weblogs (blogs), and other websites.
Much of the feedback surrounding S-D logic has been favorable, and many scholars have
embraced the opportunity to discuss the evolution of marketing and how their work contributes
to this developing mindset. However, as is often the case with dramatic shifts in thought, some
SERVICE-DOMINANT LOGIC: A REVIEW AND ASSESSMENT 127
hesitation, misunderstanding, and skepticism have emerged as well. These diverse viewpoints
enrich the discussion.
The purpose of this chapter is to review and consolidate the S-D logic writing of Vargo and
Lusch,
1
to review the S-D logic work (and viewpoints) of others, to examine the implications of
the S-D logic mindset, and to point toward directions for future research. First, an overview of the
need for and development of a revised worldview of marketing and the foundational bases of S-D
logic are provided. Next, S-D logic’s unique market and marketing perspectives are offered. The
theoretical integration and conceptual expansion of a service-centered perspective of marketing
are then examined, with special attention to the clarifcation of common misunderstandings. The
major elaborations and extensions of S-D logic that have been contributed by marketing-related
scholars are then explored. Next, an assessment of the role of S-D logic in the evolution of mar-
keting knowledge is provided. We conclude with a discussion of the major research frontiers and
opportunities that S-D logic offers.
S-D Logic: An Alternative Worldview
A dominant worldview is rarely clearly stated or specifcally promoted; rather it permeates into
the mindsets of researchers and practitioners through individual beliefs and collective paradigms.
Kuhn (1970, p. 10) defnes paradigms as “accepted examples of actual scientifc practice that
provide models from which spring particular coherent traditions of scientifc research.” Draw-
ing on Kuhn, Arndt (1985, p. 11) views paradigms as “social constructs refecting the values and
interests of the dominant researchers in a science and their reference groups.” Hunt (1991) uses
the term in a broad sense to connote a “worldview.”
Although S-D logic is not a paradigm (Lusch and Vargo 2006b; Vargo and Lusch 2006;
Vargo 2007b), according to the criteria above, it functions at a paradigmatic level and provides
an alternative lens, a mindset, through which phenomena can be examined. Therefore, it could
become a paradigm if, by defnition, it becomes a worldview. But worldviews are determined
bottom up rather than top down, and, thus, it is the discipline that will make this determina-
tion over time. Although the current underlying paradigm, or dominant logic of marketing, as
well as economic science and its other derivatives, remains goods-dominant, a paradigm shift
is possible.
Goods-Dominant (G-D) Logic
As the label suggests, G-D logic (Vargo and Lusch 2004a; Lusch and Vargo 2006b) focuses on
goods—ormoregenerally,“products,”encompassingbothtangible(goods)andintangible(ser-
vices)unitsofoutput—asthebasisofexchange.G-Dlogiccanbeparaphrasedasfollows(see
Vargo and Lusch 2004a):
1. Economic exchange is fundamentally concerned with units of output (products).
2. These products are embedded with value during the manufacturing (or agricultural, or
extraction) process.
3. For effciency, this production ideally (a) is standardized, (b) takes place in isolation from
the customer, (c) can be inventoried to even out production cycles in the face of irregular
demand.
4. These products can be sold in the market by capturing and stimulating demand in order
to maximize profts.
128 STEPHEN L. VARGO, ROBERT F. LUSCH, MELISSA ARCHPRU AKAKA, AND YI HE
In essence, G-D logic says that the purpose of the frm is to make and sell things. It has also been
called the “neoclassical economics research tradition” (e.g., Hunt 2000), “manufacturing logic”
(e.g., Normann 2001), and “old enterprise logic” (Zuboff and Maxmin 2002).
The foundation for G-D logic is grounded in economic science, as developed from the work
of Adam Smith (1776/1904), “the father of economics.” Smith did not literally invent economics,
nor was that even his purpose. Smith was a moral philosopher whose intention was to identify the
normative activities that would lead to national wealth rather than to provide a positive framework
for economic science.
Smith initially built his political-economic views on the foundational proposition of the eff-
ciency of the “division of labor,” resulting in the necessity of “exchange.” For Smith (1776/1904,
p. 1), labor was the “fund which originally supplies (the nation) with all the necessities and con-
veniences of life which it annually consumes.” Thus labor, the application of mental and physical
skills—thatis(essentially)service(seeVargoandLusch2004a)—providedthefoundationfor
exchange.
However, having established labor/service as central to exchange and well-being, and the
central metric of exchange as value-in-use—beneft in relation to the labor required to achieve
it—Smithpartiallyabandonedthismodel.Hewasnotinherentlyconcernedwithallofexchange
or with economic exchange in general. As noted, he was seeking a normative explanation about
which types of service should be promoted in order to advance national wealth. He thus shifted
the focus to value-in-exchange (nominal value, market price), rather than value-in-use, which he
felt was easier to understand and also simplifed his task of the identifcation of activities that
contributed to the creation of national wealth.
In Smith’s eighteenth-century world, with limitations on personal travel and the nonexistence of
electronic communication, the primary route to wealth creation was the export of tangible goods,
and the source of these goods was manufacturing. Thus, his underlying model was centered on the
product—surplustangiblegoodsthatcouldbeexported.Thisnarrowedfocusontheexchangevalue
of tangible goods can be seen in his extended discussion of the distinction between “productive”
and “unproductive” activities (see Vargo and Morgan 2005). For Smith, only those activities that
contributed to the creation of surplus tangible goods were deemed “productive.” Other activities,
though useful and essential to individual well-being, were called “unproductive” because they
did not create exportable, tangible goods.
The economic philosophers (e.g., Say 1821; Mill 1848/1929) who followed generally dis-
agreed with Smith’s productive versus unproductive distinction, reasoning that all activities that
contributed to well-being were productive; but, having done so, they also generally acquiesced.
Smith’s (1776/1904) productive/unproductive distinction had taken solid root, and, over time,
“products” (tangible goods that could be exported) became the focus of economics; value morphed
from usefulness to an embedded property of goods (essentially value-in-exchange); unproductive
morphed into services (intangible goods); and a clear distinction between producers (creators of
value) and consumers (destroyers of value) was established.
This product-, or goods-, based model of economic activity was also convenient because it
was compatible with the increasing desire of the economists to turn economic philosophy into
economic science. The model of “science” at that time was Newtonian Mechanics, a model of
matter embedded with properties. Therefore, an economic model of products embedded with
utility had natural compatibility and appeal. At least partly because of the desire for scientifc
respectability, the goods-centered paradigm survived and fourished. Economics and the derivative
businessdisciplines—aswellasmoregeneral,societalunderstandingsofcommerce—emerged
and developed from this G-D paradigm. Services (usually plural), from this G-D perspective, are
SERVICE-DOMINANT LOGIC: A REVIEW AND ASSESSMENT 129
seen as either (1) a restricted type of good (i.e., as intangible units of output) or (2) an add-on that
enhances the value of a good.
The dominance of a goods-centered paradigm can be recognized in Shostack’s (1977, p. 73)
statement, “The classical ‘marketing mix,’ the seminal literature, and the language of marketing all
derive from the manufacture of physical goods,” and the terminology used to describe the related
marketing phenomena, such as “producer,” “consumer,” “goods and services,” “supply chains,”
“channels of distribution,” “value-added,” etc. Arguably, this G-D paradigm is increasingly viewed
as severely restricted, as evidenced by the call for a more encompassing and solid paradigmatic
foundation by a number of scholars (e.g., Gronroos 1994; Gummesson 1995; Hunt and Morgan
1995; Schlesinger and Heskett 1991; Shostack 1977).
Service as a Unifying Concept
S-D logic moves the understanding of markets and marketing from a product or output-centric
to a service or process-centric focus. The most distinguishing difference between G-D logic and
S-D logic can be seen in the conceptualization of service. As mentioned, in S-D logic service is
defned as the application of competences (knowledge and skills) for the beneft of another party
(Vargo and Lusch 2006). The use of the singular “service” as opposed to the plural “services,” as
traditionally employed in G-D logic, is intentional and signifcant. It signals a shift from thinking
about value creation in terms of operand resources—usually tangible, static resources that require
someactiontomakethemvaluable—tooperant resources—usually intangible, dynamic resources
that are capable of creating value (Constantin and Lusch 1994). That is, whereas G-D logic sees
services as (somewhat inferior to goods) units of output, S-D logic sees service as the process of
doing something for and with another party, and thus always as a collaborative process.
In S-D logic, the purpose of economic exchange is to provide service in order to obtain re-
ciprocalservice—thatis,service is exchanged for service. While goods are sometimes involved
in this process, they are appliances for service provision; they are conveyors of competences.
Ineithercase—serviceprovideddirectlyorindirectlythroughagood—itistheknowledgeand
skills (competences) of the providers and benefciaries that represent the essential source of value
creation, not the goods, which are only sometimes used to convey them.
Importantly, S-D logic represents a shift in the logic of exchange, rather than a shift in the type of
product that is under investigation. It is a shift that Vargo and Lusch (2004a) insist is already taking
place. They point out that evidence of this “new logic” can be found in somewhat diverse academic
felds such as information technology (e.g., service-oriented architecture), human resources (e.g.,
organizations as learning systems), marketing (e.g., service and relationship marketing, network
theory), and the theory of the frm (e.g., resource-based theories), etc., as well as in practice.
Additionally, this “new logic” is actually an old logic in the sense that it recaptures the foun-
dational ideas of value creation through the reciprocal application of knowledge and skills that
Smith (1776/1904) established before abandoning them to discuss national wealth creation. It
also can be seen in the work of Bastiat (1848/1964, p. 162), a nineteenth-century economist who
claimed, “Services are exchanged for services . . . it is the beginning, the middle, and the end of
economic science.”
S-D logic does not imply that goods-based models of exchange should be modifed to transition
to a service orientation. Rather, it suggests that a service-based foundation, built upon service-
driven principles, establishes a generalizable logic for understanding all economic activity (i.e.,
even when goods are involved) and provides a more robust logic for transitioning from a goods-
centered to a service-centered perspective.
130 STEPHEN L. VARGO, ROBERT F. LUSCH, MELISSA ARCHPRU AKAKA, AND YI HE
Thus, S-D logic plays a unifying role; it not only accounts for goods in exchange, it actually
gives them an important role as service-delivery vehicles. The same is not the case with the treat-
ment of service(s) in G-D logic, in which service(s) has traditionally been all but ignored and has
only recently been treated as somewhat inferior (i.e., lacking in tangibility, inability to be standard-
ized, inability to be created separate from the customer, and incapable of being inventoried). This
“goods-versus-services” rift has required separate streams of marketing literature. Arguably, more
generally, G-D logic has created additional conceptual bifurcations, such as the producer-consumer
and the related business-to-consumer versus business-to-business distinctions, and necessitated
the development of other (sub)disciplines (see Vargo and Lusch 2008c). As we will discuss, these
distinctions largely vanish in an S-D logic conceptualization of exchange, markets, and marketing,
creating at least the potential for a unifed theory of marketing and exchange.
Foundations of S-D Logic
Many of the concepts (e.g., value co-creation and operant resources) for which S-D logic argues
are neither exclusive to nor invented by S-D logic itself. S-D logic captures shifting contemporary
marketing thought, in which marketing is seen as a facilitator of ongoing processes of voluntary
exchange through collaborative, value-creating relationships among social and economic actors
(e.g., individuals and organizations). S-D’s logic development began largely through the unifca-
tion of existing and emerging views of exchange that stray from the traditional goods-centered
logic. This service-centered view draws on historical arguments such as Smith’s (1776/1904)
defnition of “real value” rooted in labor, Say’s (1821) creation of utility rather than matter, Mill’s
(1848/1929) classifcation of productive labor, and Bastiat’s (1860) criticism of tying value to
tangible resources.
S-D logic is grounded in the convergence of historical ideas and existing literature in marketing,
economics, and management (e.g., Gummesson 1995; Normann and Ramirez 1993; Shostack 1977),
as well as infuential marketing theories in services and relationship marketing (e.g., Gummes-
son 1995; Gronroos 1994), resource-advantage theory (e.g., Hunt 2000), core competency theory
(e.g., Day 1994; Prahalad and Hamel 1990), and network theory (e.g., Achrol 1999; Hakansson
and Snehota 1995; Norman and Ramirez 1993), that bring to light an alternative, service-centered
logic of the market (for detailed evolution see Vargo and Lusch 2004a). When the discussion of
an S-D logic for marketing emerged (Vargo and Lusch 2004a), eight foundational premises (FPs)
were offered to establish a framework for the service-centered mindset. Driven by the spirit of
co-creation and continuous evolution, these premises have been revised and extended through
the dialogue and discussion among various scholars. Minor revisions and one addition (FP9)
occurred in The Service Dominant Logic of Marketing: Dialog, Debate, and Directions (Lusch
and Vargo 2006a; Vargo and Lusch 2006). A more complete revision and the addition of FP10
were presented in Vargo and Lusch (2008a), in the special issue of the Journal of the Academy of
Marketing Science. The ten FPs, as modifed, are shown in Table 6.1 (Vargo and Lusch 2008a, p.
7) and discussed below. Together, they provide the foundation for S-D logic.
FP1. Service Is the Fundamental Basis of Exchange
FP1 establishes the core premise of S-D logic: the purpose of exchange is mutual service provi-
sion. Service, as defned in S-D logic, is the use of one’s competences for the beneft of another
party. It is differentiated from the plural “services,” which implies a type of good and is charac-
terized by (often considered inferior) qualities of intangibility, heterogeneity, inseparability, and
SERVICE-DOMINANT LOGIC: A REVIEW AND ASSESSMENT 131
Table 6.1
Service-Dominant Logic Foundational Premises
Original foundational
premise
Modifed/new founda-
tional premise Comment/explanation
FP1 The application of
specialized skill(s)
and knowledge is the
fundamental unit of
exchange.
Service is the fun-
damental basis of
exchange.
The application of operant resources (knowl-
edge and skills), “service,” as defned in S-D
logic, is the basis for all exchange. Service is
exchanged for service.
FP2 Indirect exchange
masks the fundamental
unit of exchange.
Indirect exchange
masks the fundamen-
tal basis of exchange.
Because service is provided through complex
combinations of goods, money, and institu-
tions, the service basis of exchange is not
always apparent.
FP3 Goods are a distribu-
tion mechanism for
service provision.
Goods are a distribu-
tion mechanism for
service provision.
Goods (both durable and nondurable) derive
their value through use—the service they
provide.
FP4 Knowledge is the
fundamental source of
competitive advantage.
Operant resources
are the fundamental
source of competitive
advantage.
The comparative ability to cause desired
change drives competition.
FP5 All economies are ser-
vices economies.
All economies are
service economies.
Service (singular) is only now becoming
more apparent with increased specialization
and outsourcing.
FP6 The customer is always
a co-producer.
The customer is
always a co-creator of
value.
Implies value creation is interactional.
FP7 The enterprise can
only make value propo-
sitions.
The enterprise cannot
deliver value, but
can only offer value
propositions.
Enterprises can offer their applied resources
for value creation and collaboratively (inter-
actively) create value following acceptance of
value propositions, but cannot create and/or
deliver value independently.
FP8 A service-centered
view is customer ori-
ented and relational.
A service-centered
view is inherently
customer oriented
and relational.
Because service is defned in terms of cus-
tomer-determined beneft and co-created, it
is inherently customer oriented and relational.
FP9 Organizations exist to
integrate and trans-
form microspecialized
competences into
complex services that
are demanded in the
marketplace.
All social and eco-
nomic actors are
resource integrators.
Implies the context of value creation is net-
works of networks (resource integrators).
FP10 Value is always
uniquely and phe-
nomenologically
determined by the
benefciary.
Value is idiosyncratic, experiential, contextual,
and meaning laden.
Source: Vargo and Lusch 2008a.
132 STEPHEN L. VARGO, ROBERT F. LUSCH, MELISSA ARCHPRU AKAKA, AND YI HE
perishability (e.g., Zeithaml, Parasuraman, and Berry 1985). Thus, economic exchange involves
doing something for another party under the condition that the other party applies its competence
reciprocally. The complex and indirect nature of economic exchange, however, makes this rather
simple tenet diffcult to see (FP2).
FP2. Indirect Exchange Masks the Fundamental Basis of Exchange
Complex, indirect processes associated with exchange make its service-for-service nature easy
to miss. That is, service is often provided through goods (see FP3) and goods can also be used as
a form of currency (e.g., held for trade rather than used for self-service). Service exchange also
often occurs through the combination of the applied competences of internal micro-specialists
(e.g., assembly-line workers) and/or the combination and integration of the micro-specializations
(e.g., the combination of all the resources contributed and integrated by the various participants
in the “value network or constellation”). Furthermore, in monetized exchange, reciprocal service
provision is lagged in relation to the initial transaction until the rights to future service (money) are
used in subsequent exchange. But all these exchange vehicles (i.e., goods, money, organizations,
and networks) represent intermediaries of complex exchange processes, rather than the essential
bases of exchange. Behind these institutions are individuals applying their competences for the
ultimate beneft of another party so that they can receive the beneft of applied competences that
they do not possess. That is, regardless of its dynamic and complex structure, the essence of market
exchange remains the same; to better the circumstances of both parties, people still exchange their
applied competences (e.g., knowledge and skills) for the applied competences of others. They
exchange service for service.
FP3. Goods Are a Distribution Mechanism for Service Provision
When service is understood as the basis of all exchange, goods take on a role of vehicles or
transmitters for service. The value of a good is not created in a factory and distributed to the
market; rather, it is derived and determined through its contribution to the customer’s self-service
process—itsvalue-in-use.Thus,ratherthan“services”representingaspecialcaseof“intangible
goods,” as they have been conceived under G-D logic, goods are actually a special case of, or a
vehicle for, indirect service provision. The basis of exchange is always service provision; goods,
when used, are appliances for service provision.
FP4. Operant Resources Are the Fundamental Source of Competitive Advantage
One of the hallmarks for S-D logic (Vargo and Lusch 2004a) and most critical differences between
S-D logic and G-D logic is the distinction between operand and operant resources (Constantin and
Lusch 1994). Operant resources produce effects, whereas operand resources need to be acted upon
to do so. Operand resources are usually tangible and static, whereas operant resources are usually
intangible and dynamic. Almost by defnition, G-D logic is centered on operand resources. S-D logic
refocuses exchange on operant resources by shifting from units of output to the process of using
competencesforthebeneftofanotherparty—thatis,service—sothattheotherpartywillreciprocate
with its own applied competences. Thus, the ability to compete in the market is a function of knowl-
edge, both individual and collective (e.g., organizational). This does not diminish the importance of
operand resources in human well-being. It simply acknowledges that operand resources only become
valuableinthecontextofactiveresources—forexample,modifcation,combination,anduse(see
SERVICE-DOMINANT LOGIC: A REVIEW AND ASSESSMENT 133
Zimmerman 1951). Since S-D logic implies that value is created through activity, it points toward
the primacy of the human resources of the frm (Lusch, Vargo, and O’Brien 2007) and underscores
the necessity of seeing the customer as endogenous to value creation (see FP6).
FP5. All Economies Are Service Economies
Contrary to the popular perspective of the “new service economy,” service provision is not just
now becoming abundant, nor is it only recently gaining importance. According to S-D logic, what
is often seen as an emerging “service economy” is actually an aberration of a G-D logic perspec-
tive in which manufacturing (and agriculture and extraction) has been considered primary. What
is happening now is that the service nature of exchange is becoming increasingly apparent as
specialization increases and as less of what is exchanged fts the dominant manufactured-output
classifcations of economic activity. In S-D logic, there is no “service revolution,” except for the
revelation in service-centered thinking. However, arguably, one revelation that is making the service
nature of exchange more apparent is an information revolution (Rust and Thompson 2006). That
is, the increase in specialization can be understood in terms of the exponential rate of increase in
knowledge and the increasing ability to exchange information (operant resources) in a relatively
pureform—thatiswithoutbeingtransportedbypeopleand/ormatter(liquifcationinNormann’s
[2001]terms)—throughdigitization.
FP6. The Customer Is Always a Co-creator of Value
Service implies interactivity. In the parlance of the G-D logic vision of services, this is captured
in the inseparability of production and consumption. While Vargo and Lusch (2004a, b) argue
that inseparability is not a useful distinguishing characteristic of service, it is probably a univer-
sal characteristic of value creation. That is, value creation occurs at the intersection of providers
and benefciaries and is always determined by the latter. Stated somewhat differently, value is
always created through use, rather than manufactured and then delivered. Thus, use implies the
application of the customer’s operant resources in addition to those applied by the provider. All
thissuggeststhatthecustomerisalwaysanactiveparticipantofthevalue-creationprocess—that
is, a co-creator of value.
The term “co-creator” requires further explanation. In the original FP6 (Vargo and Lusch 2004a),
the term “co-producer” was used. Clearly, “co-producer” has G-D logic connotations. Thus, it was
changed to co-creator of value in Vargo and Lusch (2006). However, the term co-production has a use-
ful S-D logic meaning as well. While the “co-creation” of value describes the effect of the process of
joint application of operant resources among frms and customers in creating beneft for the customer,
“co-production” can be considered a subset of co-creation. Co-production involves the creation of the
core offering itself and can occur through shared inventiveness, design, and/or production of the frm’s
value proposition. Therefore, from a service-centered perspective, the customer always co-creates value
through use and can be, though is not always, a participant in the co-production process. This require-
ment, that value must be co-created, implies that the frm can only propose its creation.
FP7. The Enterprise Cannot Deliver Value, but Can Only Offer Value Propositions
Consistent with FP6, FP7 makes explicit the idea that the frm cannot make and deliver value. That
is, based on the collaborative nature of value creation and the customer’s determination of value,
derived contextually and through use, the frm can offer only value propositions.
134 STEPHEN L. VARGO, ROBERT F. LUSCH, MELISSA ARCHPRU AKAKA, AND YI HE
FP8. A Service-Centered View Is Inherently Customer Oriented and Relational
In the G-D logic conceptualization of exchange, with its focus on transactions and units of output,
“customer orientation” usually means something like making units that the customer will buy, and
“relationship” usually refers to multiple transactions occurring over time. That is, they are both
normative adjustments to G-D logic necessary for increasing the long-term proftability of the
frm through selling more goods (tangible or intangible). However, S-D logic’s central tenets of
service being the basis of exchange, service being defned in terms of beneft, and the application
of operant resources from both parties to create value, make exchange inherently interdependent
and relational, benefciary (e.g., customer) oriented and benefciary centered. Stated alternatively,
in the consideration of value creation within G-D logic, the frm and the customer are separate,
with the former seen as a producer of value and the latter as a destroyer. Within S-D logic, value
creation is an interactive process, and thus, value is created in a relational context.
FP8 is a positive, rather than normative, statement about how value is created through the rela-
tionships of parties in service-for-service exchange. Customer centricity and relationships are not
options; they are realities of value-creation processes within markets. The service-for-service nature
of exchange extends customer centricity dual (“frm”-“customer”) to “balanced centricity” (see
Gummesson 2008). In FP9, the relational orientation is extended to the frm’s network of resources
