Internal Marketing at Continental Airlines: Convincing Employees that Management Knows Best

Marketing Letters 13:2, 75–89, 2002

# 2002 Kluwer Academic Publishers. Manufactured in The Netherlands.

Internal Marketing at Continental Airlines: ConvincingEmployees that Management Knows Best

ASHUTOSH PRASAD* AND ERIN STEFFES

School of Management, The University of Texas at Dallas, Richardson, TX 75083

*Corresponding author. Tel.: þ 1-972-883-2027; Fax: þ 1-972-883-2799; E-mail: [email protected]

Received October 25, 2001; Revised February 5 2002; Accepted February 13, 2002

Abstract

Maintaining a high level of customer service quality is necessary for success, particularly for firms in service

industries, but employees need to be motivated to provide it. Management can provide the motivation through the

use of compensation schemes and internal marketing. In this paper we examine profit sharing compensation

schemes that reward employees for achieving customer service objectives. We discuss how such schemes should

be implemented, and explain why management needs to convince employees through internal marketing programs

about the benefits of its scheme. We obtain the optimal amount of profit that the firm should share with

employees, and the optimal effort it should spend on internal marketing. Finally, we relate the analysis to a

successful scheme implemented by Continental Airlines.

Key words: internal marketing, incentives, employee compensation

1. Introduction

Customer service quality is important for all firms; in particular, firms in service industries,

such as hotels, airlines, and health clubs, cannot remain competitive if they provide poor

service (Cowell, 1984; Heskett et al., 1994; Schlesinger and Heskett, 1991). Maintaining

and improving service quality depends on employees. For instance, in the airline industry,

the service sold to customers is timely, reliable transportation for customers and their

baggage (Bethune and Huler 1998). A large number of employees, from pilots to baggage

handlers, must work together to deliver a satisfactory customer experience. Motivating

employees to provide better service is essential because the employee-customer interaction

is the primary component of the service firm’s product, and quality can be created or

destroyed each time the customer interacts with the firm’s employees (Lovelock, 1983).

To motivate employees, firms use a combination of internal marketing and incentive

schemes (Bethune and Huler, 1998; Cooper and Cronin, 2000). In this paper, we examine

the use of internal marketing and its relationship to incentive schemes that reward the

achievement of specific objectives by employees.

Internal marketing has been defined as the expense and effort of motivating employees

to provide better customer service (Cooper and Cronin, 2000). It may encompass some or

all of the following practices: Communicating with the internal audience of the organiza-

tion through seminars, memos, and regular meetings between management and employees;

increasing interaction between employees and customers; improving internal customer

service; using evangelists to explain new initiatives; and continuous training of employees

(Cooper and Cronin, 2000; George, 1990; Pitt and Foreman, 1999). As Kotler (2000)

notes, it is clear that internal marketing must precede external marketing since it makes

little business sense to promise the customer a level of service that the firm’s employees are

unwilling or unable to provide.

For our incentive scheme, we examine profit sharing, which is the primary method for

aligning the employee’s goals with the goals of the firm (Coughlan and Sen, 1989).

Employees are compensated with a share of the firm’s profits, and because this profit is a

consequence of their collective action, there is a motivation for each employee to work

harder. An alternative method is to set a quality performance goal for each employee, but

in practice the high cost of monitoring employee performance makes this an infeasible

proposition. Individual effort, therefore, is unobserved (e.g. Basu, Lal, Srinivasan and

Staelin, 1985).

An example of a successful profit-sharing scheme is provided by Continental Airlines in

1995 (Bethune and Huler, 1998; Brenneman, 1998). For every month that Continental

ranked above average in on time flight performance, Continental employees would each

receive a payment of $65. Continental management had determined that if their flights

departed and arrived on time, the airline would earn an additional $5 million in profits.

They then decided that half of this profit would be given to the employees, which funded

the potential monthly incentive payment of $65. A great deal of internal marketing from all

levels of management was required to convince employees that the program would be

successful (Bethune and Huler, 1998).

