Homophily and Influence: Pricing to Harness Word-of-Mouth on Social Networks

Large-scale social platforms have enabled marketers to obtain rich data on the structure of wordof-mouth (WOM) networks and the correlation of friends’ preferences (network assortativity). However, the literature is silent on how the similarity or difference of friends’ reservation prices for a product should affect the optimal price and advertising levels for that product. To answer this question, we present an analytical model of informative advertising and pricing over a social network. Connections between consumers are added in a way that allows neighbors’ preferences to be positively or negatively correlated, thereby introducing homophily or heterophily in the model. Consumers may learn about products either directly via advertising, or via WOM spread by their peers who have adopted a product. We find that in the typical scenario when blanket advertising is not affordable, firms set a price lower than the naïve optimum in order to leverage the social value of more price-sensitive customers. We also characterize the relationship between assortativity and the marketing instruments (price and advertising) of the firm, linking the comparative statics to the achieved penetration of the available market. Finally, we show how this relationship may change under intense competition for a market of high-valuation customers.