as well as the customer’s. Vargo (2009, forthcoming) more explicitly distinguishes relationship from
repeat patronage, or multiple transactions, by associating the former with the more comprehensive,
networked process of value creation and transactions as “temporal isolates” in that process.
FP9. All Social and Economic Actors Are Resource Integrators
The premise that value is co-created through the combined activities of providers and benefciaries
implies that value is determined through the integration of both provider-supplied and benefciary-
supplied resources. That is, the value derived and determined by each actor in an exchange is hetero-
geneous, based on existing competences (e.g., knowledge and skills), access to other resources (both
operant and operand), and the situational context. In the traditional G-D logic–based literature, this
integration is most often captured in concepts of supply chains (or more recently, value networks) and
manufacturing. In the G-D logic–based “services” literature, it is partially captured in the observation
of the heterogeneity of services. S-D logic extends the manufacturing logic from making things to
integrating resources to create “densities” (Normann 2001). Normann (p. 27) defnes maximum
density as a situation in which “the best combination of resources is mobilized for a particular
situation—forexample,foracustomeratagiventimeinagivenplace—independentoflocation,to
create the optimum value/cost result.” Think of it as follows: At a given time and place, can a party
bring together and integrate all the resources necessary to co-create the best possible value? With
S-D logic, the integrating of resources to create densities is extended from the concept of provider
and supply networks to the service benefciary (e.g., “customer”) and benefciary networks. This
network-with-network model, in which each actor is combining resources from multiple parties to
create value, is similar to Gummesson’s (2006) “many-to-many” marketing.
The integrative, network-with-network model of value creation is not limited to individuals
and frms or to economic exchange. It applies equally to all actors and institutions (e.g., families,
frms, cities, nations) in their creation of value for themselves through the integration of resources
acquired through both economic and social exchange. This foundational premise is a generalized
version of the more restricted FP9 introduced by Vargo and Lusch (2006), as modifed by Vargo
and Lusch (2008a).
SERVICE-DOMINANT LOGIC: A REVIEW AND ASSESSMENT 135
FP10. Value Is Always Uniquely and Phenomenologically Determined by the Benefciary
This tenth foundational premise was added (Vargo and Lusch 2008a) to capture the experiential
nature of value more explicitly. Although implicitly suggested by the S-D logic defnition of ser-
vice, various FPs (e.g., FP6, FP8, and FP9), and other, less-formalized, conceptual notions (e.g.,
consumer’s perceptions, meeting higher-level needs, customer determination), Vargo and Lusch
(2008a) formalized the unique and contextual interpretation of value. The word “phenomenologi-
cal,” rather than “experiential,” was selected because the term “experience” is often interpreted to
havepositive-onlyconnotations(e.g.,somethingofa“DisneyWorldevent”—a“wow”factor),
rather than positive, neutral, or negative contextually specifc meanings.
Conceptual Transitions
Embracing a service-centered perspective requires rethinking marketing, if not all of economic
science. It requires transitioning from one mental model to another and from one lexicon to an-
other. S-D logic intimates a very different kind of purpose and process for marketing activity and
for the frm as a whole: to provide service to stakeholders, including customers, stockholders, and
employees. In general, by placing service, rather than goods, at the center of exchange, S-D logic
moves the focus of marketing and value creation from tangible (operand) resources to intangible
(operant) resources, such as knowledge and skills (Lusch and Vargo 2006c). Table 6.2 (Lusch and
Vargo 2006c, p. 286) provides a summary of this and other conceptual transitions associated with
moving from the dominant goods-logic toward the emerging service-logic for marketing.
The S-D logic–related concepts represent a vision of the language that is needed to further a
service-centered logic. No doubt that these will be revised and elaborated as S-D logic evolves
(see for example Lusch, Vargo, and Wessels 2008). However, this transition from G-D logic to
Table 6.2
Conceptual Transitions
Goods-Dominant
Logic Concepts Transitional Concepts
Service-Dominant
Logic Concepts
Goods Services Service
Products Offerings Experiences
Feature/attribute Beneft Solution
Value-added Co-production Co-creation of value
Value-in-exchange Value-in-use Value-in-context
Proft maximization Financial engineering Financial feedback/learning
Price Value delivery Value proposition
Equilibrium systems Dynamic systems Complex adaptive systems
Supply chain Value chain Value-creation network/constellation
Promotion Integrated marketing communications Dialogue
To market Market to Market with
Product orientation Market orientation Service orientation
Source: Adapted from Lusch and Vargo 2006c, p. 286.
136 STEPHEN L. VARGO, ROBERT F. LUSCH, MELISSA ARCHPRU AKAKA, AND YI HE
S-D logic–compatible concepts is a diffcult one, partly because the former serves not only as the
formal language of the goods-centered model of economic exchange, but also as the vernacular
foundation for everyday thought about exchange, marketing, and business in general. Thus, frst
attemptsatgraspingandexpressingS-Dlogicareoftenthroughtransitionalconcepts—G-Dlogic
interpretations of S-D logic (middle column).
The emergence of S-D logic can also be seen in another transition, in marketing “with” rather
than “to” customers. The shift in primacy of resources, from operand to operant, has implications
for how exchange processes, markets, and customers are perceived and, thus, with how they are
approached. Focusing on the primacy of operant resources, S-D logic views customers as resources
that are capable of acting with other resources and collaborating to co-create value with the frm
(Vargo and Lusch 2004a). Thus, S-D logic considers customers as dynamic, knowledge-generating,
and value-creating resources. This is a fundamental transition away from G-D logic, which views
customers as operand resources that the frm acts upon. From a G-D logic perspective, customers
are considered exogenous to the frm and are “segmented” and “targeted,” and often considered
“manipulated” in the process of value creation. The primary focus of marketing within G-D logic
is to identify customers, and market and sell to them.
In the same way that G-D logic considers customers as operand resources, this output-focused
paradigm also treats employees and other network partners as static resources that are “managed,”
if not manipulated. Alternatively, S-D logic views all exchange partners as operant resources that
can, and arguably must, be collaborated within the value-creation process. From this perspective,
employees, customers, and other network partners become the primary source of a frm’s innova-
tion, competence, and value. In addition, while the G-D marketing paradigm assumes the external
environments (legal, competitive, social, physical, technological, etc.) as largely uncontrollable
and forces to which the frm needs to adapt (McCarthy 1960), S-D logic inverts this assumption
and views the external environments as resources the frm draws upon for support by overcoming
resistances and co-creating these environments. Figure 6.1 (Lusch, Vargo, and O’Brien 2007, p.
7) depicts the shift of marketing philosophies and the evolution from a goods- toward a service-
dominant logic.
Figure 6.1 The Evolution of Marketing.
Source: Adapted from Lusch, Vargo, and O’Brien (2007), p. 7.
To Market
(Matter in motion)
Marketing To
(Management of
customers
and markets)
Marketing With
(Coll aborate with
customers and
partners to
produce and sustain
value)
Through 1950 1950–2010 2010 onward
(Matter in motion)
(Management of
customers
and markets)
(Coll aborate with
customers and
partners to
produce and sustain
value)
SERVICE-DOMINANT LOGIC: A REVIEW AND ASSESSMENT 137
Market and Marketing Perspectives of S-D Logic
S-D logic’s focus on interdependent relationships and reciprocal, service-for-service exchange
suggests that markets and marketing have primary societal functions. Society and service exchange
are almost synonymous concepts. Human well-being, if not survival, depends on the reciprocal
exchange of applied competences (knowledge and skills). This exchange is sometimes purely
social and sometimes economic, but most often both, in a complex web of service-for-service
exchange (Lusch and Vargo 2006b).
Marketing as a Social and Economic Process (Rather than an Outcome)
S-D logic’s emphasis on systems of service-for-service exchange suggests that an examination of
the market needs to precede marketing analysis (Venkatesh, Penaloza, and Firat 2006). From this
perspective, organizations and other social and economic institutions are co-created to facilitate the
exchange of applied knowledge and skills among individuals. Furthermore, language, knowledge,
norms, culture, money, and scientifc paradigms are all part of a network of co-creation activities
of individuals and organizations that represent society. In a real sense, society can be viewed as a
macro service-provision system. This service-driven society is not a new phenomenon, nor does
it lead to a new era of the economy. Ironically, it is the growth and complexity of the institutions
of service exchange, particularly those associated with “industrialization” (see Vargo and Lusch
2004b; Vargo and Morgan 2005), that have masked the service-for-service nature of exchange.
Figure 6.2 (see also Lusch and Vargo 2006b, p. 410) portrays the masking role of institutions
and intermediaries in service-for-service exchange in society. It is important to note that it is only
because of the complexities of the market, including (1) money as a medium of exchange, (2)
goods as channels of distribution for service(s), (3) organizations as service intermediaries, and
(4) networks that link together parties of mutual service provision, that marketing has overlooked
the fundamental economic principle that service is exchanged for service. Value does not reside in
and is not directly derived from money, goods, organizations, and/or the network; value is found
in the joint application of knowledge and skills that generates reciprocal service provision to better
Figure 6.2 Service(s) Exchanged for Service(s)
Intermedi aries of Service-for-Service Exchange
Party A
Performi ng
Service(s)
Party B
Performi ng
Service(s)
The Market
Money as a medium of exchange
Goods as distribution channels
Organizations as resource integrators
Networks as linkages for exchange
Money as a medium of exchange
Goods as distribution channels
Organizations as resource integrators
Networks as linkages for exchange
138 STEPHEN L. VARGO, ROBERT F. LUSCH, MELISSA ARCHPRU AKAKA, AND YI HE
the circumstances for each other and humankind (society). Money, goods, organizations, and the
network merely provide vehicles for exchange.
Learning in Competitive Markets
S-D logic recognizes service-for-service exchange and competing through service as learning
processes. Competing within an S-D logic mindset refocuses the purpose of exchange from the
acquisition of tangible, operand resources to the generation and integration of intangible, oper-
ant resources. Economic commerce is deeply embedded within social exchange, and the two are
diffcult, at best, to separate. S-D logic argues that social and economic actors exchange with
other actors in an attempt to improve their existing conditions through improving the conditions
of others (Lusch et al. 2007). Service-for-service exchange is driven by a simple hypothesis that
if the actor takes a certain action (and changes), it will be better off. However, this hypothesis
is tested by the perceptions of service rendered and the value derived through an exchange and
consequent use. Actors enter into exchange and experience the consequences frsthand. They learn
that their hypotheses can be falsifed, particularly when the service rendered does not contribute
to the desired experience. Each actor has an ongoing desire to improve its condition and thus,
via exchange, learns what works and what does not work. The actor then responds by returning
to the market to integrate more resources, developing competences that enable it to better adapt
the original service rendered in exchange or fnding alternatives to the market such as more self-
service, communal sharing, or other institutions for enhancing well-being.
The learning process surrounding exchange provides evidence that we live in an adaptive
and changing world. In S-D logic, micro entities seek to better their lives by specializing and
exchanging their service(s) for the service(s) of others. Macro structures such as organizations,
market segments, lifestyle groupings, fashion movements, and legal and government regulations
emerge from these individual actions and become more salient. However, behind all these macro
and visible trends are individuals seeking to improve their stake in life and engaging in exchange
to accomplish this. By participating in exchange, individuals stimulate additional changes that
ripple throughout society. As this ripple occurs, we see more and more creative effort because
more and more signals are transmitted about what works and what does not work, what results
in satisfaction and what creates dissatisfaction, and what results in gain over loss. The system
is not perfect, but once the power of individuals exchanging, based upon their micro specializa-
tions, starts to roll out throughout the local, regional, national, and world economy and society,
more and more change occurs and more variety manifests itself via the creative learning process
of exchange (Lusch and Vargo 2006b). Some have argued that the effect is opposite and that the
global expansion of markets has resulted in homogeneity. However, with more exchange, there
is increasing refnement, division, and reintegration of resources, creating more, rather than less
variety. More importantly, this debate signifes another reason why more formal study of the
market and market processes is needed in marketing.
Theoretical Clarifcations of S-D Logic
The idea of a service logic is fnding increasing acceptance in academic marketing and beyond.
This should not be entirely surprising, since what has become known as S-D logic was not so
much created by Vargo and Lusch (2004a) as it was reported and extended. That is, S-D logic is
both deeply seeded in historical roots related to economic thought (e.g., Bastiat 1848/1964; De-
launay and Gadrey 1992) and representative of the convergence and extension of trends in theory
SERVICE-DOMINANT LOGIC: A REVIEW AND ASSESSMENT 139
development from within marketing, especially its subdisciplines (see Vargo and Lusch 2008c),
as well as related disciplines, such as economics and human resources. Additionally, the further
development and elaboration of S-D logic since Vargo and Lusch (2004a) has been characterized
by collaboration and co-creation. However, S-D logic has also been developed in the paradigmatic
context and pervasive lexicon of G-D logic. Thus, in addition to the contentious substantive is-
sues that are expected in any major scientifc endeavor, there are issues of communication and
interpretation. Most of these issues of understanding can be organized around the following topics:
(1) general issues related to the G-D logic lexicon, (2) value as a phenomenological concept, (3)
service logic as transcendence versus a goods-services dichotomy, (4) service provision as the
common denominator of all exchange, and (5) the role of S-D logic as a foundation for a positive
theory of the market versus S-D logic as a normative theory of marketing.
The Goods-Dominant Logic Lexicon Infuence
As mentioned, the deeply seeded roots of a goods-centered lexicon have created diffculties for the
communication and development of S-D logic in marketing. That is, the language of G-D logic
is the foundational language of marketing and, as such, contributes both directly and indirectly
to much of the concern regarding S-D logic. The dominant lexicon refects more than just words
available to talk about marketing; it refects the underlying paradigm for the thinking about and
understanding commerce, the market, and exchange in general. This presents problems for discuss-
ing and describing a counter-paradigmatic view, such as S-D logic. Often, there are no alternative,
generally acceptable, counter-paradigmatic or even neutral words available. Several misperceptions
of S-D logic have been noted (Lusch and Vargo 2006c; Vargo and Lusch 2006; Vargo and Lusch
2008a) that can be directly attributable to language limitations, such as the concepts of “service”
versus “services,” “co-creation” versus “co-production,” and “use value” versus “utility.”
Arguably, the most critical semantic issue surrounding S-D logic centers on the use of “service”
as its designator. Also arguably, no other issue is as tied to the diffculty of using words that have
specifc G-D logic meanings for explicating the nuances of S-D logic. Some have raised concerns
that “service” has too much baggage (e.g., Lehmann 2006). Others have suggested that the S-D
logic defnition of service is “novel” or “inconsistent” (e.g., Achrol and Kotler 2006; Levy 2006),
and still others have argued that it is just the wrong choice and/or it creates a false dichotomy
between goods and service (e.g., Brodie, Pels, and Saren 2006).
Most of the issues surrounding the use of the term “service” by S-D logic seem to be tied to
the fact that in G-D logic, the term “services” is usually intended to refer to units of output, intan-
gible goods. S-D logic, on the other hand, uses the singular term “service” to refer to a process,
and is neither faulty nor novel (Vargo and Lusch 2006). We Vargo and Lusch (2006; 2008b) have
acknowledged the baggage associated with the term “services,” but emphasize that the term “ser-
vice” is precisely correct, if not essential, because no other word is more appropriate. Likewise,
the use of the term service transcends the old, intractable (see Vargo and Lusch 2004b) debate
concerning the difference between goods and services (intangibility, heterogeneity, inseparability,
and perishability) by reframing the issue to emphasize the relationship: service is the common
denominator of exchange; goods are service-provision mechanisms. Thus, the notion of a false
dichotomy between goods and service(s) (Brodie et al., 2006) is not created by S-D logic, but
rather was created by G-D logic and is, arguably, resolved by S-D logic (Lusch and Vargo 2006c;
Vargo and Lusch 2008b).
The problem and diffculty of G-D logic–inspired words’ being inadvertently used to describe
S-D logic were evident in the initial selection of the term “co-production” (Vargo and Lusch
140 STEPHEN L. VARGO, ROBERT F. LUSCH, MELISSA ARCHPRU AKAKA, AND YI HE
2004a) to capture the collaborative nature of value creation. Perhaps at least in part, the use of
co-production led to the argument that S-D logic does not always apply, because customers do not
always want to be active participants (e.g., Wilkie and Moore 2006; Rust and Thompson 2006). As
we Lusch and Vargo (2006c; Vargo and Lusch 2006, 2008a) have acknowledged, co-production is
an inappropriate term to capture the “co-creation” of value, the term used since the modifcation
of FP6, “The customer is always a co-creator of value” (Vargo and Lusch 2006). Nonetheless,
“co-production” was retained to describe the involvement of the customer in the creation (e.g.,
codesign, or shared production, etc.) of a frm’s core offering. This argument is made with the
caveat that co-production is an option (for both the provider and the customer), but value is always
co-created. That is, co-creation is the common denominator for value creation and superordinate
to co-production in the same way that service is superordinate to goods.
Value as a Phenomenological Concept
For somewhat the same, G-D lexicon–based reasons for the confusion between co-creation of value
and co-production, the S-D logic meaning of value is also sometimes misunderstood. Some have
suggested that the service in S-D logic implies only utilitarian or “functional” benefts, essentially
what has been captured by concepts of “utility” or “value-added” (e.g., Prahalad 2004; Schembri
2006). Typically, in conversation explaining S-D logic, the use of “utility” and “value-added” are
avoided. The problem is that, even though “utility” was originally intended to capture “value-
in-use,” or “usefulness,” it morphed into a meaning of embedded value, or “value-in-exchange,”
essentially the same as value-added, a clearly G-D logic–related concept (see Vargo and Lusch
2006). S-D logic generally supports a “value-in-use” interpretation, but even that term has at least
subtle G-D logic connotations.
This G-D logic connotation of “value-in-use” might also exacerbate the occasional interpreta-
tion of service as referring to value in terms of functional benefts, rather than a phenomenological
interpretation by the customer. As Vargo and Lusch (2006, p. 50) noted:
We suspect that our emphasis on service satisfying higher-order needs is missed because,
as with many misperceptions about S-D logic, the dominant paradigmatic perspective is
G-D logic. Arguably, G-D logic implies functional benefts and its dominance is why the
literature is just now evolving toward grasping the role of more experiential, expressive,
phenomenological, and emotional benefts.
To further clarify this issue, FP10 was added (Vargo and Lusch 2008a), which captures S-D
logic’s phenomenological view of value and also helps to clarify the misunderstanding that S-D
logic is a restatement of the consumer orientation. S-D logic’s emphasis on value-in-use centers
on the phenomenological view of value and, thus, is inherently customer oriented and customer
centered. Within S-D logic, the identifcation of consumer orientation becomes redundant.
Although S-D logic takes a customer-centric approach to value creation and emphasizes that
value is derived through use, it does not suggest that value-in-exchange is not important. Rather,
S-D logic recognizes the importance of fnancial feedback from the market (exchange value) as
a learning mechanism and is compatible with the idea that such feedback is tied to accounting
systems that capture value-in-exchange. Thus, while S-D logic argues that value-in-exchange
could not exist independent of value-in-use, it recognizes the importance of value-in-exchange
as feedback to the frm and an intermediary of service provision.
The transition in thinking that occurs when one moves from focusing on value-in-exchange to
SERVICE-DOMINANT LOGIC: A REVIEW AND ASSESSMENT 141
value-in-use is illustrated in Table 6.2. We are now beginning to recognize that value-in-use is a
transitional concept that takes us from the goods-dominant concept of value-in-exchange toward
a service-dominant concept of value. However, “value-in-use” does not fully refect S-D logic
thought—thatis,itistransitional—andthustheterm“value-in-context” (see Vargo, Maglio, and
Akaka 2008) may be more ftting. Value-in-context suggests that not only is value always co-created,
it is also contingent on the integration of other resources and is contextually specifc. Consider
the purchase of a new car. The price paid for the car is the value-in-exchange; the benefts from
the use of the car represent the value-in-use. But that value is contingent on integration with other
resources(drivingability,maintenance,fuel,roads,)andtheusecontext—forexample,integrating
a car with family activities, such as weekend soccer games, establishes a different value-in-use
from integrating it with individual needs, such as a daily commute to work.
Service-Dominant Logic as Transcendence Versus a Goods-Services Dichotomy
As noted, in S-D logic, “service” transcends goods (and “services”) by delineating the relation-
ship between service (a process of using competences for the beneft of another party) and goods
(service-provision vehicles), rather than looking for the differences between types of output (goods
and “services”). Similarly, rather than replacing goods with service, as some have suggested (e.g.,
Achrol and Kotler 2006; Brodie et al. 2006) or goods logic with service logic, S-D logic makes
service and service logic superordinate to goods and goods logic in terms of classifcation and
function. That is, although some have argued otherwise, S-D logic does not consider service to
be a substitute for goods. Rather, S-D logic establishes a nested relationship in which S-D logic
transcends G-D logic, meaning that the theoretical and conceptual components of G-D logic are
relevant, but are not as deep or broad as those of S-D logic. Thus, it resolves the goods versus
service dichotomy that is created by the G-D logic distinctions.
Similarly, this notion of transcendence can be used to respond to arguments that a plurality
ofparadigmsisneeded—thatis,S-DlogicandG-Dlogicshouldcoexist(e.g.,Sweeney2007;
Winklhofer, Palmer, and Brodie 2007). At frst glance, this pluralistic stance may seem as if it
resolves the debatable ideas stemming from the emergence of S-D logic. However, this pluralistic
approach is also unnecessary and conceivably incoherent. A service logic and a goods logic can
coexist in a nested relationship, as they do in S-D logic, but that is very different from making
both service and goods primary (e.g., “dominant”). Essentially, “plurality is what the discipline
has had with the separation of goods marketing and services marketing. In S-D logic, that separa-
tionisnotonlyunnecessary;it(arguably)isresolved—serviceandgoodscoexistwithacommon
purpose (service) in S-D logic” (Vargo 2007b, p. 109).
Service Provision as the Common Denominator of All Exchange
One of the most consistent restatements and misstatements of the S-D logic thesis is that it is ap-
propriate for marketing to adopt models of “services,” rather than goods, because the former are
now dominant in developed economies (see, e.g., Achrol and Kotler 2006; Ambler 2006; Brodie et
al. 2006; Shugan 2004). Some have even suggested that S-D logic does not go far enough in refect-
ing the transition in the market (e.g., Rust 2006). S-D logic does not deny that service dominates
exchange today; however the transition-focused perspective does not refect a full understanding
of the central tenet of S-D logic: service is exchanged for service. Thus, service has always been
the foundational basis for all exchange.
Importantly, goods neither become replaced nor unimportant in S-D logic. Service is just the
142 STEPHEN L. VARGO, ROBERT F. LUSCH, MELISSA ARCHPRU AKAKA, AND YI HE
commondenominator.Thefunctionofgoods,wheninvolved,istoenableservice—thatis,goods
represent a special case of service provision. As noted, it is only from the perspective of a model
that includes the fundamental assumption that exchange is driven by goods (G-D logic) that the
importance of service is just now becoming apparent and that the economy is perceived to be
transitioning from goods to service focused.
In S-D logic, service provision is the basis of exchange in all economies as well as industries