Strong anecdotal and empirical evidence supports the assertion that Continental’s

scheme worked. After the profit sharing program was launched in early 1995, Continental

improved its flight performance by landing 80% of flights on time, beating the industry

average of 79% (Bethune and Huler, 1998). The positive impact of the scheme was also

verified in an empirical study that compared Continental’s on time performance at airports

that implemented the scheme to airports that did not, and found a significant improvement

in the former (Knez and Simester, 2001).

We now discuss why an internal marketing campaign is required in addition to the

profit-sharing scheme to motivate employees to provide better service quality. For profit

sharing to work, employees must be convinced that management’s desired outcome is

actually linked to their increased effort with some probability. Internal marketing is used to

convince employees about management’s certainty that the benefits of the scheme will be

realized. Table 1 discusses the limitations of three alternative schemes that do not include

internal marketing.

The fundamental argument is that if the firm has information that would induce the

employees to work harder then it should communicate this information to the employees in a

credible manner through internal marketing. Thus, just as advertising is required to com-

municate information to customers, internal marketing is required to communicate informa-

tion to employees. The following research issues arise from the descriptions in Table 1:

76 PRASAD AND STEFFES

RI1: Continental shared half of the $5 million profit gain that resulted from improved

flight performance with employees. When is profit sharing appropriate and what

is the optimal proportion to share?

RI2: Continental spent a great deal of internal marketing effort on motivating and

promoting the scheme to employees. How much money or effort should manage-

ment spend on internal marketing?

On examining the marketing literature related to these issues, we observe that theoretical

work on incentives has received wide application. Examples can be found in the areas of

salesforce compensation, employee compensation and franchising and channel manage-

ment (e.g. Basu et al., 1985; Chu and Desai, 1995; Hauser, Simester and Wernerfelt, 1997;

for a review see Coughlan and Sen, 1989). The literature on group incentives, in contrast,

is rather limited in marketing (e.g. Knez and Simester, 2001) and in the economics

literature (e.g. Holmstrom, 1982; Hermalin, 1998). In addition, we do not find theoretical

work on the use of internal marketing. This paper, therefore, makes an original contribu-

tion in filling this gap in the literature.

In the rest of the paper we develop a model with asymmetric information between the

firm and employees to answer these questions. Sections 2 through 4 develop and analyze

the model. Section 5 discusses results and Section 6 concludes.

2. The Model

Consider a firm with N identical employees. We assume that the particular task, such as

improving flight timeliness, can be treated as separate from regular work since it represents

an extra effort for which incentive must be provided (Hauser, Simester and Wernerfelt,

1997). Since the incentive is typically small, employees are assumed to be risk-neutral.

Employees expend effort, e, and have a disutility from effort given by e2=2. The firm may

also exert effort, denoted E at a cost E2=2.

Table 1. Alternative Schemes

Possible Scheme Limitation

1. Give $65 directly to employees. Employees will have no incentive to work

harder since they are assured of the money

regardless.

2. Offer a share of the profit realized due to

customer service improvement.

This works only if the employees and the firm

are equally informed. Otherwise, employees

don’t know what realized profit to expect;

hence less incentive.

3. Offer a share of the profit realized due to

customer service improvement, and inform

employees what the profit is expected to be.

Employees should rationally disbelieve the firm’s

reported expectation since it has an incentive to

lie by claiming a very high value (see Section 4

below).

INTERNAL MARKETING AT CONTINENTAL AIRLINES 77

The firm’s effort E consists of both a productive component and a component not

directly productive in achieving the objective even in normal times when no internal

marketing is required. When we consider the internal marketing scenario, we will dis-

tinguish it as the additional effort that the firm applies at that time, denoted DE. Internal

marketing programs such as communicating the incentive program to the employees,

training and educating the employees on how to achieve the goal, and monitoring and

planning the firm’s progress towards the goal, also have direct and indirect effects on

productivity, and therefore, are not distinguished from normal effort on this dimension. It

is best seen as enhanced effort during the period when management is trying to convince

employees about its scheme.

