The Effects of Service Quality and Word of Mouth on Customer Acquisition, Retention and Usage

Abstract:     
This paper documents the existence of the direct and indirect (via word-of-mouth) effects of service quality on new customer acquisition, usage and retention using behavioral data from the launch of a new video on demand type service. For this technology, service quality - the quality of the signal determining the number of movies available for viewing - is exogenously determined and objectively measured. This information, coupled with location and neighborhood information for each subscriber allows us to measure both the direct and indirect effects of service quality. Our identification strategy for these effects arises from both the main effect of neighbors who have previously adopted and the interaction between the number of neighbors and their realized service quality, while controlling for other geographic and demographic covariates.

We find a direct effect of service quality on rental usage and termination behavior. In addition, we find that word of mouth affects about one-fifth of the subscribers with respect to their activation behavior. However, this indirect effect of service quality acts as a double-edged sword as it is asymmetric. We find that the effect of negative word of mouth is twice as high as the effect of positive word of mouth for consumers influenced by word of mouth. We find these effects after controlling for unobserved heterogeneity, marketing activity, distance to retail and demographics.

Consumers affected by word of mouth tend to be heavy users once they adopt the service. The implication from these results is that service quality is important for new customer acquisition in the sense that the heavy users tend to be acquired by word of mouth rather than advertising. In terms of profitability, we find that a 10% increase in service quality leads to a 7% increase in customer lifetime value. Finally, for our sample of adopters, we find that word of mouth effects also lead to acceleration in adoption behavior.

Keywords: Services, New Products, Service Quality, Word of Mouth, Contagion, Social Interaction, Social Networks, High Technology, Hazard Models

JEL Classifications: L65, M30, M31

Working Paper Series