and is the primary function of all organizations. Thus, though some have argued that S-D logic is
not likely to apply to all organizations and/or situations (e.g., Day 2006), once service is accepted
and understood as the basis of all exchange, S-D logic does not have boundary conditions. That
is, it applies equally to what have traditionally (under G-D logic) been differentiated as “services”
and “manufacturing” industries and organizations.
The Positive vs. Normative Nature of S-D Logic
Some (e.g., Venkatesh et al. 2006; Wilkie and Moore 2006) have either implicitly or explicitly
indicated that S-D logic might not go far enough because it does not move marketing beyond
its present managerial, or frm-centric, orientation and/or does not adequately provide a market
focus. Based solely on the original Journal of Marketing article (Vargo and Lusch 2004a), their
observations are possibly well founded. Marketing, by defnition, is largely a managerial activ-
ity, as it should be given its origin and its original focus on application. That is, it has normative
connotations.Eventheword“marketing”impliesdoingsomething—goingtomarket,actingon
themarket,andsoon—asopposedtoamorepositivetermlikemarketscience.Also,theconcep-
tualization of S-D logic emerged (Vargo and Lusch 2004a) in the Journal of Marketing, which
has an editorial policy of managerial relevance. Thus, Vargo and Lusch (2006) have recognized
that some of the initial presentation of S-D logic was couched in managerial terms. However, S-D
logic is not inherently managerial, and the non-managerial implications need to be more fully
explored (see, e.g., Gummesson 2006; Laczniak 2006; Venkatesh et al. 2006; Wilkie and Moore
2006; and Lusch and Vargo 2006b).
More importantly, Venkatesh et al. (2006) argue that what is missing in marketing is an adequate
understanding of the market (Vargo and Lusch 2006). In agreement, Lusch and Vargo (2006b;
Vargo 2007a; Vargo and Lusch 2008c) suggest that S-D logic offers a foundation for a much-
needed positive theory of markets, on which better normative theories of marketing could be based.
That is, the basic premise of S-D logic, the mutual exchange of applied, specialized skills and
knowledge, is a more solid foundation for understanding markets and marketing than is the very
limited foundation of exchange centered on goods. Thus, S-D logic not only points toward better
marketing theory but also possibly points toward a better, process-centered theory of economics
and society. Further integration of the literature and generation of knowledge will likely offer
insight on social and not-for-proft entities as well as ethical, legal, societal, and ecological issues
(Vargo and Lusch 2008c). Such areas are already being examined (see, e.g., Abela and Murphy
2008) and show initial support for S-D logic as a more integrative approach for studying ethical
and socially benefcial aspects of marketing.
Service-Dominant Logic Knowledge Extensions and Integration
Since its introduction in academic marketing, S-D logic (Vargo and Lusch 2004a) has stimulated
scholarly dialogue concerning marketing theory and thought in general, as well as more specifc
phenomena of concern in various subdisciplines (e.g., service marketing, relationship marketing,
SERVICE-DOMINANT LOGIC: A REVIEW AND ASSESSMENT 143
industrial marketing, etc.). Although the dialogue surrounding S-D logic continues to evolve, three
subthemes have emerged that underlie much of the elaboration of service-centered concepts and
refect the foundational premises of S-D logic. These subthemes are: (1) the S-D logic meaning
of service, (2) a resource-based perspective of the market, and (3) the process-orientation of value
co-creation. The growing conversation built upon the three subthemes of S-D logic has contributed
back to the research streams from which S-D logic was derived (e.g., service and relationship mar-
keting) and continues to expand into other areas of marketing and marketing-related research (e.g.,
consumer behavior and business-to-business marketing). The purpose of the following section is
to highlight the primary, salient issues and insights emerging from these scholarly conversations.
This dialogue integrates S-D logic with existing and developing ideas related to marketing and
elaborates and/or extends service-centered concepts.
S-D Logic Meaning of Service
Growing research focused on service-centered thinking suggests that S-D logic has the potential
to provide a foundation for a paradigm shift in marketing. As a result, the existing concepts and
models for marketing are increasingly being questioned and reconsidered to refect the evolu-
tionary transition (e.g., Ekeledo and Sivakumar 2004; Rust 2004; Woodruff and Flint 2006). The
discussion surrounding the S-D logic meaning of service, as the application of operant resources
(e.g., knowledge and skills) for the beneft of another, has been at the core of this dialogue and
evolution. While the clarifcations of why the term “service” is appropriate and precise have been
discussed above, the following sections provide extensions in the literature that further develop
this core concept (cf. Vargo and Lusch 2004b).
Rethinking Service Marketing
The S-D logic conceptualization of service appears to have a signifcant impact on the service
marketing literature. Ottenbacher et al. (2006, p. 346) argue that S-D logic introduces “a renewed
focus on the conceptual fuency between what is relevant in product marketing and what is relevant
in services marketing.” As mentioned, “services” are conventionally distinguished from goods by
four differentiating characteristics: intangibility, heterogeneity, inseparability, and perishability
(Zeithaml et al. 1985), designated as “IHIP” characteristics (Lovelock and Gummesson 2004).
Over the past few decades, the IHIP characteristics of services have been widely accepted and
applied as the conventional wisdom of service marketing. However, the introduction of S-D
logic directly challenges these characteristics by arguing that the IHIP differentiators assume the
primacy of goods (i.e., services are what goods are not) and therefore are evidence of a G-D logic
(Vargo and Lusch 2004b). Lovelock and Gummesson (2004) have questioned their usefulness in
the delineation of services from goods on somewhat similar grounds.
The S-D logic conceptualization of service has at least partially redirected the discussion of
service from the distinction of “goods versus services” by obviating the need for a “goods versus
services” dichotomy because, in S-D logic, “service,” is a transcending concept. That is, service,
defned in terms of using competences for the beneft of another party, is an inclusive term, with
goods representing a mechanism for service provision.
While the discussion has been redirected, in part, the issues are not fully resolved, perhaps
somewhat refecting the paradigmatic power of G-D logic. For example, Edvardsson et al. (2005)
question the traditionally accepted defnition of services for its managerial and frm-centered fo-
cus and argue that services may be defned from the customer’s perspective by incorporating the
144 STEPHEN L. VARGO, ROBERT F. LUSCH, MELISSA ARCHPRU AKAKA, AND YI HE
conceptualization of service and the idea of value co-creation supported by S-D logic (Vargo and
Lusch 2004a, 2006). Edvardsson et al. (2005) reported preliminary research fndings that support
the connection between the S-D logic conceptualization of service and the defnition of services
in the traditional “services industry.”
Some scholars continue, however, to consider the goods versus service(s) debate valid and use-
ful. For example, Sampson and Froehle (2006) argue that there is no single, comprehensive, and
consistent structure to differentiate goods and services, while others suggest that the characteristics
of exchange phenomena should be considered on a case-by-case basis (Laine et al. 2005). Still
others continue to believe that it is important to distinguish between goods and services in order to
capture the important differences in consumer price fairness perceptions (Bolton and Alba 2006).
As S-D logic evolves, its service-centered understanding of exchange continues to develop and
raises questions regarding the relative role of goods.
In contrast to this continuing debate, and consistent with S-D logic, several marketing scholars
have initiated attempts to redefne the role of service marketing with regard to the overall discipline.
For example, Gronroos (2006, p. 362) contends that “goods marketing” is a special case of service
marketing and proposes three conclusions for marketing’s traditional focus on goods:
1. Concentrating on the product draws the marketer’s attention away from what ultimately
is important for the customers: their value-creating processes.
2. Goods can be seen as a platform for services.
3. For the customer to use goods, other resources must accompany them, and the goods are
only one resource among others in the process of supporting customers’ value-generating
processes.
Focusing on the centrality of service in marketing not only informs the marketing of goods,
but also sheds light on the management of marketing in general. For example, Brown and Bitner
(2006, p. 31) suggest six service-centered best practices that serve as a foundation for contemporary
marketing. These best practices are proposed for all types of organizations and include:
1. Keeping promises to customers
2. Understanding service from the customer’s point of view
3. Recognizing that employees are the product
4. Involving customers in co-producing services
5. Enabling customers to serve themselves
6. Recovering when failures occur.
The emergence of S-D logic has emphasized the centrality of service in marketing and suggests
that the theories and models developed in service marketing are applicable to all of marketing
(Vargo and Lusch 2008c), including the subset of instances in which goods are involved. The
dialogue surrounding service-centered phenomena has marked a starting point to broaden the
scope of service marketing literature and reexamine service, in terms of what it is and where it
stands in the feld of marketing.
Solutions and Symbols
The service-centered perspective of S-D logic has punctuated the emerging shift from an
output-oriented to a solution-oriented approach for marketing (Michel, Vargo, and Lusch 2008).
SERVICE-DOMINANT LOGIC: A REVIEW AND ASSESSMENT 145
Saw hney (2006, p. 365) urges marketers to go beyond the product and focus on service provi-
sion that integrates customized solutions for customers by “embracing a solutions mind-set” and
focusing on providing “customized outcomes for specifc customers.” He further specifes that the
solution-centered mindset refects an S-D logic for marketing and is fundamentally different from
G-D logic. Contrasting the goods-centered mindset that starts with products, a solution-centered
design begins with an analysis of a customer’s problem and ends with the identifcation of the
resources, both operant and operand, that will be needed to solve the entire problem.
The solution-centered mindset emphasizes the central role of the customers and customized
experiences in the overall marketing process. Rust and Thompson (2006, p. 284) suggest, “as
companies become increasingly service-oriented, marketing strategy will need to accompany
this shift and become less product-centered and increasingly customer-centered.” The authors
argue that using a customer-based, fexible framework to guide marketing strategy will lead to
the greatest payoff for frms.
While many are supportive of a solution-orientation for marketing, several researchers have rec-
ognized the challenges associated with the transition from a product mindset to a solution-centered
approach to marketing. Day (2006, p. 88) notes that it will be diffcult for frms to pursue an S-D logic
and a solution-oriented marketing strategy because it would entail satisfying fve criteria (integration,
interaction, co-production, customization (tailored), and customer risk) for a deep relationship that
transfers a supplier’s skills and knowledge to a customer who lacks such competences.
Extending the movement from a product- toward solution-oriented approach for marketing,
several researchers emphasize the symbolic and experiential, rather than purely functional, nature
of service. For example, Flint (2006) calls upon symbolic interactionism to discuss the dynamic
meanings of customer resources. “Rather than focusing on products as vessels that hold symbolic
meaning for the possessor/user [symbolic interactionism] focuses on the dynamic use, interpreta-
tion, and changing meanings of symbols within social interaction” (p. 351). Flint explains that
symbolic interaction echoes the notion of co-creation in S-D logic by emphasizing the active,
rather than reactive, role of customer value.
Along the same vein, Venkatesh et al. (2006, p. 253; emphasis in original) extend S-D logic’s
view of the service nature of the economy (Vargo and Lusch 2004a) to that of a system of sym-
bolic meaning and explain, “[Vargo and Lusch] use the term service economy in moving from an
emphasis on products to services in understanding market exchange. In contrast we put forward
the term market, in which the sign is a key in understanding exchange.” In addition, Duncan and
Moriarty (2006) apply the notion of service and symbols in the branding literature and argue that
service and integrated marketing communications perspectives and brands are correlated and
interdependent. The authors suggest using integrated marketing communication touchpoints to
operationalize S-D logic. Brodie et al. (2006) recognize the conceptual similarities between S-D
logic and the service brand (Berry 2000). Brodie et al. (2006, p. 372) draw on the discussion of
sign systems raised by Venkatesh et al. (2006) and suggest that “the service brand is a sign system
that symbolizes the value processes.”
While the scholarly debate on the S-D logic meaning of service continues throughout various
research streams, Anderson (2006) anticipates that future modeling in the marketing discipline will
continue to evolve. He argues that marketing models will shift from a goods-based perspective,
which examines how marketing can infuence individual purchase decisions, to a service-based
perspective of customer solutions and interdependent relationships. Through this elaboration of
S-D logic’s meaning of service, particularly as a solution and/or symbol (phenomenological inter-
pretation), the intangible and dynamic forces that underlie the creation of value are highlighted,
and the operant resources that drive exchange are diffcult to ignore.
146 STEPHEN L. VARGO, ROBERT F. LUSCH, MELISSA ARCHPRU AKAKA, AND YI HE
Resource-Based Perspective of Marketing
As noted, S-D logic adopts a resource-based perspective of marketing and argues for the primacy
of operant, rather than operand, resources in exchange (Vargo and Lusch 2004a). Since operant
resources are usually infnite and dynamic, the sustainable comparative advantages of frms are
usually derived from the application and management of such resources (e.g., knowledge, skills,
and competences), especially those that are tacit and not easily imitable or transferable (Lusch et
al. 2007; Madhavaram and Hunt 2008). This resource-based perspective, focused on operant re-
sources, serves as an instrumental conceptual framework to understand marketing phenomena.
Elaborating the Concept of Resources
A resource-based perspective on business activities was introduced into marketing largely through
resource-advantage (R-A) theory (e.g., Hunt and Morgan 1995; Hunt 2000, 2002). This theory has
been recognized as one of the fundamental conceptualizations tied to the emergence of S-D logic
(Vargo and Lusch 2004a). R-A theory argues that heterogeneous, imperfectly mobile resources
meet heterogeneous demands in the market. This theory implies signifcant diversity among frms
and proposes resource-based comparative advantages.
Supporting a resource-based perspective for marketing, Hunt and Madhavaram (2006) suggest
using R-A theory to guide business and marketing strategy and further develop an S-D logic for
marketing. The authors suggest that R-A theory provides S-D logic with a defnition of resources:
“tangible and intangible entities available to the frm that enable it to produce effciently and/or
effectively a market offering that has value for some marketing segment(s)” (p. 69). Maintaining a
strong focus on the competitiveness of the frm, Hunt and Madhavaram (2006, p. 70) also explain
how the value of a resource is determined,
For R-A theory, not all resources that have value to the frm have an exchange value or price.
That is, relatively immobile resources such as competences are not commonly or easily
bought and sold in the marketplace. . . . Therefore, the value of such operant resources is
determined not by exchange, but by the extent to which each contributes to the frm’s abil-
ity to produce effciently/effectively market offerings that are perceived by some market
segments to have value.
While R-A theory’s focus aligns with S-D logic’s emphasis on the exchange and application
of operant resources, S-D logic expands the focus of resources beyond the frm to systems of ser-
vice exchange (Lusch and Vargo 2006c). S-D logic considers the operant resources of customers,
employees, and the environment endogenous, rather than exogenous, to the frm. Thus, the com-
petences of customers (e.g., Prahalad and Ramaswamy 2000), employees, and other stakeholders
are key components in the competitive advantage of the frm (Lusch et al. 2007). In addition, the
distinction of operant versus operand resources in S-D logic has further extended R-A theory by
suggesting the primacy of operant resources in achieving competitive advantage. Madhavaram
and Hunt (2008) have furthered the integration of S-D logic’s primacy of operant resources with
R-A theory by developing a hierarchy of operant resources for the frm: basic, composite, and
interconnected.
The primacy of operant resources is not limited to those of the frm. The nature and purpose of
operant resources have also been elaborated in relation to the customer, through the intersection
of S-D logic and consumer culture theory (CCT) (Arnould and Thompson 2005; Arnould 2005;
SERVICE-DOMINANT LOGIC: A REVIEW AND ASSESSMENT 147
Arnould, Price, and Malshe 2006). In particular, Arnould et al. (2006, pp. 93–94) defne custom-
ers’ operant resources as physical, social, and cultural:
Physical Resources: Consumers vary in their physical and mental endowments. This affects
their life roles and projects; for example, low literate and physically challenged consumers’
life roles and life projects appear to differ qualitatively from those with average physical
endowments. . . . Through understanding customers’ operant physical resources, frms can
tailor their offerings including virtual environments that relieve physical constraints.
Social Resources: Social operant resources are networks of relationships with others includ-
ing traditional demographic groupings (families, ethnic groups, social class) and emergent
groupings (brand communities, consumer tribes and subcultures, friendship groups) over
which consumers exert varying degrees of command (Giddens 1979).
Cultural Resources: Consumer culture theorists conceive of cultural operant resources as
varying amounts and kinds of knowledge of cultural schemas, including specialized cultural
capital, skills, and goals.
Arnould et al. (2006) emphasize the role of customers as active players in economic activities
and suggest that customers, like businesses, possess different types of resources. These resources
are integrated “to co-create value through patterns of experiences and meanings embedded in the
cultural life-worlds of consumers” (p. 91).
The notion of operant customer resources has stimulated the discussion of value co-creation
and resource-integration from a customer’s perspective. Arnould et al. (2006) parallel the role
of frms and customers in the value creation process, in which frms deploy operant resources
to mold operand resources and value propositions, while customers use operant resources to co-
create value and determine value-in-use. Such interactions present opportunities for developing
and enhancing value propositions by leveraging customers’ operant resources. Figure 6.3 (Arnould
et al. 2006, p. 92) illustrates the role of the customer’s operant and operand resources in the co-
creation of value.
Along a similar vein, Etgar (2006) brings the resource-based notion into understanding consumer
behavior. He argues that customers need to make economic decisions like those used by managers
in frms to optimize the use of resources available to them. Therefore, like managers, customers
strive for a balance between minimizing costs and optimizing performance.
S-D logic’s perspective that customers and suppliers are operant resources suggests
a symmetrical, rather than asymmetrical, relationship among exchange partners (Lusch
et al. 2006). This balance of mutual service provision is not limited to the dyadic relationship
between a frm and customer; rather, service is continually provided through a network or
constellation of value-creating activities. As S-D logic evolves, the central role of networks
and interaction in value creation draws increasing attention and continues to be more heavily
emphasized (e.g., Lusch and Vargo 2006b; Vargo and Lusch 2008a). Arnould (2008) argues
for the further integration of S-D logic with various resource-oriented theories to investigate
how operant resources interact and create value for individuals, frms, and society. Develop-
ing research on the market as a network and service as the basis of exchange will continue to
refocus the understanding of value creation away from a unidirectional, chainlike process to
the integration of dynamic and interconnected processes that make up systems, or networks,
of service-for-service exchange.
148
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SERVICE-DOMINANT LOGIC: A REVIEW AND ASSESSMENT 149
Systems of Resource Integration
The examination of resource-based processes for value creation offers insight concerning how frms
should integrate resources through various marketing systems, networks, and intermediaries. Within
S-Dlogic,the“venue”ofvaluecreationisfoundinvalueconfgurations—interactionsamongeco-
nomicandsocialactors—andthus,valueiscreatedwithinandamongsystemsofexchange,atvarious
levels of aggregation (Vargo and Lusch 2008a). Based on an S-D logic view, a “value network” or
“service ecosystem” (Lusch et al. forthcoming) has been recognized as a “spontaneously sensing
and responding spatial and temporal structure of largely loosely coupled value proposing social and
economic actors interacting through institutions and technology, to (1) co-produce service offerings,
(2) exchange service offerings, and (3) co-create value.” Recent literature integrates this S-D-logic
conceptualization of a value network with models of value chain management. Although “value
chains” are used to describe several of these related models, it is important to note that while S-D
logic recognizes that linear processes exist, they do so within the framework of complex intercon-
nections and interactions with other actors and processes. For example, Flint and Mentzer (2006, p.
140) present an S-D logic model for integrated value chain management with “fully interconnected
and smoothly operating supply chains . . . [that] clearly refect the goal for which supply chain man-
agement now strives: a service orientation to multiple enterprise management.”
Within a business-to-business context, Flint and Mentzer (2006, p. 139) substantiate the no-
tion of integrated value chain management by emphasizing the use of information about and by
all business functions to facilitate the fow of value propositions, which now involve “products,
processes, experience (history), and network relationships, all aimed at superior value creation.”
The information fow in value chains aids both suppliers and frms to ensure the accuracy and
effciency of the co-production process. In addition, Flint and Mentzer suggest that the integrated
supply chains facilitate the process of co-creating knowledge about markets and operations, as
well as the knowledge about knowledge generation; that is, frms learn how to learn together.
Kalaignanam and Varadarajan (2006) further explore the involvement of customers as co-producers
along a frm’s value chain and the implications for marketing strategy effectiveness and marketing
operations effciency. They examine how product, market, customer, and frm characteristics affect
the extent of customer involvement in value chain management. In sum, the notion of systems
of resource integration has redefned the role of channel members, including customers, in the
integrated value chain or value constellation (in S-D logic terms) management system.
Mouzas (2006) investigated the underlying processes of marketing action within manufacturer-
retailer networks and found that companies’ marketing actions may be best understood through
their network relationships. Along a similar vein, Lambert and Garcia-Dastugue (2006) present a
network framework for supply chain management and address the complexity of value creation
by discussing the cross-functional business processes required for implementing S-D logic in
an organization. The authors integrate S-D logic with the Global Supply Chain Forum (GSCF)
framework for supply chain management. The GSCF framework suggests that “whoever has the
relationship with the end user has the power in the supply chain” (p. 153) and focuses the frm on
value-in-use for an individual end user.
Lambert and Garcia-Dastugue (2006, p. 153) demonstrate the support for an S-D logic frame-
work for managing supply networks by using three steps: (1) mapping the network structure, (2)
deciding which customers and suppliers to link with which business process, and (3) deciding
the level of management to dedicate to each relationship. Figure 6.4 illustrates the complexity
of managing suppliers of resources, which begins at the access of raw materials and continues
through to customer use.
150 STEPHEN L. VARGO, ROBERT F. LUSCH, MELISSA ARCHPRU AKAKA, AND YI HE
The resource-based perspective of marketing supports S-D logic’s premise that value is always
co-created through the integration of multiple resources and is largely dependent on individual
circumstance. This understanding of resource integration suggests that value is created through
a continuous process of knowledge sharing and generation and is largely infuenced by culture,
competences, and context. This systematic view has been captured by the emergence of service
science(seeMaglioandSpohrer2008),whichfocusesontheexaminationofservicesystems—
interactive and dynamic interactions among technology, individuals, and frms. Value, within this
context, is created through the integration of various resources, including existing knowledge and
skills, and determined through experience. These experiences trigger learning and the generation
of new operant resources and form pathways for feedback and dialogue among frms, customers,
and other social and economic actors are formed.
The network structure of value creation suggests that value cannot be created and delivered
by any one entity. This process inherently involves customer competences in the co-creation of