Let the function gðP

e;EÞ denote the total effort directed towards the goal by the firm

and employees, whereP

e is the sum of the efforts of all employees. The success of the

effort in terms of how well it translates into profit is uncertain. A stochastic probability-of-

success parameter, denoted y, is used, where the parameter value is realized after effort has

been expended. The probability of success depends on exogenous factors that are not

influenced by the firm such as how the market will respond to its efforts, macroeconomic

factors affecting revenues, and demand and competitive scenarios. It is assumed that the

firm, due to market research, managerial analysis, or greater experience, can accurately

forecast the probability of success. However, except in a full information scenario, the

employees do not know the correct value precisely although they know the range y 2 ½y; �yy�in which y lies.

The firm promises a share x of the expected profit to employees as the incentive. Each

employee, thus, expects to receive xyVgðP

e; EÞ=N ; which is the profit shared with

employees divided by the total number of employees. Here, V is an exogenous productivity

factor that links effort to gross profit. One can interpret V as productivity in the best case

scenario (y¼ 1), for example V¼ $40 per worker hour. If y¼ 0.5 the same effort translates

into only half as much profit. Since they are confounded, one can consider yV together as a

random variable, however, as we consider y to be a probability measure, it is necessary to

include V separately as a scaling parameter. The expected profit for the firm is written as:

ð1 � xÞyVgX

e;E� �

�1

2E2; ð1Þ

i.e., the profit retained by the firm less the disutility of effort for the firm.1 To continue, we

require a functional specification of the total effort gðP

e;EÞ: We assume that this is a

linear sum of firm and employee efforts (e.g. Hermalin, 1998):

gX

e;E� �

¼X

e þ lE ð2Þ

The parameter l is the firm’s relative efficiency of effort, which will be referred to as

‘relative efficiency’. It determines whether a unit of effort by management counts more,

less or the same as a unit of employee effort in affecting the outcome. At the extreme when

l¼ 0, managerial activity has no direct effect on the outcome. However, as we shall see,


even when l¼ 0 management may engage in some effort to provide a signal to employees

and thereby indirectly affect the outcome.

3. Full Information Benchmark

We first examine a full information model where both the firm and employees are cor-

rectly informed about the probability of success. The firm announces a sharing rule x

and the employees choose their actions after learning x. Each employee’s problem is to

maximize his or her utility with respect by spending the optimal amount of effort. For

employee i:

eFI ;i ¼ arg max xyVXN

j¼1

ej þ lE

" #,N �

1

2e2

i ð3Þ

From which is obtained the optimal level of effort:

eFI ;i ¼ xyV=N ð4Þ

where subscript FI denotes the full-information scenario. Since employees are considered

to be identical, the subscript i will be omitted in the remainder of the paper. Examining (4)

we see that employee effort is positive and increasing in x, y and V. In each case an

increase in the parameter implies higher rewards for effort. Effort is decreasing in N since

the total incentive is shared with more coworkers resulting in a lower reward for effort.

Anticipating employees’ choice of effort, the firm makes its decisions on x and E by

maximizing expected profit with respect to these variables:

xFI ;EFI 2 arg maxð1 � xÞyV ðxyV þ lEÞ � 12

E2 ð5Þ

Where the profit expression for the firm comes from inserting (4) in (2) and (2) in (1).

Solving the conditions for maximum yields the equilibrium values.

Proposition 1: Under the full information scenario, the sharing rule is xFI ¼ ð1 � l2Þ=

ð2 � l2Þ; the efforts of the employee and firm are respectively, eFI ¼ yV ð1 � l2

Þ=ð2 � l2

ÞN and EFI ¼ yVl=ð2 � l2Þ; and the profit to the firm is PFI ¼ y2

V 2=2ð2 � l2Þ:

When l¼ 0, i.e., when the effort by employees is the only productive effort, the firm

shares half the gains with the employees, otherwise, as long as l< 1, it shares less than

half. The share of profit given to the employees must be substantial enough to induce the

effort necessary to achieve the company goals without excessively sacrificing firm revenue.