value, in their own context, but may also include the participation of customers in co-production of
the frm’s value proposition or core offering. Etgar (2008) provides a model of the co-production
process, in which the frm establishes fve stages: (1) development of antecedent conditions, (2)
development of motivations that prompt customers to engage in “co-production,” (3) calculation
of the co-production cost-benefts, (4) activation when the customers engage in co-producing
activities, and (5) generation of outputs and evaluation of the process.
Figure 6.4 Supply Chain Network Structure
Source: Douglas M. Lambert (ed.), Supply Chain Management: Processes, Partnerships, Performance,
2d ed. (Sarasota, FL: Supply Chain Management Institute, 2006), 5. Adapted from Douglas M. Lambert,
Martha C. Cooper, and Janus D. Pagh, “Supply Chain Management: Implementation Issues and Research
Opportunities,” The International Journal of Logistics Management 9, 2 (1998), 3. Copyright © 2008 Supply
Chain Management Institute. See www.scm-institute.org.
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SERVICE-DOMINANT LOGIC: A REVIEW AND ASSESSMENT 151
In addition, Xie, Bagozzi, and Troye (2008) argue for the “productive” nature of “consumption”
by exploring a theory of co-creation based on the idea of “prosumption.” The authors argue that
“prosumption is a process rather than a single act (e.g., purchase) and consists in an integration
of physical activities, mental effort, and socio-psychological experiences” (p. 10). Although this
terminology seems refective of the G-D logic language, with its emphasis on production, the
underlying meaning of prosumption appears closely in line with S-D logic’s understanding of
the co-creation of value, as “people participate in this process by providing input of money, time,
effort and skills” (ibid., p. 10).
The Process Orientation of Value Co-creation
According to S-D logic, value is “defned by and co-created with the consumer rather than embed-
ded in output” (Vargo and Lusch 2004a, p. 6). This viewpoint highlights the inherent consumer-
orientation of S-D logic (FP8) and stresses the importance of collaboration and learning from and
with customers by being sensitive to ever-changing individual needs.
From an S-D logic perspective, value creation is a continuous process focused on the provision
of service, and, when production is involved, it is considered as an intermediary step (Vargo and
Lusch 2004a). As such, S-D logic stresses a process-oriented value creation model (rather than the
output-oriented value creation model derived from G-D logic). This process orientation of value
co-creation has been extended by the discussion of relationships and interaction and emphasizes
S-D logic’s phenomenological view of value.
Relationships and Interaction
Once the study of marketing focuses on processes rather than outputs, there is a natural link among
value-in-context, value-in-use, and value-in-exchange that points toward the process-oriented and
relational nature of exchange. Payne, Storbacka and Frow (2008) provide a framework for the
process orientation of value co-creation from an S-D logic perspective. They propose a model
that examines the value-creation processes of the frm and those of the customer as well as the
interaction that occurs in market encounters. Gummesson (2006) commends the evolution of
S-D logic and takes a network approach to value creation by suggesting the implementation of a
win-win strategy held by relationship marketing, particularly through the use of “lean production”
and “lean consumption” (see Womack and Jones 2005). Gummesson (2006, 2008) argues for
balanced centricity among frms and customers and extends this view by widening the context of
value creation beyond a dyadic relationship between a frm and a customer and presents a many-
to-many theory for creating value.
Highlighting the interdependent relationships among frms and customers, Roos, Gustafsson,
and Edvardsson (2006) use S-D logic as part of their theoretical framework in defning relation-
ship quality for customer-driven business development. They argue that no objective defnition
of a company’s service really exists: it is all a question of perspective. If the aim is to strive for
relationship strategy, the perspective has to be that of the customer and may have to include an
additional behavioral aspect. As such, similar to the notion of value co-creation and inherent to S-D
logic, interaction and interdependence are central to developing relationships in the market.
Several marketing scholars (e.g., Achrol and Kotler 2006; Gronroos 2006; Gummesson 2006)
have pointed out that interaction and networks play a more central role (beyond relationships) in
value creation and exchange than was immediately apparent in the initial S-D logic article (Vargo
and Lusch 2004a). However, Lusch and Vargo (2006b) have argued that it is not so much that
152 STEPHEN L. VARGO, ROBERT F. LUSCH, MELISSA ARCHPRU AKAKA, AND YI HE
S-D logic ignores interaction and networks, but rather they were originally dealt with somewhat
implicitly. The centrality of markets as networks and interaction has been made considerably
more explicit throughout the development of S-D logic (e.g., Vargo and Lusch 2008c). Through
this elaboration, it becomes considerably more evident that S-D logic embraces the idea that
value creation is a process of exchanging, integrating, and generating resources, which requires
interaction and implies networks.
Ballantyne and Varey (2006, p. 224) extend S-D logic’s notion of interaction and suggest that
“dialogical” interaction appears to be “an ideal form of communication within the S-D logic be-
cause it supports the potential for co-creation of value and sustainable competitive advantage.”
The authors advance S-D logic’s focus on operant resources by providing a triad of exchange
activities that represent the fundamentals for service-dominant marketing. They suggest that the
threestrands—communicativeinteraction,relationshipdevelopment,andknowledgeapplication—
make up “a fundamental conceptual unity of exchange activities,” and it is “diffcult to isolate one
strand of exchange activity and its effects without reference to the others” (2006, p. 230). Further,
they suggest that understanding value co-creation from a triangulated viewpoint supports mutual
learning and knowledge renewal. Figure 6.5 (Ballantyne and Varey 2006, p. 231) illustrates this
triangular relationship and presents the tripartite fundamentals for S-D logic in marketing.
While Ballantyne and Varey (2006) demonstrate the connections between interaction, dia-
logue, and knowledge in exchange, Berthon and John (2006) focus on the role of interactions in
the exchange process. In recognition of interaction as the root of S-D logic, the authors call for
a shift in focus from the entities in an exchange process to the interaction between entities. This
is because service is codesigned and co-created through interaction, which constitutes “the very
fabric of exchange” (p. 196). Applying the notion of interaction and dialogue in the business pro-
cess, Jaworski and Kohli (2006) suggest that customer needs should be identifed by the process
in which a frm and its customers co-create the voice of customers. In particular, they suggest that
in the needs co-creation process, both frms and customers are engaged in a joint learning process,
followed by a mutual understanding concerning customers’ wants and needs.
Offering a more critical approach toward the interaction among customers and frms, Wilkie
and Moore (2006) emphasize the challenges with engaging in dialogue with customers. They argue
that customers are often not aware of their own needs and best options for solving problems, or
they are unable to communicate reliable information and are not always straightforward with frms.
Further, Rust and Thompson (2006) express concerns that customers cannot, and many times do
not, want to keep close, one-to-one relationships with all the frms that they interact with. In this
case, an assessment process, such as that proposed by Moller (2006), appears to be crucial. His
assessment involves an evaluation of the competency and accessibility of the customer, which
is critical to the optimization of performance in the value co-creation process and the creation
of a “user friendly” offering. The complexities that arise in the examination of relationships and
interaction in marketing emphasize the process-orientation of exchange and point toward both
opportunities and challenges that underlie value creation. Arguably, some of these discussions do
not make the distinction between co-creation of value and co-production that Vargo and Lusch
(2008a) offer, as discussed above.
Experiential Nature of Customer Value
S-D logic’s notions of value co-creation and value-in-use (or, more recently, value-in-context)
are directly tied with literature relating to customer value. Holbrook (2006) draws connections
between the original eight FPs of S-D logic and the concept of customer value (CCV) with a
SERVICE-DOMINANT LOGIC: A REVIEW AND ASSESSMENT 153
model of a service-logic schema. According to Holbrook, the evolution of S-D logic argues for
marketing as resource operant (RO), skills exchanging (SE), performance experiencing (PE),
knowledge informed (KI), competence enacting (CE), co-producer involved (CI), value emerging
(VE), and customer interactive (CI), which he abbreviates as “ROSEPEKICECIVECI.” Holbrook
compares S-D logic with CCV and argues that CCV provides a more compact foundation for a
marketing paradigm than S-D logic. In fact, he suggests that CCV provides a “wholesale” version
of S-D logic. Vargo and Lusch (2006, p. 182) responded to this claim by explaining S-D logic’s
compact or “wholesale” foundation is that “service is exchanged for service,” which offers even
more parsimony than “ROSEPEKICECIVECI” and also importantly is more isomorphic with
markets and exchange systems.
Against the background of the evolving S-D logic, Woodruff and Flint (2006) critically examine
the consumer value literature and suggest that the extant marketing research on consumer value
has primarily focused on defning and categorizing consumer value typology. They argue, “For
Figure 6.5 Tripartite Fundamentals for Service-Dominant Marketing
Source: David Ballantyne and Richard J. Varey, “Introducting a Dialogical Orientation to the Service-
Dominant Logic of Marketing,” in The Service-Dominant Logic of Marketing: Dialog, Debate, and Directions,
ed. Robert F. Lusch and Stephen L. Vargo (Armonk, NY: M.E. Sharpe, 2006), p. 231. Used by permission.
Communicative
interaction
Knowledge
application
Relationship
development
Service-dominant
exchange activities
154 STEPHEN L. VARGO, ROBERT F. LUSCH, MELISSA ARCHPRU AKAKA, AND YI HE
the S-D logic to succeed as a paradigm shift, marketing thought and practice must be founded
on greater in-depth understanding of customer value phenomena” (p. 183). Although S-D logic’s
emphasis on the phenomenological nature of value has been addressed, the elaborations in the
literature are important here.
Arguing for a stronger emphasis on the experiential nature of exchange in S-D logic, Woodruff
and Flint (2006) discuss the phenomenological nature of customer value. The authors propose
the examination of specifc value-related phenomena and offer a research agenda for studying
value creation (understand customer value phenomena, understand seller value phenomena, and
test theories across contexts). Others have also elaborated and extended the experiential nature
of value in S-D logic. For example, in response to the emergence of S-D logic, Prahalad (2004)
elaborates the idea of the customer’s involvement and engagement in the value-creation process.
He argues that “when we escape from the frm and product-/service-centric view of value creation
. . . and move onto an experience-centric cocreation view, new and exciting opportunities unfold”
(p. 23). In addition, Schembri (2006) advocates customer experience as “the point of departure
for a new service orientation within marketing” (p. 390).
Arnould et al. (2006, p. 94) build upon the experiential nature of co-creation and introduce the
term “co-consumption.” They extend the phenomenological nature of value co-creation beyond
the isolated experience of one customer by explaining four ways that value is increased for a
customer through co-consumption:
1. Co-consuming groups represent a form of consumer agency. Enhanced by computer-
mediated communication . . . consumer groups have a greater voice in the co-creation
of value than in the more atomistic situations that prevailed in the recent past.
2. Co-consuming communities represent an important information resource for participants.
Co-consumer participants in brand fests and other such manifestations can not only easily
turn to one another for information about products and brand, but share cultural schema
nuances associated with how to consume the product or brand creatively, and interpret
these experiences “properly” (Cova and Cova 2001).
3. Co-consuming groups often exhibit a sense of moral responsibility that translates to
socialization of other co-consumers . . . Building on the interconnected structure of rela-
tionships and sentiments, ritual activities in consumption-oriented groupings facilitate,
create and reproduce community.
4. Co-consuming groups tend to bring a relatively celebratory ethos to the consumption
context.
Similarly, Denegri-Knott, Zwick, and Schroeder (2006) draw from the discursive-power model
to depict the increasingly powerful role of customers in the process of exchange and interaction,
or the co-creation of value. The discursive-power model attempts to capture the value co-creation
process, as it views power as the force that structures the possible interactions and exchanges of
free agents (Foucault 1994). This theoretical framework helps illustrate the process of value co-
creation and, thereafter, introduces innovation opportunities for marketers. The elaborations and
extensions of value co-creation have helped to extend the service-logic perspective toward the
phenomenological nature of customer value.
In addition, although not directly referring to S-D logic, recent publications in major marketing
journals have also refected and alluded to the fundamental viewpoints that are highlighted in the
threesubthemesofS-Dlogic—theS-Dlogicmeaningofservice,theresource-basedperspective
ofmarketing,andtheco-creationofvalue—presentedabove.InlinewiththeS-Dlogicmeaning
SERVICE-DOMINANT LOGIC: A REVIEW AND ASSESSMENT 155
of service, Constantinides (2006) pointed out the limitations of a goods-dominant framework, or
4Ps marketing mix, especially the model’s managerial orientation and lack of personalization.
Similarly, Iacobucci (2006) observed the adoption of the core ideas of service marketing into the
mainstream. Support has been offered for the resource-based perspective of marketing through
numerous studies that have recently been published on resource integration or collaboration on both
the intra-organizational (e.g., Chimhanzi 2004) and the inter-organizational levels (e.g., Amaldoss
and Rapoport 2005; Bradford, Stringfellow, and Weitz 2004; Yaprak, Cavusgil, and Kandemir
2006; Ross and Robertson 2007; Singh et al. 2005; Srinivasan et al. 2004). In particular, these
recent publications point toward the complexity, interconnectivity, and multiplicity of the network
relationships between frms (e.g., Ross and Robertson 2007; Singh et al. 2005). Finally, the discus-
sions of the process of value co-creation can be found in recent scholarly works on relationship
marketing (e.g., Rust and Chung 2006; Singh et al. 2005; Peng and Wang 2006; Palmatier et al.
2006) and customer orientation (Bettencourt et al. 2005; Donavan et al. 2004).
The evolution of S-D logic continues as elaborations and extensions are made on service-
centered phenomena in the literature. The ongoing discussions surrounding the S-D logic meaning
of service, the resource-based perspective of marketing, and the process orientation of value co-
creation are at their early stages of development. However, increasing attention toward the major
concepts associated with or supported by S-D logic indicates the need for a unifcation of emerging
ideas. In this sense, S-D logic appears to provide a unifying framework for alternative thinking in
marketing that points toward service as the basis of exchange, the primacy of operant resources,
and the necessity of interaction and interdependence in value creation. The ongoing development
of service-centered research seems to call for a grand theory of marketing (e.g., Gummesson 2006;
Hunt and Madhavaram 2006) that connects the complexities of the market with the fundamental
drivers of exchange. While S-D logic itself is not a theory (e.g., Lusch and Vargo 2006a; Vargo
2007a), it provides a revised understanding of market-related phenomena that could establish the
foundation for the development of a unifying theory of the market and marketing.
S-D Logic and the Evolution of Marketing Knowledge: An Assessment
The marketing discipline has evolved drastically through decades of integrating research on eco-
nomic, social, and psychological phenomena. Even a cursory audit of the collective knowledge
generation and impact of the evolution of marketing would reveal the impressive exponential
expansion of the discipline over the past century. One hundred years ago there were essentially no
university professors formally educated in marketing. As late as ffty years ago the discipline was
growing through the teachings of a substantial number of PhD-qualifed faculty from the social
sciences, particularly economics, sociology, and psychology. The hiring of such faculty is now
the exception. Since the early twentieth century, formal literature on marketing has expanded to
include specialized research in an increasing number of subdisciplines in marketing. Research
outside North America has grown, and advances in research methods, particularly quantifcation,
have been signifcant. A variety of scholarly marketing journals focused on a growing number of
subareas (e.g., industrial, international, and service) are now published throughout the world in
a number of languages.
The most advanced form of study in marketing, the pursuit of the PhD, has fourished beyond
North America over the years and is now conducted across the globe and is supplying business
schools in North America, Europe, Asia, and South America with marketing-specialized faculty.
In addition, marketing as an undergraduate major is often number one or two in popularity for
business students, and many MBA students focus their studies on either marketing or fnance.
156 STEPHEN L. VARGO, ROBERT F. LUSCH, MELISSA ARCHPRU AKAKA, AND YI HE
Along with indicators of increased volume of interest and specialization in marketing, there is
evidence of the infuential quality of marketing research. For instance, the Journal of Marketing
is among over seventeen hundred journals tracked by the social science citation index (SSCI) and
is often among the top fve to ten percent in terms of impact ratings.
It is evident that the marketing discipline has made tremendous strides in advancing the study
of economic and social exchange phenomena. However, is it possible that this assessment of the
collective knowledge and infuence of marketing as a discipline may be misguided? The emer-
gence of a service-logic for marketing forces the discipline to question the marketing knowledge
base that has been developed over the past century. A meta-analysis of traditional goods-centered
literature (e.g., pricing, promotion, placement, and products) raises more questions than answers
when approached from an S-D logic lens.
An evaluation of the marketing discipline through an S-D logic lens challenges the underlying
G-D logic framework for marketing, as well as the purpose of the frm, and asks, “Is the fundamental
purpose of marketing really to maximize frm profts by targeting and capturing customers and
making decisions based on the four Ps?” Similarly, challenges to the study of customer intent and
behavior surface as well, and ask, “Is the market really driven by customers attempting to make
purchase decisions in order to maximize and/or optimize utility or satisfaction for themselves?”
or, as suggested by FP1, “Is it possible that the market is essentially driven by the application
of competences and service-for-service exchange?” If the latter more adequately refects the
purpose and nature of marketing and the market, then, as suggested by FP9, are not all economic
and social actors fundamentally integrating resources to create value for themselves, others, and
society at large? If such is the case, then perhaps it makes sense to see economics as addressing
issues of resource allocation, whereas marketing is addressing issues of resource creation and
integration. From this perspective, marketing’s historical tie to exchange is protected, but the
means of exchange are viewed as service through resource integration and application, and the
end is viewed as value co-creation.
It may seem that these challenges to the foundation of marketing thought would most likely
come from critics of marketing, who have outside paradigms and biased views of the discipline.
However, should it not be the individuals that have participated in the evolution of marketing
knowledge to ask questions, criticize, and develop answers regarding these critical issues? The
marketing discipline has already begun to acknowledge and address deeply rooted limitations in
understanding imposed by the constraints of a G-D logic paradigm. As mentioned, these explora-
tions have been made largely under the hats of a variety of subdisciplines (e.g., service marketing,
relationship marketing, industrial marketing, etc.) in the pursuit of solving marketing problems
that the goods-centered, production-oriented models and concepts could not (Vargo and Lusch
2008c). The fragmentation of these research streams has called attention to the need for a unifying
theory for marketing (e.g., Hunt 2000; Gummesson 2006).
In the attempt to develop a grand or general theory of marketing, it seems that the G-D logic
paradigm is not conducive to understanding the fundamental basis of exchange and all that results
from it (e.g., social and economic systems, higher-order needs, evolution). In fact, this review
of the foundation of S-D logic and evolution of marketing has essentially been focused around
making this singular point, that the traditional goods-centered paradigm of marketing, focused
on the production of units of output (tangible and intangible) to maximize proft, has directed the
discipline away from understanding the core purpose and process of exchange. Whereas S-D logic
constitutes neither a theory nor a paradigm shift as yet (see Vargo and Lusch 2006; Vargo 2007a),
it does appear to provide a more robust perspective and inclusive lens for studying exchange
phenomena and the development of market relationships.
SERVICE-DOMINANT LOGIC: A REVIEW AND ASSESSMENT 157
The Formalization of S-D Logic
Venkatesh et al. (2006; see also Vargo 2007a) have argued that to develop a rich understanding of
the purposes, patterns, and processes of marketing phenomena, a theory of the “market” is needed to
serve as the foundation for theories of marketing. In support for a positive service-centered theory
of the market, Vargo (2007a, p. 60, emphasis in original) explains, “‘Marketing theory,’ almost
by any defnition, implies normative theory. A theory of the market on the other hand, suggests
a positive theory of exchange.” As Hunt (2002) has stressed, normative theory normatively rests
on a positive foundation: “good normative theory is based on good positive theory” (p. 238). S-D
logic’s focus on the integration of resources, in systems of service exchange, provides a positive
approach for studying exchange relationships.
Although S-D logic is not a theory, Vargo and Lusch (2008c; Lusch and Vargo 2006c) have sug-
gested that it could provide a foundation on which a true positive theory of exchange (see also Vargo
2007a) can be built. They have suggested that the development of a positive theory of the market
requires a critical shift in thinking, from focusing on how frms should make different goods for
different customers and market to them, to studying the meaning and process of value creation for
all social and economic actors (Vargo 2008c). They also suggest that it requires getting rid of the
producer/consumer distinction. Thus, from an S-D logic viewpoint, positive theory building points
toward understanding how operant and operand resources are integrated to beneft individuals, groups
of individuals (e.g., an organization), and/or society at large and centers on FP9: All social and eco-
nomic actors are resource integrators. The development of this positive theory (general theory of the
market) could, in turn, provide a foundation for a normative theory (general theory of marketing) to
guide managers in effectively and effciently approaching market-based exchange.
In the meantime, even though a full S-D logic–grounded, positive theory of the market and its
associated normative marketing theories have not been established, S-D logic can be used to de-
velop empirically testable propositions. For example, the applicability of S-D logic for developing
empirical studies has been demonstrated with a set of nine propositions related to competition in
the market (Lusch et al. 2007). While these propositions were derived from and refect S-D logic’s
positive foundations, they also have normative implications and are capable of explaining how
frms can compete through service. Table 6.3 (Lusch et al. 2007, p. 8) lists the nine derivative,
testable propositions that focus on collaboration, interdependent relationships, and knowledge
generation, along with the rationale for each.
Within S-D logic, market competition becomes a function of how one frm provides service, or
applies operant resources, to meet the needs of customers relative to other frms applying such operant
resources. This has important implications for the societal contributions frms make in their attempts
to achieve sustainable competitive advantages, both tactically and strategically. Proposition 1 suggests
that competitive advantage is a function of how one frm applies its operant resources to meet the needs
of the customer relative to how another frm applies its own operant resources. S-D logic suggests
that a frm’s competitiveness depends on its collaborative abilities and collection of competences
and operant resources, which the frm can continually renew, create, and transform. Emphasizing the
need for collaboration among frms, Proposition 2 argues that collaborative competence is a primary
determinant of a frm’s ability to acquire knowledge and establish a competitive advantage. Within
and throughout the value network or constellation, knowledge and information are highly dispersed,
and the frm needs to fnd a way to integrate knowledge and information resources.
Proposition 3 highlights the infuence of information technology on the market, suggesting that
the continued ascendance of advancing technologies, with the associated decrease in communication
and computation costs, provides frms opportunities for increasing competitive advantage through
158
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f

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l
a
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t
o

h
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w

a
n
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f
r
m

a
p
p
l
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s

i
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s

o
p
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a
n
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r
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s
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c
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s
.
S
i
n
c
e

a
p
p
l
i
e
d

o
p
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r
a
n
t

r
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s
o
u
r
c
e
s

a
r
e

w
h
a
t

a
r
e

e
x
c
h
a
n
g
e
d

i
n

t
h
e

m
a
r
-
k
e
t

(
F
P
1
)
,

t
h
e
y

a
r
e

t
h
e

s
o
u
r
c
e

o
f

c
o
m
p
e
t
i
t
i
v
e

a
d
v
a
n
t
a
g
e

(
F
P
4
)
.
2
.
C
o
l
l
a
b
o
r
a
t
i
v
e

c
o
m
p
e
t
e
n
c
y

i
s

a

p
r
i
m
a
r
y

d
e
t
e
r
m
i
n
a
n
t

o
f

a

f
r
m

s

a
c
q
u
i
r
-
i
n
g

t
h
e

k
n
o
w
l
e
d
g
e

f
o
r

c
o
m
p
e
t
i
t
i
v
e

a
d
v
a
n
t
a
g
e
.
T
h
e

a
b
i
l
i
t
y

t
o

i
n
t
e
g
r
a
t
e

(
F
P
9
)

o
p
e
r
a
n
t

r
e
s
o
u
r
c
e
s

(
F
P
4
)

b
e
t
w
e
e
n

o
r
g
a
-
n
i
z
a
t
i
o
n
s

i
n
c
r
e
a
s
e
s

a
b
i
l
i
t
y

t
o

g
a
i
n

c
o
m
p
e
t
i
t
i
v
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a
d
v
a
n
t
a
g
e

t
h
r
o
u
g
h

i
n
n
o
v
a
t
i
o
n
.
3
.
T
h
e

c
o
n
t
i
n
u
e
d

a
s
c
e
n
d
a
n
c
e

o
f

i
n
f
o
r
m
a
t
i
o
n

t
e
c
h
n
o
l
o
g
y
,

w
i
t
h

a
s
s
o
c
i
a
t
e
d

d
e
c
r
e
a
s
e

i
n

c
o
m
m
u
n
i
c
a
t
i
o
n

a
n
d

c
o
m
p
u
t
a
t
i
o
n

c
o
s
t
s
,

p
r
o
v
i
d
e
s

f
r
m
s

o
p
p
o
r
t
u
n
i
t
i
e
s

f
o
r

i
n
c
r
e
a
s
e
d

c
o
m
p
e
t
i
t
i
v
e

a
d
v
a
n
t
a
g
e

t
h
r
o
u
g
h

i
n
n
o
v
a
-
t
i
v
e

c
o
l
l
a
b
o
r
a
t
i
o
n
.
R
e
d
u
c
e
d

b
a
r
r
i
e
r
s

t
o

t
e
c
h
n
o
l
o
g
y

u
t
i
l
i
z
a
t
i
o
n

c
o
m
b
i
n
e
d

w
i
t
h

t
h
e

t
r
e
n
d
s

o
f

o
p
e
n

s
t
a
n
d
a
r
d
s
,

s
p
e
c
i
a
l
i
z
a
t
i
o
n
,

c
o
n
n
e
c
t
i
v
i
t
y
,

a
n
d

n
e
t
w
o
r
k

u
b
i
q
-
u
i
t
y

i
n
c
r
e
a
s
e

t
h
e

l
i
k
e
l
i
h
o
o
d

o
f

c
o
l
l
a
b
o
r
a
t
i
o
n

w
i
t
h

f
r
m
s

a
n
d

c
u
s
t
o
m
-
e
r
s

(
F
P
6
,

F
P
8
)
.
4
.
F
i
r
m
s

g
a
i
n

c
o
m
p
e
t
i
t
i
v
e

a
d
v
a
n
t
a
g
e

b
y

e
n
g
a
g
i
n
g

c
u
s
t
o
m
e
r
s

a
n
d

v
a
l
u
e

n
e
t
w
o
r
k

p
a
r
t
n
e
r
s

i
n

c
o
-
c
r
e
a
t
i
o
n

a
n
d

c
o
-
p
r
o
d
u
c
t
i
o
n

a
c
t
i
v
i
t
i
e
s
.
B
e
c
a
u
s
e

t
h
e

c
u
s
t
o
m
e
r

i
s

a
l
w
a
y
s

a

c
o
-
c
r
e
a
t
o
r

o
f

v
a
l
u
e

(
F
P
6
)

a
n
d

t
h
e

f
r
m

i
s

a

r
e
s
o
u
r
c
e

i
n
t
e
g
r
a
t
o
r

(
F
P
9
)
,

c
o
m
p
e
t
i
t
i
v
e

a
d
v
a
n
t
a
g
e

i
s

e
n
h
a
n
c
e
d

b
y

p
r
o
a
c
t
i
v
e
l
y

e
n
g
a
g
i
n
g

b
o
t
h

c
u
s
t
o
m
e
r
s

a
n
d

v
a
l
u
e
-
n
e
t
w
o
r
k

p
a
r
t
n
e
r
s
.
5
.
U
n
d
e
r
s
t
a
n
d
i
n
g

h
o
w

t
h
e

c
u
s
t
o
m
e
r

u
n
i
q
u
e
l
y

i
n
t
e
g
r
a
t
e
s

a
n
d

e
x
p
e
r
i
e
n
c
e
s

s
e
r
v
i
c
e
-
r
e
l
a
t
e
d

r
e
s
o
u
r
c
e
s

(
b
o
t
h

p
r
i
v
a
t
e

a
n
d

p
u
b
l
i
c
)

i
s

a

s
o
u
r
c
e

o
f

c
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m
p
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t
i
t
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v
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a
d
v
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n
t
a
g
e

t
h
r
o
u
g
h

i
n
n
o
v
a
t
i
o
n
.
S
i
n
c
e

v
a
l
u
e

i
s

c
o
-
c
r
e
a
t
e
d

(
F
P
6
)
,

c
o
m
p
r
e
h
e
n
d
i
n
g

h
o
w

c
u
s
t
o
m
e
r
s

c
o
m
b
i
n
e

r
e
s
o
u
r
c
e
s

(
F
P
8
,

F
P
9
)

p
r
o
v
i
d
e
s

i
n
s
i
g
h
t

i
n
t
o

c
o
m
p
e
t
i
t
i
v
e

a
d
v
a
n
t
a
g
e
.
6
.
P
r
o
v
i
d
i
n
g

s
e
r
v
i
c
e

c
o
-
p
r
o
d
u
c
t
i
o
n

o
p
p
o
r
t
u
n
i
t
i
e
s

a
n
d

r
e
s
o
u
r
c
e
s

c
o
n
-
s
i
s
t
e
n
t

w
i
t
h

t
h
e

c
u
s
t
o
m
e
r

s

d
e
s
i
r
e
d

l
e
v
e
l

o
f

i
n
v
o
l
v
e
m
e
n
t

l
e
a
d
s

t
o

i
m
p
r
o
v
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d

c
o
m
p
e
t
i
t
i
v
e

a
d
v
a
n
t
a
g
e

t
h
r
o
u
g
h

e
n
h
a
n
c
e
d

c
u
s
t
o
m
e
r

e
x
p
e
r
i
e
n
c
e
.
E
x
p
e
r
t
i
s
e
,

c
o
n
t
r
o
l
,

p
h
y
s
i
c
a
l

c
a
p
i
t
a
l
,

r
i
s
k

t
a
k
i
n
g
,

p
s
y
c
h
i
c

b
e
n
e
f
t
s
,

a
n
d

e
c
o
n
o
m
i
c

b
e
n
e
f
t
s

i
n
f
u
e
n
c
e

c
u
s
t
o
m
e
r
s


m
o
t
i
v
a
t
i
o
n
,

d
e
s
i
r
e
,

a
n
d

a
m
o
u
n
t

o
f

p
a
r
t
i
c
i
p
a
t
i
o
n

(
F
P
6
,

F
P
9
)

i
n

s
e
r
v
i
c
e

p
r
o
v
i
s
i
o
n

t
h
r
o
u
g
h

c
o
l
l
a
b
o
r
a
t
i
o
n

(
F
P
8
)
.
7
.
F
i
r
m
s

c
a
n

c
o
m
p
e
t
e

m
o
r
e

e
f
f
e
c
t
i
v
e
l
y

t
h
r
o
u
g
h

t
h
e

a
d
o
p
t
i
o
n

o
f

c
o
l
l
a
b
o
r
a
-
t
i
v
e
l
y

d
e
v
e
l
o
p
e
d
,

r
i
s
k
-
b
a
s
e
d

p
r
i
c
i
n
g

v
a
l
u
e

p
r
o
p
o
s
i
t
i
o
n
s
.
A
p
p
r
o
p
r
i
a
t
e
l
y

s
h
i
f
t
i
n
g

t
h
e

e
c
o
n
o
m
i
c

r
i
s
k

o
f

e
i
t
h
e
r

f
r
m

o
r

c
u
s
t
o
m
e
r

t
h
r
o
u
g
h

c
o
-
c
r
e
a
t
e
d

(
F
P
6
)

v
a
l
u
e

p
r
o
p
o
s
i
t
i
o
n
s

(
F
P
7
)

i
n
c
r
e
a
s
e
s

c
o
m
-
p
e
t
i
t
i
v
e

a
d
v
a
n
t
a
g
e
.
8
a
.
T
h
e

v
a
l
u
e

n
e
t
w
o
r
k

m
e
m
b
e
r

t
h
a
t

i
s

t
h
e

p
r
i
m
e

i
n
t
e
g
r
a
t
o
r

i
s

i
n

a

s
t
r
o
n
g
e
r

c
o
m
p
e
t
i
t
i
v
e

p
o
s
i
t
i
o
n
.
T
h
e

a
b
i
l
i
t
y

t
o

e
f
f
e
c
t
i
v
e
l
y

c
o
m
b
i
n
e

m
i
c
r
o
-
s
p
e
c
i
a
l
i
z
e
d

c
o
m
p
e
t
e
n
c
e
s

i
n
t
o

c
o
m
p
l
e
x

s
e
r
v
i
c
e
s

(
F
P
9
)

p
r
o
v
i
d
e
s

k
n
o
w
l
e
d
g
e

(
F
P
1
)

f
o
r

i
n
c
r
e
a
s
e
d

c
o
m
p
e
t
i
t
i
v
e

a
d
v
a
n
t
a
g
e

(
F
P
4
)
.
8
b
.
T
h
e

r
e
t
a
i
l
e
r

i
s

g
e
n
e
r
a
l
l
y

i
n

t
h
e

b
e
s
t

p
o
s
i
t
i
o
n

t
o

b
e
c
o
m
e

t
h
e

p
r
i
m
e


i
n
t
e
g
r
a
t
o
r
.
9
.
F
i
r
m
s

t
h
a
t

t
r
e
a
t

t
h
e
i
r

e
m
p
l
o
y
e
e
s

a
s

o
p
e
r
a
n
t

r
e
s
o
u
r
c
e
s

w
i
l
l

b
e

a
b
l
e

t
o

d
e
v
e
l
o
p

m
o
r
e

i
n
n
o
v
a
t
i
v
e

k
n
o
w
l
e
d
g
e

a
n
d

s
k
i
l
l
s

a
n
d

t
h
u
s

g
a
i
n

c
o
m
p
e
t
i
t
i
v
e

a
d
v
a
n
t
a
g
e
.
S
i
n
c
e

c
o
m
p
e
t
i
t
i
v
e

a
d
v
a
n
t
a
g
e

c
o
m
e
s

f
r
o
m

t
h
e

k
n
o
w
l
e
d
g
e

a
n
d

s
k
i
l
l
s

(
F
P
4
)

o
f

t
h
e

e
m
p
l
o
y
e
e
s
,

i
t

c
a
n

b
e

e
n
h
a
n
c
e
d

b
y

s
e
r
v
a
n
t

l
e
a
d
e
r
s
h
i
p

a
n
d

c
o
n
t
i
n
u
a
l

r
e
n
e
w
a
l
.
S
o
u
r
c
e
:

L
u
s
c
h
,

V
a
r
g
o
,

a
n
d

O

B
r
i
e
n

2
0
0
7
,

p
.