It can be shown (see appendix) that when l 5 1,eFI ¼ xFI ¼ 0; EFI ¼ lyV ; and

PFI ¼ l2y2

V 2=2; i.e., the firm finds it best to share no revenue with employees. As a

result, employees contribute no effort, and it is solely the firm’s effort that determines the

outcome. That the firm would ever want to undertake all the effort rather than sharing it


with employees is a surprising result given that the disutility for effort is convex. In

practice, the result implies that incentive schemes should be used only when effort by the

firm is less efficient than effort by employees. For example, in small proprietary

establishments where the owner is also involved in the operations, perhaps such schemes

would be less used. Even for large organizations, for tasks that require significant

management input, such schemes are not useful. For the rest of the paper we restrict

our attention to the domain of interest, l 2 ½0; 1� where these schemes are useful.

4. Asymmetric Information

Let us now examine the case where the firm correctly knows y but employees do not,

believing it instead to be ~yy: Performing the calculations as in the previous case reveals that

the effort choice of the employee is proportional to ~yy rather than y while the profit of the

firm is proportional to y~yy rather than y2, i.e., e ¼ x~yyV=N and P ¼ y~yyV 2=2ð2 � l2Þ:

From the profit expression, the firm always benefits when ~yy is higher. The firm will try

to induce a higher belief among employees, and if they believe the firm, it should lie to the

greatest extent. If it lies, and is believed, the effort level of the employees is higher than

what their optimal effort level should be given the expected reward, which is a function of

y only and not ~yy: Therefore, employees should rationally disbelieve the firm when it makes

an announcement greater than ~yy given that it has every incentive to lie.

An example will clarify this further. Let y 2 ½y; �yy� ½0; 1�: Let ~yy ¼ 0:5: To obtain a

contradiction, let there be a value yy > ~yy; say 0.7, which is the maximum reported value

that is believed. Then all firm types will report 0.7, since no type has reason to report less,

and no type has reason to report more (if they report more they are not believed and

instead they get ~yy ¼ 0:5:) Hence, a report of 0.7 is uninformative about the type and does

not update employees’ prior beliefs. Thus, there can be no yy > ~yy:To conclude, if employees have a prior belief ~yy less than y there is degradation of the

firm’s profit because of the wrong belief. (From the firm’s perspective, the situation where~yy is equal to or larger than y requires no intervention. We therefore concentrate on

y 2 ½~yy; �yy�; and for continuity in exposition refer to this as ½y; �yy�). One solution to this

inefficiency is to use internal marketing.

4.1. The Internal Marketing Solution

Managers can exert increased effort, referred to as internal marketing, to convince

employees about the probability of success. The effort is made prior to employees

choosing their level of effort. In the first stage, the firm announces the employees’

share, x, and exerts effort, E. Employees observe x and E and draw conclusions about ybefore choosing their effort level in the second stage.

It should be noted that employees would expect that some effort, EbaseðyÞ will be spent

by the firm even when y ¼ y; and it is only effort beyond this, DE ¼ E � EbaseðyÞ that has


a signaling effect in indicating y� y ¼ Dy: We use the notation f (DE) to denote the

assessment of Dy given observation of the level of internal marketing DE. Therefore, the

effort chosen by the employees in the second stage will be:

e ¼ ½yþ f ðDEÞ�xV=N ð5Þ

Anticipating this, the firm now has to determine x and DE. Since the revenue is obtained

in the second stage, it is discounted by a discount factor, d:

PIM ¼ ð1 � xÞdyV ½ðyþ f ðDEÞÞxV þ lE� � 12

E2 ð6Þ

The solution is given by the following proposition.