8
.
SERVICE-DOMINANT LOGIC: A REVIEW AND ASSESSMENT 159
innovative collaboration. In line with this notion of collaboration, Proposition 4 argues that frms
can gain a competitive advantage by involving customers, employees, and other network partners
in both the co-production and the co-creation of value. Proposition 5 states that understanding
how the customer uniquely integrates and experiences service-related resources (both private and
public) is an additional source of competitive advantage.
Concentrating on engaging the customer with the frm, Proposition 6 says that providing ser-
vice co-production opportunities and resources consistent with the customer’s desired level of
involvement leads to improved competitive advantage through enhanced customer experience.
While it is generally understood that organizations should proactively link co-production and
pricing strategies, S-D logic implies a price co-production (Lusch and Vargo 2006b) link to the
frm’s value proposition. A co-produced value proposition can make the price contingent upon
the quality of service experience or other agreed-upon application of service. Here, the value-in-
exchange (price) is tied to the value realized by the customer. Consequently, if both buyer and
seller have something at risk and something to gain, then collaboration will be more fruitful. Hence
Proposition 7 states that frms compete more effectively through the adoption of collaboratively
developed, risk-based pricing value propositions.
Proposition 8 (a and b) considers the different organizations in the market and suggests that the prime
integrator in a system or market is in a stronger competitive position, and that often this prime integrator
takes the form of a retailer. While this proposition suggests that there may be optimal positions in the
market for integrating resources, it is important to keep in mind that all social and economic actors are
resource integrators (FP10) and that all organizations must work with other frms, employees, custom-
ers, and other stakeholders to co-create value. Proposition 9 emphasizes the importance of developing
employee competences and argues that frms that treat their employees as operant resources will be
able to develop more innovative knowledge and skills and thus gain competitive advantage.
These propositions, derived from S-D logic’s foundational premises, focus on the frm’s ability
to generate internal operant resources and integrate external operant resources, through collabora-
tion and value co-creation. Each proposition provides a positive service-centered perspective of
the market, which points toward one or more social and economic managerial implications. The
underlying position of this perspective of competition is that frms gain competitive advantage by
adopting a business philosophy based on the recognition that all entities collaboratively co-create
value by serving each other. Competing through service is ultimately about grasping and applying
this understanding of value-creation processes better than the competition.
Advancing Marketing Science
The formalization of an S-D logic lexicon is necessary for advancing the science of marketing
through S-D logic, but this initial effort marks only the beginning of the transition. Marketing sci-
ence, as is true of all sciences, can be viewed as a meta-competency that is co-created by members
of a value network or constellation, in which the various actors are linked via value propositions
connecting internal and external service subsystems. In order to advance the scientifc approach
of an S-D logic for marketing, S-D logic must be co-created by the value network of marketing
and marketing-related scholars.
The knowledge integration portion of this review presented the early discussions, elaborations,
and extensions surrounding the foundational bases of S-D logic. In addition to the development
of the core concepts of service-centered marketing, methodological issues in S-D logic have been
raised (see Vargo 2007b). Connections have also been made beyond the discipline of marketing
to the emerging industry-led, university-supported discipline of service science (Maglio and
160 STEPHEN L. VARGO, ROBERT F. LUSCH, MELISSA ARCHPRU AKAKA, AND YI HE
Spohrer 2008), in which the S-D logic meaning of service is used and emphasized in the study of
interactions within and among service systems. In addition, S-D logic has made its way into the
discussion of new approaches toward innovation (Flint 2006; Michel, Brown, and Gallan 2008),
as well as management education (Ford and Bowen 2008).
The acceptance of an S-D logic for marketing is in the hands of the academics and practitioners
who have built up and will continue to advance the discipline. The development of a service-
centered approach to marketing remains in its infancy, and there is much work to be done. It is our
hope that scholars from marketing and related social and economic disciplines will continue to
participate in this development and evolution of marketing thought. In order to further S-D logic,
several fundamental questions about its integration and application in marketing science need to
be addressed. We encourage others to join us in exploring several central issues in understanding
and developing an S-D logic for marketing science.
The frst major area of development that requires attention addresses the contents and processes
of value networks or constellations in marketing science. The exploration of questions such as “Who
comprises the value-network or constellation for marketing science?” and “What are distinguishing
characteristics of internal and external service systems of the discipline?” will provide insight into
the nature and evolution of knowledge generation in marketing science. This undertaking presents
a variation on stakeholder theory with a new vantage point that all systems and subsystems are
involved in the exchange of competences, which both create and integrate resources. To date, most
knowledge advances in marketing, at least recognized by the public domain, arise in marketing
departments and universities. It is important to understand the value propositions that marketing
scientists are making to their departments, universities, and students, as well as to the public and
society and the implications made by changes in these relationships.
The second major issue deals with S-D logic’s notion of value co-creation and asks, “How
do we begin to study social and economic actors without separating them or assuming one is a
‘consumer’ and one is a ‘producer,’ but that both are creators of value?” In the development of
marketing science, the exchange of operant resources and co-creation of value is undeniable, and
collaboration and competition are well known as the driving forces of innovation and evolution.
However, the questions remain: “Can we co-develop methods and theories that focus more on
interaction than the actions of separate actors?” and “How do we shift the focus of analysis from
a unit of output to something more amorphous, such as a system?” Perhaps by understanding how
value is co-created within marketing science, a general understanding of value co-creation and the
value that is derived through interactions among actors can be developed further.
A third area of research that needs further exploration focuses on the primacy of operant
resources and S-D logic’s view that resources have no value without human appraisal. Value
is only derived through and determined by human ingenuity and judgment. This implies that
service-exchange systems are constantly flled with surprise and uncertainty because resources are
continuously created and integrated throughout the dynamic network of exchange partners. Thus,
linear model ftting and tightly controlled experiments are unlikely to capture this unfolding, as
controlling or attempting to control a system creates a different system. The current limitations on
measuring systems of exchange increase the need for methods that focus on the logic of discovery,
particularly those that can capture emergent phenomena.
Research Frontiers
Although the evolution of S-D logic challenges some central tenets of marketing thought and has
the potential to broaden and deepen the scope of marketing science, it is careful to protect certain
SERVICE-DOMINANT LOGIC: A REVIEW AND ASSESSMENT 161
aspects that are central to the continued advancement of marketing. It offers marketing a differ-
ent and, arguably, more robust model of exchange that is also arguably more societally friendly.
S-D logic also maintains marketing’s managerial relevance and does not reject current marketing
knowledge as much as it transcends it. Consider the following examples:
1. Moving from viewing the customer as someone who is exogenous to the frm, to be tar-
geted and captured, to endogenous, a potential collaborator for the co-production of the
frm’s offerings and co-creator of value. S-D logic’s consideration of marketing “with,”
rather than “to,” customers provides opportunities for exploring these phenomena.
2. Moving from being constrained by external environments to drawing upon them and
integrating them to develop new resources. Little attention has been paid to how frms
can integrate competition, public policy, culture, and technological and ecological envi-
ronments as sources of support rather than treating them as resistances or constraints.
3. Moving from the marketing mix and strategy being frm designed to being co-created by
the customer (and other members of the value network). Although some initial work has
been done, a deeper exploration of the customer’s involvement in innovation, co-pro-
duction of value propositions, and dialogue and conversation with the frm is needed.
Each of these examples represents a potentially deep research frontier for marketing science.
Although newcomers to the discipline are encouraged to address these topics, it is likely that
established scholars in consumer behavior, pricing, promotion, product innovation, placement
and distribution, and segmentation will provide very valuable insights on the evolution of S-D
logic in marketing science. It is our hope that those who have helped to develop the discipline of
marketing will be a part of the community that further develops S-D logic by providing expertise
and insight in their respective areas of research.
We have become increasingly aware of the importance of understanding the aggregate marketing
system (see Gummesson 2006; Layton 2007; Meade and Nason 1991; Shultz 2007; Wilkie and
Moore 2006) and other large-scale marketing systems. We believe the emerging feld of service
science (Maglio and Spohrer 2008), when coupled with marketing science, using an S-D logic
framework, can contribute to this often-neglected topic. This implies something like a fractal
model of the market. It views all systems from small systems, such as an individual or family, to
larger systems, such as frms and countries, to the global system, as fundamentally comprising
resources, resistances, and needs. Each system, micro and macro, strives to meet its needs through
reducing resistances and integrating resources using exchange systems.
Some may approach the topic of marketing systems using a different framework, but we believe
this systematic, service-centered approach is vital to the advancement of marketing science. Mar-
keting does not occur in the isolation of economic exchange; it is integrated with other elements of
society and should be explored from a positive viewpoint. As noted, a theory of markets is central
to the development of normative marketing theory and understanding marketing phenomena. A
fractal model of marketing systems, focused on service-for-service exchange, potentially provides
the fundamental framework needed for a positive exploration of the market and a deeper and
broader foundation for the advancement of marketing science.
Concluding Comments
Service-dominant logic is a work-in-progress; in fact, it is more incomplete than it is complete.
It also is not fully captured by the work of Vargo, Lusch, and coauthors. As noted, S-D logic
162 STEPHEN L. VARGO, ROBERT F. LUSCH, MELISSA ARCHPRU AKAKA, AND YI HE
represents the convergence of a host of diverse models, conceptualizations, and research streams,
with the common feature of responding to the inadequacies of traditional, goods-centered logic.
Importantly, the development of S-D logic is increasingly involving a growing, worldwide com-
munity of scholars who have joined to help co-create, elaborate, and extend this “new dominant
logic” for marketing. Further, the logic is increasingly being extended not only to marketing but
alsotothemarket—thecentralexchangeinstitutionuponwhichmost,ifnotall,societiesarebuilt.
Thus, S-D logic has implications in social as well as economic exchange.
There are a host of continuing challenges associated with the further growth and development
of S-D logic, but most central is the need to further develop a language and lexicon to describe the
market and marketing consistent with a service-centered mindset. Despite the need to continue to
refne the lexicon of S-D logic, we believe that now is the time to begin empirical study using a
multitude of research methods. Although S-D logic was initially not developed as a theory with
testable elements, we believe that propositions like those derived (see Table 6.3) from the initial
foundational premises are empirically testable. Also, the revised and expanded foundational
premises (Table 6.1) can be used to further derive testable propositions or hypotheses. These
premises can be studied in several domains, such as household resource integration, enterprise
value-proposing, and customer co-creation, as well as a multitude of others. However, care must
be taken to ensure that propositions derived from S-D logic are tested with S-D logic–compatible
metrics (see Vargo 2007b).
Finally, we encourage work that deals with multiple levels of aggregation and/or analysis and,
in this regard, work that simultaneously deals with the market and marketing. Importantly, this
research framework may help to break down the separation between micro-marketing and macro-
marketing. All micro-marketing unfolds into larger macro-systems, and all aggregate marketing
systems infuence the micro-actors in the system. Seeking to understand the market and marketing
from a holistic perspective is what S-D logic uniquely offers the marketing discipline (and others).
If we neglect to take up this grand challenge of unifcation, we will have shortchanged both the
marketing discipline and society.
Note
1. Because we are consolidating our prior writing on S-D logic, this chapter is a condensed form and,
in selected passages, unabridged material, from prior joint publications of Lusch and Vargo or vice versa,
as well as other coauthors.
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168
chaptEr 7
MARKETING IN A WORLD WITH COSTS OF
PRICE ADJUSTMENT
shaNtaNu dutta, MarK E. BErGEN, aNd sourav ray
Abstract
We suggest that consideration of costs of price adjustment in marketing offers a promising re-
search direction. These costs can have substantial implications for research in pricing—from
determining the magnitude and frequency of price changes to asymmetric pricing, pass-through
in channels, and price synchronization. Our understanding of the nature and scope of these costs
has been undergoing an evolution recently, from simple menu costs to richer decision-making,
organizational, and customer-based costs. In this chapter, we review the literature in marketing
and economics to summarize what we know about the nature, magnitude, and broad impact of
these costs. We then identify some areas of potential interest to both researchers and practitioners
in marketing, where consideration of price adjustment costs is likely to yield greater insights into
marketing decisions.
Introduction
Pricing is one of the central decisions studied in marketing, and there is a wealth of research that
hasmadesubstantialcontributionstoourunderstandingofthisactivity—frompricesensitivityto
competitive implications for pricing to pricing in channels of distribution to a variety of interesting
pricing phenomena across a wide variety of markets.
1
Most of this pricing research has assumed
that organizations are endowed with the ability to adjust prices costlessly in response to changes
intheenvironment—allowingpricestoadjustfexibly,andallowingfrms,industries,markets,
and economies to function in the ways developed in classical economic theory. Indeed, this as-
sumption is so deeply ingrained in our thinking that most of the existing literature in marketing,
business, and strategy takes this ability for granted, assuming it as kind of inalienably inherent
in organizations.
There is, however, another perspective that assumes there are limits to the organization’s ability
to adjust prices. Marketers have known about these limits for quite some time. These issues are
raised in the frst volumes of the Journal of Marketing, and the 1939 April volume has a section on
“recent contribution to prices and price policies,” where Rufus S. Tucker (1939, p. 329) discusses
theclaimthat“theworkingsofpriceareobscuredbycustom—meaningnotonlytheconventions
of accounting and business practice but especially the habits of and social standards of customers.”
These limits are currently studied in the literature on the “costs of price adjustment,” which sug-
gests that pricing can be a complex and costly organizational problem. Caplin and Leahy (1995)
MARKETING IN A WORLD WITH COSTS OF PRICE ADJUSTMENT 169
emphasize that price adjustment is a “very diffcult, costly and time-consuming process”; Levy
and his coauthors (1997) suggest that changing prices “is a complex process, requiring dozens
of steps and a non-trivial amount of resources”; Dutta, Zbaracki, and Bergen (2003) describe the
“extraordinary complexity of the price setting process”; Zbaracki and colleagues (2004, p. 518)
state that “the price change process reveals a series of managerial activities of vast scope and
complexity.”
Moreover, our understanding of the nature and scope of these costs has recently been undergo-
ing an evolution in this literature. Some of the recent work has provided the frst direct estimates
of the magnitude of these costs, and a deeper exploration of the sources of these adjustment costs
and their implications. This has moved the literature from simple menu costs to richer decision-
making, organizational, and customer-based costs. This evolution is increasing the value of “costs
of price adjustment” literature for the marketing and economics disciplines, and bringing these
costs back to the roots that Tucker suggested seventy years ago in the Journal of Marketing.
Akeyimpactofthesecostsispricerigidity—thepropensityofpricestoremainunchangedin
response to changes in the environment. Again, marketers have long been engaged in understand-
ing issues related to price rigidity, such as pricing thresholds (Kalyanaram and Little 1994), price
inertia (Srinivasan, Pauwels, and Nijs 2008), deal frequency (Krishna 1994), and price pass-through
(Moorthy 2005). These costs can also have substantial macroeconomic implications. According to
Blinder and his coauthors (1998, p. 21), costs of price adjustment have become “one of the main
strands of New Keynesian theorizing,” as many predictions of traditional Keynesian and more
recent New Keynesian models crucially depend on the existence of some form of price rigidity.
Price rigidity is also central to microeconomic theory, ranging from theories of the frm (Coase
1937; Cyert and March 1963; Williamson 1979) to industrial organization (Carlton and Perloff
1990). According to Carlton (1986), sources of price rigidity fundamentally alter the outcomes
ofmodelsinmicroeconomicsandindustrialorganization—theverymodelsthatlieattheheart
of our work in marketing, including such areas as pricing, channels of distribution, competitive
strategy, and so forth. For marketers, this makes understanding the costs of price adjustment of
fundamental interest.
Despite the importance of these costs and their implications, the broader literature in market-
ing has long tended to ignore the role of these price adjustment costs and their relation to pricing
strategy. It is only in recent years that marketing has seen a rising interest in the domain. Some
recent papers that consider these costs are: asymmetric pricing (Chen et al. 2008; Ray et al. 2006),
impact of item pricing laws (IPLs) on price levels (Bergen et al. 2008), price inertia (Srinivasan,
Pauwels, and Nijs 2008), past price dependence (Nijs, Srinivasan, and Pauwels 2007), and price
pass-through (Dutta, Bergen, and Levy 2002; Levy, Dutta, and Bergen 2002; Müller and Ray
2007; Ray et al. 2006).
We believe that consideration of costly price adjustment, and the subsequent rigidity it suggests,
offers a promising interdisciplinary research opportunity for the feld of marketing. Empirically,
marketing sits in the ideal position to study the sources and consequences of these costs. The kind
of data required to make headway in our understanding of these costs requires a richer range of
datasourcesandtechniquesthatlieattheheartofthemarketingdiscipline—fromtransactiondata
to surveys, interviews, feldwork, and experiments. Theoretically, the marketing discipline has a
wealth of managerial and behavioral theories that can be drawn upon to better understand these
emerging organizational and customer-based sources of price adjustment and their consequences.
We believe that some of the most promising future work on the costs of price adjustment and
theirimplicationscanoccurinthefeldofmarketing—allowingustoinformrelatedfeldssuch
as economics, strategy, and business. The marketing discipline itself can beneft from consider-
170 SHANTANU DUTTA, MARK E. BERGEN, AND SOURAV RAY
ationofthesecostsofpriceadjustment—tobetterunderstandpatternsofpriceadjustmentand
market dynamics, as well as increasing our understanding of pricing phenomena such as pricing
thresholds, asymmetric pricing, price pass-through, price points, promotion frequencies, pricing
formats (such as EDLP or HI-LO), and the links between regulation, macroeconomic policy, and
market prices.
In this chapter we frst review the relevant literature in economics and marketing about what
is known about the costs of price adjustment and its impact on different pricing decisions. We
then relate some issues of key interest to marketers and go on to discuss the implications for
the marketing literature and future research in marketing, economics, and the interdisciplinary
boundaries between the two.
Literature Review
We start with a broad overview of the literature pertaining to the costs of price adjustments. We frst
discuss the nature and scope of these costs and then move on to a discussion of the implications
of these costs, primarily from a marketing perspective. For the frst part, much of the literature
is drawn from the “new-Keynesian” literature in economics.
2
For the second part, we draw upon
the economics as well as the relevant marketing literature.
The Nature of Price Adjustment Costs: Sources, Magnitudes, Forms
Until recently, little was actually known about what the sources and magnitudes of these costs re-
ally are. This led to doubts about the usefulness of “costs of price adjustment” in economics. For
example, Prescott (1987, p. 113) suggested that theories of price adjustment costs “will never be
taken seriously” until we know how to measure these costs directly. Similarly Blinder (1991, p.
90) emphasizes the importance of measuring these costs, stating that in the absence of an ability
to measure them, theories of price adjustment costs “can be tested at best indirectly, at worst not
at all.” And Kashyap (1995, p. 269) points out the weaknesses of the existing models of price
adjustment because these models “do not explain why these [price adjustment] costs exist in the
frst place.”
So what are these “costs” really? How do we even measure these costs? A natural and direct
way to understand their size is to go to the source, organizations adjusting prices, and observe
how they do this. Interestingly, early marketers also had an appreciation for the value in studying
how pricing was done by managers. In fact, they were very descriptive in their methods. The
earliest authors in the Journal of Marketing often described in rich detail how prices were set in
practice, with an aim to inform and improve our understanding in marketing. For example, in
the frst volume of the Journal of Marketing, Taylor (1936) describes work being done by H.E.
Agnew on the “Fundamentals of Price Making,” where the purpose of the study was to record all
the infuences that go into practical price making. E.T. Grether’s work (1939) eventually became a
book on price control under fair trade legislation; that of P.D. Converse (1938) became an article
in the Journal of Marketing that studied pricing patterns in local retail stores; and work by H.F.
Taggart (1936) studying minimum prices under the National Recovery Administration (NRA).
Rao (1984 S. 54) echoed a similar appreciation of the benefts of this kind of study: “the benefts
of knowing more about decision processes of how industry managers go about determining (and
changing) prices for their products are quite apparent.”
In economics, there is early work by Hall and Hitch (1939) on how frms set and adjust prices.
More recently, Blinder et al. (1998) interviewed hundreds of managers across a wide variety of
MARKETING IN A WORLD WITH COSTS OF PRICE ADJUSTMENT 171
industries and asked them about possible sources of price rigidity. They found nearly half of all
frms face non-trivial adjustment costs, that these varied by industry, and that these adjustment
costs were perceived to be larger for price increases than price decreases. They also found that
these adjustment costs “involve things other than printing new price lists, putting new price tags on
goods, and so on,” and that concern with “antagonizing customers” is another important dimension
of these adjustment costs.
3
In a similar vein, following interviews with over 300 managers, labor
leaders, and professional recruiters, Bewley (1999) fnds that concerns with employee morale and
willingness to support organizational objectives are important sources of wage rigidity.
Other researchers have also explored price adjustment costs in different contexts. Since the
1990s, several of them have estimated these costs of adjustments by observing the pricing process
at frms. Levy et al. (1997) use a detailed time and motion study of the price change processes in
six major chains in the United States to document the frst direct measure of the physical costs of
price adjustment (the so-called menu costs) in the retail grocery industry. They estimate these costs
to be over $100,000 per store per year. This translates to an average of $0.39 per price change,
which is about 0.53 percent of revenues at the supermarket stores. Using the same methodology,
Dutta and colleagues (1999) found the average annual menu costs per store to be almost $25,000
for the chain drugstore they studied. This corresponds to very similar marginal fgures as those in
the supermarket study, with estimated costs of $0.33 per price change comprising 0.59 percent of
revenues. Zbaracki and his coauthors (2004) used a similar approach by deploying an ethnographic
methodology to directly estimate the costs of price adjustments at a large industrial manufacturer.
Using a combination of interviews, nonparticipant observations, and detailed study of internal
documents, they estimated the menu costs to be almost $44,000 per year. They further estimated
the marginal cost of a price change to be in the range of $0.80–$4.34, accounting for 0.71 percent
of net margins.
While the estimates of costs referred to in the earlier paragraphs relate to the direct physical
costs of price adjustment, there have been speculations that there are managerial and customer
dimensions of these costs that are possibly large components of price adjustment. As a case in
point, Blinder and his coauthors (1998, ch. 13) present descriptive evidence about the signifcance
of these elements. Ball and Mankiw (1994b, p. 142) “suspect that the most important costs of
price adjustment are the time and attention required of managers to gather the relevant informa-
tion and to make and implement decisions.” Blinder and colleagues (1998, pp. 313–314) suggest
that“frst,frmsoftentoldus—inavarietyofcontexts—thattheyareloathtochangepricesbe-
cause this would ‘antagonize’ their customers. This imprecise thought does not ft neatly into any
economists’ standard theoretical boxes, although it may be consistent with several. But it comes
up so often that fguring out precisely what it means should be a high priority item on any future
research agenda.”
Nevertheless, direct measures of the managerial and customer dimensions of these costs are rare.
To the best of our knowledge, the study by Zbaracki and his coauthors (2004) remains the only
one to calibrate these. Using the ethnographic methodology referred to earlier, they estimate the
“managerial costs” of price adjustments in the industrial manufacturer to be more than $280,000
annually. In terms of cost per price change, they estimate a range of $5.19–$28.05, accounting for
4.61 percent of the net margin. Interestingly, their estimate of the “customer costs” was signif-
cantly greater, at almost $900,000 annually. The marginal cost of a price change was estimated
to be in the range $16.53–$121.64, for a marginal impact of 14.70 percent of net margin. When
the managerial and customer costs were combined with the menu costs, the annual cost of price
adjustments came to more than $1.2 million for the manufacturer, the total cost per price change
being $22.52–$121.64, for a marginal impact of an astounding 20.03 percent of net margins.
172 SHANTANU DUTTA, MARK E. BERGEN, AND SOURAV RAY
While the above papers used more direct measures of price adjustment costs, another promising
direction to understand these costs comes from analysis of patterns of actual price adjustments made
by retailers. Slade (1998) used this approach to estimate these costs indirectly, using a structural
modeling approach with discrete-choice dynamic programming. Using scanner panel data on four
brands of saltine crackers across four stores, she estimated the average price adjustment costs to
be about $2.72 per price change.
Based on these feld studies, the price adjustment costs can be seen as evolving from physical
costs to a richer set of organizational and customer-based costs of price adjustment:
1. The physical (menu) costs: The direct costs of changing prices physically. For instance, in a
supermarket context, Levy and his coauthors (1997) conservatively characterize the direct
physical costs as being comprised of (a) labor costs of changing shelf prices, (b) the costs
of printing and delivering new price tags, (c) the costs of mistakes made during the price
change process, and (d) the costs of in-store supervision of the price-change process.
2. The managerial costs: This includes the managerial time and effort required to decide
and implement a price change. For instance, in the industrial marketing context, Zbaracki
and his colleagues (2004) found that the managerial costs comprised (a) information-
gathering costs, (b) decision-making costs, and (c) communication costs.
3. The customer costs: This involves the opportunity costs of lost goodwill when customers
are presented with a price change (cf. Blinder et al. 1998, p. 313). Zbaracki and coauthors
(2004) characterize these as comprising of the costs associated with (a) communication
and (b) negotiation with customers in the event of a price change.
Even as the debate around the sources and magnitude of these costs is being addressed, there
are questions about the formofthesecostsaswell—specifcallywhethertheyareconvex or fxed.
Convexity in this context refers to whether price adjustment costs are a function of the magnitude
of price changes. For example, Rotemberg (1982) models these costs as a quadratic function of
the price change. Others like Barro (1972), Sheshinski and Weiss (1977), and Caplin and Spulber
(1987) consider these to be a fxed cost. The interest in the form of these costs is not merely a def-
nitional issue. As Blinder and his coauthors (1998) point out, convex costs could anchor multiple
small price changes as opposed to larger but infrequent price changes anchored by the fxed form
(p. 229). In the retail grocery context, Slade (1998) estimates the fxed components of the costs
to be of much greater magnitudes (94 percent) than the convex ones (6 percent). In an industrial
context, on the other hand, Zbaracki and his colleagues (2004) fnd that the convex components
of these costs are of signifcantly greater magnitude than the fxed components.
The Impact of Price Adjustment Costs on Prices
The most direct implication of costs of price adjustment is price rigidity. As mentioned earlier,
price rigidity refers to the propensity of prices to remain unchanged in response to changes in
market conditions. Some of the seminal work in this area was done on patterns of price rigidity
in business-to-business markets, which were carefully documented and analyzed by authors such
as Stigler and Kindahl (1973) and Carlton (1986, 1989). There was also work on price rigidity
for administered prices in the 1930s (Means 1935), which has been revisited over the years. For
example, McRae and Tapon (1979) studied price rigidity with respect to administered pricing,
which was seen to be “infexible relative to other prices, tending to decrease less during recession
and to rise less during recovery” (p. 410).
MARKETING IN A WORLD WITH COSTS OF PRICE ADJUSTMENT 173
More recently, several authors (Bils and Klenow 2004; Cecchetti 1986; Dutta et al. 1999, 2002;
Kashyap 1995; Levy et al. 2002; Warner and Barsky 1995) have studied more micro-level price
rigidity, using even more disaggregate data at the frm and product level. For example, Cecchetti
(1986) documented price rigidity in the newsstand prices of magazines, and Kashyap (1995)
found price rigidity in goods sold through retail catalogs. Bils and Klenow (2004) used more
disaggregated data from the Bureau of Labor Statistics to document wide-ranging levels of price
rigidity across over 350 categories of goods and services.
This micro-level rigidity tends to be of particular interest to marketers. In this section, we discuss
fourformsofpricerigiditythathavebeenaddressedinthemarketingliterature—(1)rigidityin
terms of magnitude (that is, the relative/absolute change in price levels), (2) rigidity in terms of
frequency (the length of time between price changes), (3) rigidity in terms of pass-through (the
proportion of upstream cost changes that is passed through as downstream price changes in a
distribution channel), and (4) rigidity in terms of price synchronization (the degree to which the
inter-temporal nature of rigidities is correlated across different products). As will be clear soon,
despite the interest in rigidity, few papers in marketing directly relate rigidity to costs of price
adjustments. Moreover, even in economics, price adjustment costs are not the only explanation
of price rigidity (Blinder et al. 1998; Peltzman 2000; Bils and Klenow 2004). Therefore, we frst
review the relevant literature on rigidity in marketing and economics and then how the costs of
price adjustment impact each of these four forms of price rigidity.
Magnitudes of Price Changes: Thresholds, Asymmetric Rigidities, and Price Levels
One major form of price rigidity that marketers have uncovered is the existence of price change
thresholds that elicit no consumer reaction. For example, some authors (e.g., Della Bitta and Monroe
1981; Gupta and Cooper 1992) suggest that any price decrease less than 15 percent would be ignored
by customers and hence not result in the desired sales bump. In other words, prices should be rigid in
domains of small price changes. In a direct approach, DeSarbo et al. (1987) put forward a descriptive
model of price change that incorporates such regions of rigidity and studies price-change behavior.
He calibrates his “friction” model and concludes that pricing patterns are consistent with the notion
that price changes occur only if the composite indices that determine prices exhibit movements
beyond some high or low thresholds. And the strength of these movements, as stated in the article,
has a positive relationship with the magnitude of the price change.
An additional complexity is in the asymmetric rigidities implied by the inherent nature of these
thresholds—boththeirasymmetricmagnitudes(e.g.,KalyanaramandLittle1994)aswellasasym-
metric elasticity beyond the thresholds (Greenleaf 1995; Kalyanaram and Winer 1995; Krishnamurthi,
Mazumdar, and Raj 1992). Mela, Gupta, and Lehmann (1997) discuss an additional dimension of
theseasymmetricthresholds—wherecustomersmaybehavestrategicallyandlieinwaitforabetter
price promotion. The exact nature of the rigidities depends on the context. Pauwels, Srinivasan, and
Franses (2007), for example, discuss the relative roles of “latitude of price acceptance” effects and
“saturation” effects and how they might lead to contrasting rigidity outcomes.
The implications for rigidity notwithstanding, the literature above does not explicitly consider the
role of price adjustment costs. If at all, the roles of such costs are only implicit. For example, DeSarbo
et al. (1987) refers to the “inert areas” in prices being possibly caused by “(the) actual implementation
costs or management effort” (p. 300). A natural question, therefore, is whether these costs play any
direct role in the magnitude of price changes and, especially, for such asymmetries.
Chen and his coauthors (2008) fnd that there are far more “small” price increases than there
are “small” price decreases. That is, the magnitudes of prices are far more rigid downward than
174 SHANTANU DUTTA, MARK E. BERGEN, AND SOURAV RAY
upward, but only for “small” price changes. However, such asymmetric rigidity vanishes for
“large” price changes. They consider several possible sources of rigidity and speculate that this
could be due to the rational inattention of consumers. If the cost-beneft tradeoff of processing the
information pertaining to small price changes is unattractive, customers may ignore small price
changes. This creates an incentive for the retailer to increase prices “in the small.”
The existence of (asymmetric) thresholds has also been shown to exist in pricing models with