Proposition 2: Under internal marketing, the sharing rule is xIM ¼ ð1 � lffiffiffid

pÞ=

ð2 � lffiffiffid

pÞ; the efforts of the employee, firm, and the internal marketing are, respectively,

eIM ¼ yV ð1 � lffiffiffid

pÞ=ð2 � l

ffiffiffid

pÞN ; EIM ¼ yV

ffiffiffid

p=ð2 � l

ffiffiffid

pÞ; and DE ¼ ðy� yÞ=k; where

k ¼ ð1=2xV Þ

h�lþ

ffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffil2

þ ð4x=dð1 � xÞÞ

q i: The profit of the firm is PIM ¼ y2

V 2d=

2ð2 � lffiffiffid

pÞ2:

Unlike in the previous case, where the sharing rule depended only on l, it depends here

on the discount factor as well. Note that a firm that observes a higher y finds it optimal to

do a greater amount of internal marketing to convince employees that this value is true.

4.2. The Money Burning Solution

There is another solution to the asymmetric information problem obtained by using a

mechanism design approach in which the firm shows that it has an incentive to tell the truth

at all times. The firm credibly communicates the true probability of success to employees

by spending money in an unproductive manner ahead of employee efforts. The amount of

money spent is so high that only a firm seeing a particular state would find it optimal to

spend such an amount. This is known as money burning. The money could be spent on new

buildings, furniture, celebrations, etc. Although the firm spends money unproductively, it is

still in its best interest to do so since it induces employees to work harder.

The firm announces a value of y, say yy; in addition to burning money to the amount yðyyÞthat will lead employees to believe yy is indeed the correct value of y. Thereafter, the

employees and the firm expend effort. It should be noted that if the money burnt is spent

on employees in the form of celebrations, say, it is spent prior to the choice of effort and

not as a reward; hence, it does not directly enter their effort function, which is

e ¼ xyyV=N : ð7Þ

Let Pðyy; yÞ be the expected profit when the real state is y and the announced value is yy:The required incentive compatibility condition for truth telling is:


Pðy; yÞ �Pðyy; yÞ � 0 for all y; yy: ð8Þ

If a firm in state y announces x, yðyyÞ and yy; which employees believe, the profit is:

Pðyy; yÞ ¼ ð1 � xÞyV ½yyxV þ lE� � E2=2 � yðyyÞ ð9Þ

By maximizing profit with respect to x, E and yy; subject to the incentive compatibility

requirement, we get the following proposition:

Proposition 3: Under money burning, the sharing rule is xMB ¼ ð1 � l2Þ=ð2 � l2

Þ; the

efforts of the employee and firm are respectively, eMB ¼ yV ð1 � l2Þ=ð2 � l2

ÞN and

EMB ¼ yVl=ð2 � l2Þ; and the profit to the firm is PMB ¼ ððy2

þ ð1 � l2Þy2

ÞV 2Þ=ð2ð2 � l2

Þ2Þ: The money burnt is yMB ¼ ðy2

� y2ÞV 2ð1 � l2

Þ=2ð2 � l2Þ2:

The sharing rule and the efforts by the firm and the employees do not change from the

full information scenario. It can be seen that PMB þ yMB ¼ PFI : Thus, there is a rather

large loss in profits from the full information scenario due solely to the necessity of

signaling to employees. Observe that when y is close to the actual value y, employees do

not need much convincing, the firm does not need to spend much money in signaling and

profits converge to the full information profit, PFI :

5. Comparison of Solutions

Based on these results, the following proposition follows from direct observation of the

profit expressions and provides a comparison of the profits in the three scenarios.

Proposition 4: Comparing the profits under the three scenarios, we obtain:

1. PFI > PMB except when y ¼ y or l ¼ 1 in which case PFI ¼ PMB.

2. PFI > PIM except when d ¼ 1 and l ¼ 1 in which case PFI ¼ PIM .

3. PIM ¼ PMB if d ¼ 1; y ¼ 0 and l ¼ 0 or l ¼ 1:4. PIM > PMB if

a. y ¼ 0 and d 2 ½1; dÞ where d ¼ 4=ð2 þ l� l2Þ2:

b. d ¼ 1 and y=y 2 ½0;mÞ where m ¼ lð4 � l� l2Þ=½ð1 þ lÞð2 � lÞ2�1=2:

The following points summarize the salient information from the proposition:

The full information scenario profit dominates the profits of the internal marketing and

money burning scenarios indicating that signaling is expensive.