costs of price adjustments. Sheshinski and Weiss (1977), for example, explain how during infa-
tion, in the presence of costly price adjustment, frms might wait for real prices to fall to a level s,
before adjusting price back up to the target price level S. Ball and Mankiw (1994a) take a similar
perspective and show how infation in the presence of these costs may lead to asymmetric price
adjustments. Slade (1999) included competition in her model to illustrate and empirically demon-
strate that the (s, S) thresholds may be asymmetric. Instead of infation, however, she uses stocks
of goodwill to motivate the reasons for such types of price rigidity. Similarly, Ray and colleagues
(2006) show how these costs in a vertical channel of distribution may result in asymmetric price
adjustments. Müller and Ray (2007) also report empirical evidence that suggests asymmetric
rigidities may be consistent with a cost of price adjustment perspective. Nevertheless, there is
still much to be learned about the role of price adjustment costs in asymmetric price adjustments
(Peltzman 2000). Beyond the magnitude of price changes themselves, another intriguing question
is whether higher costs of price adjustments result in higher prices for consumers. Bergen and his
coauthors (2008) report that these costs may indeed result in higher prices for consumers. In a
natural experiment, they fnd that retailers that are subject to item pricing laws consistently charge
prices that are almost 10 percent higher than prices at retailers that are not subject to IPLs.
4
This
result holds even after controlling for demographic, store, and category factors. Since IPLs increase
the retailer’s costs of price adjustments, this is among the few documented pieces of evidence of
the link between price adjustment costs and price levels. They also fnd that prices in stores that
invest in electronic shelf labels (ESLs) are consistently lower than prices at stores that do not.
Since ESLs reduce the retailers’ marginal costs of price adjustments, this result offers additional
support for the effect of these costs on prices.
Frequency of Price Changes: Consumer Perceptions, Strategic Considerations, Price Formats
The literature on frequency of price changes in marketing looks at consumer perceptions of frequent
price changes (and the consequences for frm’s pricing) as well as the behavior of prices per se.
For example, Krishna (1991) shows how consumers’ expectations of future deal frequency are
positively correlated with their perceptions of past deal frequency. Consumers would therefore
delay their purchases if they expect a deal in the near future. Indeed, a number of subsequent
papers document the negative impact of frequent price reductions on future purchases (Krishna
1994; Mela, Gupta, and Lehmann 1997; Kopalle, Mela, and Marsh 1999), offering a logic for
greater rigidity for price reductions.
Other literature attempts to calibrate the inter-temporal variation of price rigidity by studying
the behavior of market prices. There are several perspectives to interpret such variation. One is
articulatedbyDeSarboetal.(1987),whointerpretspricerigiditiesasbelongingtothreetypes—(1)
univariate time-series models, which calibrate rigidities as past-price dependence, (2) experience
curve effects, which calibrate rigidities to product life cycle, and (3) informational cost effects,
which calibrate rigidities to the complexities of managerial decisions and efforts.
Other perspectives offer more strategic interpretations. For example, in Varian’s (1980) model,
frms randomly choose between high and low prices as a means to discriminate between informed
MARKETING IN A WORLD WITH COSTS OF PRICE ADJUSTMENT 175
and uninformed customers. Villas-Boas (1995) found empirical support for this perspective in the
coffee and saltine crackers markets. These offered no predictable patterns of rigidity. In contrast,
Sobel’s(1984)modelpredictedgreaterrigidity—longperiodsofhighpricesfollowedbyocca-
sional deep discounts. Pesendorfer’s (2002) results fnd similar patterns for the ketchup category.
In a further elaboration, Conlisk, Gerstner, and Sobel (1984) and Sobel (1991) offer models where
sellers keep their price high early on and gradually lower prices over time. Similar to Varian’s
model, this discriminates between high-valuation customers who buy early and the low-valuation
customers who buy later.
None of the above literature explicitly accounts for costs of price adjustments. Nevertheless, that
costs of price adjustment may lead to greater inter-temporal rigidity is well acknowledged. Such
costs would most certainly alter the frequencies of price changes considered above. Levy and his
coauthors (1997), for example, show that supermarkets subject to IPL (hence with higher costs of
price adjustment) indeed change prices less frequently than those that are not subject to IPL.
The frequency of price change and the depth of price increase or decrease also depend on
whether the costs of price adjustments are convex or fxed. Convexity refers to whether price
adjustmentcostsareafunctionofthemagnitudeofpricechanges—inotherwords,thecostsof
changing price increases with the magnitude of price increase. When price adjustment costs are
convex, it is easier for managers to undertake multiple small price changes as opposed to larger but
infrequent price changes anchored by the fxed form (Blinder et al. 1998, p. 229). The empirical
evidence is unclear and is likely to be context dependent. At one end of the spectrum, in the retail
grocery context, Slade (1998) estimates the fxed components of the costs to be of much greater
magnitudes than the convex ones. In an industrial context, on the other hand, Zbaracki and his
colleagues (2004) fnd that the convex components of these costs are of much greater magnitude
than the fxed components. This latter work offers particular insights into the contextual nature
of these adjustment costs.
Zbaracki and his coauthors’ (2004) paper supports the view that the organizational costs of
price adjustment are convex in settings where the price adjustment process has a substantial
managerial and organization component, that is, these costs are likely to increase with the size of
the price change (Rotemberg 1987). The processes are likely to entail more resources when the
pricechangesarelarger—moreanalysis,morediscussions,andmoreiterations.Thedatasug-
gest that when the price changes necessitated by changes in market conditions were small, the
frmdidnothavetodevotetoomanyresources—intermsofbothorganizationmembers’time
andeffort—tothepriceadjustmentdecisions.Thatisbecausemoreorganizationmemberswere
willing to give in and compromise when it came to relatively small price changes, even if they
disagreed with the initiative.
When it came to large changes, however, the company found it very costly to deal with them.
The costs of the disputes, the debates, the arguments, and the disagreements that the organization
was incurring under such conditions were enormous. These disagreements and disputes manifested
themselves not only in various functional group meetings but also in informal settings such as
during lunchtimes, in chats and conversations in the corridors and the hallways, and even in the
complaints and the frustrations the various organization members would frequently take home
with them.
The consideration of costly price adjustment is also implicit in the choice of retail formats that
guide the frequency of price changes. The Every Day Low Price (EDLP) stores position them-
selves as offering steady prices (greater rigidity) so that consumers can get good value regardless
of when they shop. The HI-LO stores, on the other hand, offer frequent promotions (low rigidity)
as a means to offer value to consumers that are willing to wait. As Hoch, Drèze, and Purk (1994)
176 SHANTANU DUTTA, MARK E. BERGEN, AND SOURAV RAY
point out, among the rationales for adopting an EDLP format are considerations of lower mana-
gerial costs “because it is easy to implement by simply matching or beating the most aggressive
local competition,” as well as lower customer costs because “[its simplicity and consistency] may
be easier to communicate to consumers” (p. 16). Shankar and Bolton (2004) document that EDLP
stores indeed have higher rigidity in their promotional prices than the HI-LO stores.
Partial and Asymmetric Pass-Through in Distribution Channels
Thereisalargeliteratureinmarketingthatdealswithpass-through—theproportionofupstream
cost changes that is passed through the channel in terms of downstream price changes (Moorthy
2005; Tyagi 1999). As Moorthy (2005) enumerates, such upstream cost changes can span a wide
spectrum, including trade promotions, changes in regular wholesale prices, idiosyncratic changes
like those in inventory positions, or even a systemwide change like changes in currency rates. In
a retail context, if the retailer immediately passes through all of such cost changes as equivalent
retail price changes, there is 100 percent pass-through and no rigidity. If the retailer does not change
itspricesimmediately—orevenifitdoes,changesbyonlyafractionofthecostchanges—there
is less than 100 percent pass-through, and prices may be said to exhibit some form of rigidity.
In a bilateral monopoly (the simplest case), this happens because of double marginalization (see
Tirole 1988). In analytical models of channels with a vertical information structure, incomplete
pass-through is a well-known result, robust to most specifcations of well-behaved demand func-
tions. Different information structures and vertical contracts have been suggested to address this
inherent source of rigidity (Ingene and Parry 1995; Jeuland and Shugan 1983; Moorthy 1988).
However, none of this research explicitly assumes costs of price changes. The question then is,
What happens to pass-through when there are costs of price adjustment? Nijs, Srinivasan, and
Pauwels (2007) fnd that retail prices exhibit a fair amount of past price dependence even in the
presence of wholesale price fuctuations (that is, rigidity in pass-through). They suggest that one
reason for this rigidity could be related to the managerial inability to “deal with multiple objectives
in the face of limited information” (p. 481), similar to the managerial costs of price adjustments
discussed earlier. They go on to explore other reasons for price rigidity in retail prices.
Another outcome of such costs of adjustments is argued to be asymmetric pass-through. This
is defned in general as a phenomenon where cost increases are more likely to be passed through
than cost decreases. Peltzman (2000) offers a summary of the literature and detailed empirical
analyses to conclude (a) the evidence of asymmetric pass-through is unclear and (b) there is no
defnitive evidence that costs of price adjustment play a signifcant role in determining asymmetric
pass-through. Using a more disaggregate approach however, Müller and Ray (2007) document
not only evidence of asymmetric pass-through in the same data but also tentative evidence that
costs of price adjustment may be playing a role.
In perhaps the most direct treatment of costs of price adjustment in channel in marketing, Ray
and colleagues (2006) show how the presence of price adjustment costs at the downstream retail
level may create incentives of asymmetric pass-through at the upstream manufacturer level. This
is because, with costs of price adjustments, retailers may have no incentive to engage in small
price changes. This would reduce manufacturers’ incentives to pass through small wholesale price
decreases, because they would not see any demand effect due to the rigidity of retail prices. On
the other hand, it may enhance their incentive to pass through small wholesale price increases,
because they invite no demand penalties due to the same rigidity of retail prices. Ray and colleagues
derive equilibrium conditions and present empirical evidence of such asymmetric adjustments
being limited to only “small” price changes.
MARKETING IN A WORLD WITH COSTS OF PRICE ADJUSTMENT 177
Price Synchronization Across Different Product Lines
Coordination of prices across the different products carried by a multiproduct frm has been of
great interest to marketers. With the growing interest in category management, these have become
of even greater importance (see Basuroy, Mantrala, and Walters 2001; Moorthy 2005; Zenor 1994
for more on the subject). At issue often is whether prices of different products will change at the
same time (synchronized) or will change at different times (staggered). Shankar and Bolton (2004)
use the term “price-promotion coordination” to empirically investigate this issue. They fnd that
the level of synchronization across the retailer’s brands depends on a number of factors spanning
competition, as well as store and product factors.
While the marketing literature above does not consider the role of price adjustment costs in
the synchronization of prices, it tends to be of great interest to economists because of the impact
synchronization may have on aggregation of inter-temporal price rigidities. Sheshinski and Weiss
(1992), for example, consider a model of price coordination under infation and price adjustment
costs. They illustrate how the extent to which prices are staggered and synchronized depends
not only on the degrees of demand complementarities but also on the nature of the price adjust-
ment costs, especially whether there are increasing returns in the adjustment costs. They point
tothecriticalroletheformofsuchcostscanplayaswell—thatis,whetherthecostsaremostly
the physical costs or have a large component of “decision costs” similar to the managerial costs
discussed earlier.
Discussion
We hope this chapter helps to serve as a call to the marketing discipline to focus more attention
on price adjustment costs and their implications in the price-setting process. The time is right,
as this literature evolves from physical (menu) costs to richer organizational and behavioral
costs, and broadens its horizons to consider richer sources of micro-pricing data. These shifts
suggest that marketing may have a great deal to offer, as well as learn from, this developing
literature on the costs of price adjustments. Among the business disciplines, marketing is perhaps
best situated to make headway on the critical issues resting at the heart of this literature. The
marketing discipline has a broad range of data sources, empirical tools, and models that can be
used to contribute to the work on price adjustment costs. Empirically this ranges from a long
history in ethnographic methods, to direct access to managers and frms, to survey methods
to develop the scale and scope of price rigidity and its sources, to large pricing data sets and
emerging empirical techniques that could study price rigidity and its antecedents. Theoreti-
cally, this ranges from models of consumers managers, channels, organizations, and strategy
that may be effective ways to model these sources of price rigidity and their implications for
markets. Given the central role of managers in price adjustment that is arising in the literature,
our marketing understanding of organizations and how they make business decisions offers
an opportunity to make fundamental contributions to price theory and all the disciplines that
rely on it. Marketing also has a lot to learn from the literature on the costs of price adjustment
and price rigidity. Incorporating these costs of adjustment and price rigidities into our think-
ing and models enlarges our toolkit for understanding the role and limitations of pricing in the
marketplace, and improves our guidance on diffcult managerial problems. Given marketers’
keen interest in price changes, it presents a particularly fertile area of research with potentially
signifcant payoffs for theory as well as for practice. We identify some of these areas and discuss
them in the following paragraphs.
178 SHANTANU DUTTA, MARK E. BERGEN, AND SOURAV RAY
Need to Know More About the Nature of These Costs and Their Implications
Take frst the basic issues surrounding the nature and scope of price adjustment costs. Given the
nature of these costs per se, our ability to easily measure and categorize these costs has been
quite limited. As future researchers attempt to bridge this knowledge gap, we see a crucial role
for more descriptive studies (Zbaracki et al. 2004) alongside structural models like that of Slade
(1998), and we encourage the use of a wide variety of marketing tools and techniques to gather
more information about these costs and their consequences for price rigidity.
This empirical research should focus on the nature of these costs of price adjustment. Despite
the growing interest in the area and increasing evidence of the signifcance and importance of these
costs, we are just beginning to gain an understanding of their sources, magnitudes, and forms. This is
especially true of the emerging organizational and customer-based dimensions of these costs, which
offer some of the most signifcant and interesting sources of price rigidity. This is also true of convex-
ity of these adjustment costs. While a number of authors (e.g., Blinder et al. 1998; Rotemberg 1982;
Sheshinski and Weiss 1977; Zbaracki et al. 2004) illustrate the important role of such convexity, only
a few (e.g., Slade 1998; Zbaracki et al. 2004) even attempt to calibrate them. For marketers this is an
area of interest. Perhaps more than any other marketing mix decision, magnitudes and frequencies
of price changes frame the marketer’s response to the dynamics of consumer tastes and competition.
Given the impact that convexity can have on the magnitude and frequency of price changes (Blinder
et al. 1998), a greater understanding of the form of price adjustment costs is a promising area to
explore. Marketing offers a wealth of behavioral theory and knowledge that can be used to unlock
the nature of these organizational, customer, and convexity issues, as well as a rich array of empirical
methodologies to uncover the empirical signifcance of these as sources of price rigidity.
In terms of the scope of these costs, while there is some empirical work that estimates these
costs in retail supermarkets (Levy et al. 1997; Slade 1998; Dutta et al. 1999), there is not much
research in other contexts. Zbaracki and coauthors (2004) are among the few that study price
adjustment costs in an industrial context. More empirical research into the nature of these costs
in various contexts is necessary to create a more robust framework.
In fact, there may be substantial variation in price rigidity patterns across product sizes, catego-
ries, brands, and channels (Gordon 1990). Different sectors vary in factors that can impact price
adjustments. This could be not only on the basis of end-products (for example, manufacturing versus
services)butalsointhenatureofchannels—thediversityofmembers,numberofdifferentlevels,
degrees of decentralization, and so forth. Newer technological advances (such as ERP systems,
RFID), practices (for example, category management and outsourcing), and economic realities
(such as globalization) may also fundamentally impact the costs of price adjustments and hence the
way prices are set in diverse sectors. As an example, Nijs, Srinivasan, and Pauwels (2007) explore
variation in past price dependence and possible explanations for these patterns of price rigidity. There
is much to be learned from documenting these variations in price rigidity and understanding the ex-
planations for this rigidity (Bils and Klenow 2004; Dutta, Bergen, and Levy 2002; Nijs, Srinivasan,
and Pauwels 2007; Stigler and Kindahl 1970). Therefore we call for a sustained effort to map the
natureofthesecostsandtheirconsequencesindifferentcontexts—suchasB2Bmarkets,service
industries, international markets, throughout entire supply chains, and so on.
Drawing Insights from Economic Modeling
Price rigidity has been widely studied in the macroeconomics literature (Sheshinski and Weiss
1977; Gordon 1990; Ball and Mankiw 1994a, b; Carlton and Perloff 1990). This literature has been
MARKETING IN A WORLD WITH COSTS OF PRICE ADJUSTMENT 179
developing to incorporate the evolving understanding of the costs of price adjustment, offering
new ways to model price rigidity. For example, Mankiw and Reis (2002) and Ball, Mankiw, and
Reis (2005) explore how modeling the price adjustment costs as the costs of managerial decision
can yield a more plausible Phillips Curve relation. There is also a literature exploring the use of
organizational rules of thumb and their implications for economic activity (Amato and Laubach
2003; Galí and Gertler 1999). Rotemberg (2005) explores the implications of customer costs of
price adjustment for macroeconomic policy. These costs can also have implications for the debate
on time-dependent versus state-dependent models of nominal price rigidity (Basu 2005).
5
This
organizational evolution also suggests exploring the span of control models (Lucas 1978; Prescott
and Visscher 1980); recasting these toward the ability of frms to adjust prices (as well as man-
age production and other activities) may be a promising direction for marketers to explore. All
of these literatures provide interesting theoretical insights into the complexities and implications
oftheseadjustmentcosts—whichcanbeofsubstantialbenefttothemarketingliteratureasit
explores these costs in the future and their implications for pass-through, price tiers, and other
dynamic pricing issues.
Managerially, one can also view the emerging literature on six sigma pricing and other process
improvement methodologies being brought into the feld of pricing as outgrowths of this deeper
understanding of the costs involved in price adjustment. For example, the work of Sodhi and Sodhi
(2008) articulates a view of pricing processes that is fraught with costs, and it helps managers
apply six sigma and other statistical and process control techniques to improve the effciency and
effectiveness of their pricing processes.
Small Versus Large Price Changes
We can beneft from a greater understanding of how price adjustment costs affect not only large
but also small price changes (Kashyap 1995). There is an intriguing juxtaposition of perspectives
in the domain of small price changes. The presence of frequent small price changes in the presence
of price adjustment costs has been puzzling to some economists like Kashyap (1995). The relation
between small price changes and the convexity of price adjustment costs has been speculated upon
as a possible explanation (Blinder et al. 1998; Kashyap 1995; Zbaracki et al. 2004). On the other
hand, for marketers, small price changes are intuitively appealing given a long history of Just
Noticeable Differences (JND) and related literature (Monroe 1973; Lichtenstein, Bloch, and Black
1988; Kalyanaram and Little 1994). Ray and colleagues (2006) and Lach and Tsiddon (2007) are
among the few that apply a price adjustment perspective to small price adjustments. We believe
greater attention to how small price changes and price adjustment costs relate to each other will
yield a rich set of insights for both theory and practice. The discussion above illustrates that when
changing prices, managers have to take into account the regions of price changes to which custom-
ers pay less attention. As price changes beyond those ranges, especially for price increases, this
large price change can increase the cost that a frm has to incur to convince the customers that the
new price still provides value to them. The frm therefore may have to pay more attention to the
importance of customer costs. The price rigidities in these thresholds can then be explained by
the costs that customers and managers incur in an effort to move prices beyond the thresholds.
This is supported by evidence found in the industrial context, where the frm incurs signifcant
managerialandcustomercostsassociatedwithapricingdecision—especiallyiftheyhavetobe
large price changes (Zbaracki et al. 2004). It also points to how marketers in certain contexts
might deal with the competing concerns of costly price changes and the business prerogative of
making a temporary price change. As documented in Levy and his coauthors (1997, 1998) and
180 SHANTANU DUTTA, MARK E. BERGEN, AND SOURAV RAY
Dutta and colleagues (1999), in the supermarkets and drugstores they study, a vast majority of the
price changes were temporary promotions, not the more permanent changes in the list or regular
prices. Presumably, changes in the list prices (given their more permanent nature) would hold more
signifcant long-term implications for the frm and hence would require greater consideration and
higher managerial costs of price adjustment.
Frequency of Promotional Price Changes
There are a number of perspectives that drive the frequency of price changes. One of the more
prominent ones is store positioning, broadly categorized as EDLP or HI-LO. Despite the general
interest in these forms (Bell and Lattin 1998; Hoch, Drèze, and Purk 1994), few papers exist to
study the implications of price adjustment costs for such pricing formats. While EDLP stores
engage in few promotional price changes, HI-LO stores undertake frequent promotions. As such,
these formats present an opportunity to understand how price adjustment costs may operate in
two very different scenarios. Deal sensitivity is yet another perspective that drives frequency
of price changes (Kopalle, Mela, and Marsh 1999; Krishna 1994; Mela, Gupta, and Lehmann
1997). The idea here is that frequent price changes may lead consumers to buy only when there
is a suffciently attractive price promotion. This may not be good news for the retailer’s bottom
line. Nevertheless, promotional pricing is often interpreted from a competition lens. What is not
clear is how the existence of price-adjustment costs across different competitors may impact the
outcomes regarding frequency of price changes. This is another area where marketing is uniquely
poised to contribute to our understanding of how price adjustment costs affect prices. Manageri-
ally, adjustment costs offer a new set of variables to consider when setting broader pricing strate-
gies such as an EDLP strategy, than the ones suggested in the existing marketing literature (e.g.,
Hoch, Drèze, and Purk 1994; Lal and Rao 1997; Bell and Lattin 1998; Bell, Ho, and Tang 1998;
Ailawadi, Lehmann, and Neslin 2001). The existence of these costs of price adjustment suggests
that in the short run any complex pricing scheme like bundling or usage-based pricing will have
to take into account the frm’s existing costs to adjust prices, and consider the costs to change the
strategyitself.Essentiallythissuggestsanotherlevelofcostsofpriceadjustment—adjustmentin
theformofpricing—asapromisingresearchdirectiontoexplore.
Asymmetric Price Adjustments
Chen and his coauthors (2008) show there is an asymmetry between positive and negative retail
pricechangesinthesmall—withsmallincreasesvastlyoutnumberingsmallpricedecreases.This
asymmetry however, vanishes for large changes. Such asymmetric price adjustments have always
been of great interest. Nevertheless, per Peltzman (2000), there are as yet no compelling explana-
tions of the phenomenon. While it has always been part of the consideration set, the empirical
evidence of the role of price adjustment costs on asymmetric adjustments are mixed in both the
economics and marketing literature (Ball and Mankiw 1994a; Müller and Ray 2007; Peltzman
2000; Ray et al. 2006). Certainly, the outcomes would be intuitive if the costs themselves were
asymmetric, that is, price decreases were more costly than price increases. However, even when
asymmetric costs were referred to (for example, in Blinder et al. 1998; Zbaracki et al. 2004), they
have usually been in different directions (price increases more costly than price decreases).
Interestingly, some recent work shows that even if these costs per se are not asymmetric, strategic
interaction between market players could still lead to asymmetric adjustments (see Ray et al. 2006).
There are only a handful of papers in this area. Among them, Slade (1999) looks at how price adjust-
MARKETING IN A WORLD WITH COSTS OF PRICE ADJUSTMENT 181
ment costs impact horizontal interactions (competition), and Basu (1995) looks at how price adjustment
costs impact pricing and production outcomes in a vertical context (channels).
A related literature from behavioral economics offers another lens to interpret asymmetric price
adjustments, whose existence as a retail pricing practice is often puzzling from a consumer fairness
perspective. Certainly, if the practice was considered patently unfair, the frm’s ability to proft
from it would be limited. To this end, Kahneman, Knetsch, and Thaler (1986a, 1986b) propose
the “dual-entitlement principle” to explain why such asymmetric pricing may still be considered
fair by consumers and hence sustainable from the frm’s point of view. However, their perspective
anchors on the manner in which prices respond to input costs but make no explicit allowance for
the costs of price adjustments or the retailer’s ability to make price changes. Despite the clear
managerial implications, there is little to no research that explores this area.
Given the rich set of tools and perspectives available to marketers to study consumer, channel,
and competitive interactions, we believe marketing is uniquely situated to yield valuable insights for
both theory and practice in this domain. These insights could draw not only from formal economic-
oriented approaches but also from more cognitive and behaviorally oriented methodologies.
Price Points and Price Rigidity
A similar line of reasoning can also be applied to the interpretation of price point rigidities (Levy
et al. 2007).The phenomenon of nine cent ending, for example, has been of continuing interest
to both economists and marketers (see Basu 1997, 2006; Schindler and Kirby 1997; Stiving and
Winer 1997; Twedt 1965). The traditional explanation of nine-cent endings suggests that retailers
strategically leverage the limits of consumers’ cognitive abilities. Nevertheless, the widespread
deployment of such price points may in fact point to a pricing routine at the retail level as opposed
to a more deliberate strategic decision (see the work on “customary prices” [Ginzberg 1936]).
This would also suggest that moving from nine-cent endings could have its own organizational
costs. Hence we call for additional research to expand our understanding of price point rigidities
by incorporating costs of price adjustments.
Price Coordination Across Competition and Across Brands
Price coordination has always been a major consideration for marketers. At an inter-retailer level,
such coordination can range from explicit collusion to simple price-follower strategy, where a
retailer merely readjusts its prices following the price leader’s adjustment. In another variation of
this, a nonstrategic cost plus rule may see all retailers in the industry automatically adjust prices
following an industry-wide cost shock (as is often observed in retail gasoline prices).
It seems intuitive that to the extent price adjustment costs impact rigidity of prices, they would
also impact the type of price coordination being referred to here. Nevertheless, it is not clear
what would be the nature of such an impact. Certainly, if the price-change process is routinized
to the extent that no new decisions are involved at the time of a price change, the outcome could
be vastly different than if each change point was an occasion for a new decision. Research on
price competition and competitive response in marketing has looked at the nature of competitive
interactions using scanner data (e.g., Kadiyali, Vilcassim, and Chintagunta 1999; Leefang and
Wittink 1996) or game theoretic models (e.g., Moorthy 1985). The existence of these costs of price
adjustment suggests more subtle modeling and empirical issues as to how they affect competition.
To the best of our knowledge, there is little work in this area, and we believe that the marketing
literature will greatly beneft from more research in this domain.
182 SHANTANU DUTTA, MARK E. BERGEN, AND SOURAV RAY
The nature of price coordination may differ as well. At the inter-brand level, a single retailer may
consider all the brands in a category collectively in its price adjustment decisions. The outcome could
be synchronized price changes (multiple brand prices change at the same time) or staggered price
changes (the price changes do not happen simultaneously). Such price coordination is considered
a key part of category management (see Basuroy, Mantrala, and Walters 2001; Shankar and Bolton
2004). Nijs, Srinivasan, and Pauwels (2007) document the proft impact of a category management
perspective. Costs of price adjustment have a particular resonance to category management. It is
not clear whether the complexity of the decision making would be necessarily greater than a more
brand-management focus. However, one would think that the nature of the costs would be a critical
consideration. In particular, if there are such economies as increasing returns to scale to these costs,
retailers would be more prone to coordinate price changes across multiple brands. At the same time,
it is unclear if these economies would necessarily lead to price coordination in the sense of syn-
chronization. For example, it may be possible for retailers to incur a fxed decision cost that would
dictate whether the synchronized or the staggered patterns would be deployed. As Sheshinski and
Weiss (1992) point out, price synchronization (or lack thereof) could very well depend on whether
the nature of the costs is dominated by the physical or managerial components.
Our perspective also suggests that in the short run, the ability of manufacturers or retailers to
rely on pricing strategies to engender tacit collusion may depend on these costs. For instance,
Lal (1990) suggests that trade promotions can be an instrument for tacit collusion across national
brand manufacturers. This assumes that all the frms do not face substantial costs of price adjust-
ment; otherwise this may not be feasible. Similarly, the mechanism of price matching guarantees
to engender tacit collusion (Hess and Gerstner 1991; Chen, Narasimhan, and Zhang 2001) relies
on minimal costs of adjustment to make this strategy feasible.
Despite the apparent implications for pricing decisions, we know very little about the role of price
adjustmentcostsinthepricecoordinationdecisions.Wethereforecallformoreinvestigations—
empirical research to map the descriptive parameters of the relationships, as well as theoretical
research to create a framework to interpret the direct and indirect effects of these costs on price
coordination outcomes.
Interaction with Other Marketing Mix Adjustments
In the preceding paragraphs, we have highlighted some of the key tactical domains where price
adjustment costs may impact the marketer’s pricing decisions. But pricing is only a part of the
broader marketing strategy and cannot be calibrated in isolation. The notion that the marketing mix
variables are correlated is well accepted in marketing. Given the historically scant attention given
to price adjustment costs in marketing, our knowledge of how price adjustment costs interact with
the other marketing variables is also very limited. Specifcally, how price adjustment costs impact
rigidities in product introductions/innovations and/or channel structure is not explored.
It stands to reason that if price is a main marketing tool in the value exchange process, any
rigidity in prices would impact other marketing mix decisions. Examples of such interactions
abound. When Virgin Mobile introduced their new product in America, the key value proposed was
a noncomplex, no-contract pricing plan. The more established incumbents in the mobile market
were not able to change their price format to compete with Virgin because of the managerial and
customer costs they would have had to incur to make that change. Similarly, changes from HI-LO
pricing to EDLP pricing may call for major changes in the channel arrangements (for example,
EDLPP [Every Day Low Purchase Price]; see Hoch, Drèze, and Purk 1994). As Sears found out
much to its grief, such a move is not just a matter of changing price forms.
MARKETING IN A WORLD WITH COSTS OF PRICE ADJUSTMENT 183
Conclusion
In this chapter, we review the literature in marketing and economics to summarize what we
know about the nature, magnitude, and broad impact of price adjustment costs. We then identify
some areas of pricing that are of particular interest to marketers where considerations of price
adjustment costs are likely to yield insight. Our basic conclusion is that there are signifcant
domains of pricing decisions that are under-researched from the perspective of price adjust-
ment costs. We believe more explicit consideration of these costs will lead not only to greater
understanding of pricing but also to better pricing decisions. We also believe that this offers an
exciting interdisciplinary research opportunity of fundamental importance to the business and
economics disciplines, where marketers can play a leading role. Therefore, we urge marketers
to pay more attention to the evolving literature on the costs of price adjustment.
At the same time, we do not mean to suggest that the study of these costs is a panacea or the
only route to study pricing in the marketing literature. Many issues are better studied without
consideration of these complexities. Moreover, while price rigidity is a key outcome of price
adjustment costs, these costs are only one explanation for price rigidity in the literature. Our goal
here is to generate consideration of these costs and their implications for researchers interested in
studying the dynamics of pricing. We feel the research in marketing, economics, and many related
business disciplines will beneft greatly from such an approach.
Acknowledgments
The authors would like to thank the anonymous participants in their research, whose generous
cooperation made this study possible. Special thanks are due to Haipeng (Allan) Chen and Neil
Bendle for their thoughtful feedback on the manuscript. The authors would also like to thank Mark
Ritson, Daniel Levy, and Mark Zbaracki for their active participation in this line of research, as
well as Padmasri Suriyakumar and Kulothungan Jeganathan of McMaster University, and Benja-
min Lehrman of the University of Pittsburgh, for their able research assistance. The authors rotate
order of coauthorship. All authors contributed equally.
Notes