When d ¼ 1; i.e., the first stage does not take much time, and l ¼ 1; PIM ¼

PMB ¼ PFI . When, d ¼ 1 and l ¼ 0; i.e., the firm can contribute no direct productive

effort, and y ¼ 0 the money burning solution generates identical results to the internal

marketing solution in every respect, with the cost of internal marketing to the firm being


of equal value to money burnt. However, if y > 0; i.e. if there is guaranteed positive

probability of rewards, the money burning solution does better than the internal

marketing solution in this case. As l increases from zero, internal marketing begins

to dominate money burning because it provides not only signaling value but also

productive value.

There is a problem with money burning that makes internal marketing a much better

option, ceteris paribus. If management spends a great deal of money unproductively, it is

unclear whether employees will get the correct signal or whether they will make

inferences regarding poor management and become demoralized.

In group activities, the amount of effort put in is less than socially optimal due to free

riding (Holmstrom, 1982). Some authors have examined the effectiveness of mutual

monitoring, peer pressure and group norms in reducing free-riding (Barron and Gjerde,

1997; Kandel and Lazear, 1992). Whereas mutual monitoring may mitigate the effect of

free-riding it is unlikely to eliminate it. In the Continental Airlines example, it is

unrealistic that a group at one airport can monitor a group at another airport or that flight

attendants can monitor baggage handlers; therefore complete mutual monitoring cannot

exist. Perhaps the simplest way to incorporate mutual monitoring into the present model

is by reducing N to N=n where n is the number of employee groupings that can engage

in mutual monitoring. The overall analytical results and intuition from the analysis

remain unchanged. Thus, the incentive scheme should be implemented despite free

riding taking place.

6. Conclusions

Communicating firm-wide objectives and motivating employees to achieve them remains a

challenging task for today’s managers. Continental Airlines overcame this challenge by

designing a successful firm-wide incentive program focusing on timely flight arrival and

departure. It may appear self-evident that on time flights increase customer satisfaction and

airline profitability. However, before the implementation of the profit sharing plan, flight

attendants would routinely hold up a full flight to allow catering to locate a few more meals

just to avoid a small shortage. The result was delay for a plane full of passengers for the

sake of meals that many passengers would have happily exchanged for on time arrival and

a free drink (Bethune and Huler, 1998).

We investigated three scenarios, full information, internal marketing, and money burn-

ing. Although the full information scenario yields the highest profit by saving on signaling

costs, the assumption that employees and management are equally informed about the

probability of success of a scheme is not realistic. Under the two asymmetric information

scenarios, internal marketing and money burning, the firm signals its information to the

employees that their efforts will produce the desired firm-wide objective.

The profit depends on several parameters, such as relative efficiency of effort, the

discount factor, and employees’ belief about the probability of success. Consequently, the

internal marketing solution is not always more profitable than money burning.


Before choosing their communication mechanism, management must understand a

number of key issues. For example, it must obtain a clear understanding of the probability

of success, y. Without this, their objective may fail to be achieved despite optimal

employee effort, causing a loss of trust between management and employees. Second,

management must have an idea of how managerial activity affects productivity through the

relative efficiency parameter. Understanding this parameter will help managers determine

the level of profit sharing that will optimize employee effort. Table 2 compares the model’s

predictions with Continental’s successful implementation.

An area for future research is to examine whether the results would be modified if there

were two types of effort; for example, effort towards improving on-time flight arrivals and

departures and effort towards reducing baggage-handling complaints. At present all types

of effort are considered identical in their cost and their effect on productivity.

Notes

1. Another interpretation of (1) may be given in keeping with the Continental case, that rewards of V accrue if a

certain target is met (such as being above average in on-time flight performance), or 0 if the target is not met.