1. See Monroe 1973; Rao 1984; Moorthy 1985; Wilson, Weiss, and John 1990; Hoch Drèze, and Purk
1994; Wernerfelt 1994; Simester 1995; Lal and Rao 1997; Bell, Ho, and Tang 1998; Ailawadi, Lehmann,
and Neslin 2001; Stremersch and Tellis 2002.
2. See Blinder and his coauthors (1998), Ball and Mankiw (1994a, 1994b), Rotemberg (1987),
Gordon (1990), and Mankiw and Romer (1991) for a comprehensive discussion of this “New Keynes-
ian” literature.
3. See Blinder and his coauthors (1998) for an excellent presentation of the importance of price rigidity
for economics, the main theories of price rigidity, more results on costs of price adjustment, and a wealth of
other fndings on price rigidity.
4. In their most basic form, item pricing laws (IPLs) require a price tag on every item sold by a retailer.
Currently, IPLs exist in nine U.S. states; in Quebec, Canada; in some European countries; and in Israel.
5. See also Sheshinski and Weiss (1977).
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189
ABOUT THE EDITOR AND CONTRIBUTORS
Melissa Archpru Akaka is a doctoral student in marketing at the Shidler College of Business,
University of Hawaii at Manoa.
Hans Baumgartner is chair of the Department of Marketing, Smeal College of Business, Penn-
sylvania State University.
Mark E. Bergen is the Carolyn I. Anderson Professor of Business Education Excellence at the
Carlson School of Management, University of Minnesota.
Pradeep K. Chintagunta is Robert Law Professor of Marketing at the Booth School of Business,
University of Chicago.
Shantanu Dutta is Vice Dean of Research Strategy and Advancement and the Dave and
Jeanne Tappan Chair in Marketing at the Marshall School of Business, University of Southern
California.
yi He is Assistant Professor at the Department of Marketing and Entrepreneurship, College of
Business and Economics, California State University, East Bay.
Dipak C. Jain is the Dean of the J. L. Kellogg School of Management at Northwestern University.
Robert F. Lusch is Lisle and Roslyn Payne Professor in Marketing and the Department of Mar-
keting Head at Eller College of Management, University of Arizona.
Naresh K. Malhotra is Regents’ Professor in the Department of Marketing, College of Manage-
ment, Georgia Institute of Technology.
Matthew S. O’Hern is an Assistant Professor at Lundquist College of Business, University of
Oregon.
Koen Pauwels is Associate Professor of Business Administration at the Tuck School of Business,
Dartmouth College.
Sourav Ray is Associate Professor of Marketing at the DeGroote School of Business, McMaster
University.
Dave Reibstein is the William Stewart Woodside Professor and Professor of Marketing at The
Wharton School, University of Pennsylvania.
190 ABOUT THE EDITOR AND CONTRIBUTORS
Aric Rindfeisch is Professor of Marketing and Associate Dean for Research and PhD Programs
at the School of Business, University of Wisconsin–Madison.
Siddharth S. Singh is Assistant Professor of Management at the Jesse H. Jones Graduate School
of Management, Rice University.
S. Sriram is Assistant Professor of Marketing at the Stephen M. Ross School of Business, Uni-
versity of Michigan.
Stephen L. Vargo is Professor of Marketing and Shidler College Distinguished Associate Profes-
sor at the Shidler College of Business, University of Hawaii at Manoa.

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