Under this interpretation, the probability of the target being reached is given by yg(�). It then becomes

necessary to ensure that the probability yg(�) remains bounded in [0, 1], but without taking a non-linear

transformation that would significantly complicate the analysis. We can do this conceptually by dividing yg(�)

by a scalar M to normalize it, and adjusting M into V. The present analysis is unaffected.

Table 2. Comparisons of Model Results to Practice at Continental

Research Issue Model Results

Practice at Continental

(from Bethune and Huler, 1998)

(RI.1) Should an incentive

scheme be used?

As long as employees are relatively

more efficient in determining the

outcome, a profit sharing incentive

scheme is appropriate (Proof of FI

scenario in appendix.).

It was clearly understood that flight

timeliness was dependent on

employee action with little

role for management. A profit

sharing incentive scheme was used.

What signaling method

should be used?

Internal marketing and money

burning yield identical results if

l ¼ 0; and d ¼ 1 as is likely for the

Continental case (Prop. 4).

Internal marketing. The CEO and top

management spent a great deal of

time and effort with employees

to communicate their scheme.

(RI.1) What sharing rule

should be used?

Since l ¼ 0 and d ¼ 1;

the share is x¼ 1=2 (Prop. 2).

x¼ 1=2

(RI.2) How much effort

should be spent on

internal marketing?

DE ¼ ðy� yÞV=2 when l ¼ 0

and d ¼ 1 (Prop. 2).

Not precisely known, but stated as

initially large. In subsequent months,

employees were more confident about

receiving their share (i.e. y higher) and

management spent less effort

propagating the scheme, in line with

the analysis.


Acknowledgements

The authors thank Kissan Joseph, Barton Weitz and an anonymous reviewer for their

helpful suggestions.

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Appendix

Proof of Full Information Scenario

From (5) the firm’s objective is to maximize with respect to x and E the following profit

function:


ð1 � xÞyV ðxyV þ lEÞ � 12

E2 ða1Þ

The first order condition with respect to E is:

ð1 � xÞyVl� E � 0 c:s: E � 0 ða2Þ

where c.s. stands for the Kuhn-Tucker complementary slackness condition. Since the first

term on the LHS is non-zero, (a2) holds with equality, i.e., E ¼ lyV ð1 � xÞ: The first order

condition for x is:

yV ½ð1 � xÞyV � ðxyV þ lEÞ� � 0 c:s: x � 0 ða3Þ

The second order condition for maxima is that the Hessian be negative definite requiring

ð�1Þð�2y2V 2Þ � ð�lyV Þ

2 > 0; which is satisfied if l2 < 2: Supposing this is so, solving

(a2) and (a3) simultaneously yields:

if l2 > 1 then x ¼ e ¼ 0;E ¼ lyV ; P ¼ l2y2V 2=2: ða4Þ

if l22 ½0; 1� then x ¼

ð1 � l2Þ

ð2 � l2Þ; e ¼

yV ð1 � l2Þ

ð2 � l2ÞN

;

E ¼yVl

ð2 � l2Þ

and P ¼y2

V 2

2ð2 � l2Þ: ða5Þ

Proof of Internal Marketing Scenario

The objective function to be maximized with respect to x and DE is:

PIM ¼ dð1 � xÞyV ½ðyþ f ðDEÞÞxV þ lE� � 12

E2 ðb1Þ

The first order condition for x gives:

x ¼ 12� lE=2ðyþ f ðDEÞÞxV ðb2Þ

The first order condition for DE gives:

dð1 � xÞyV ½ f 0ðDEÞxV þ l� � E ¼ 0 ðb3Þ

This implies:

y ¼ E=dð1 � xÞV ½ f 0ðDEÞxV þ l� ðb4Þ


Given truth telling, the LHS above must be yþ f ðDEÞ: In (b4), replacing y by

yþ f ðDEÞ and E by EbaseðyÞ þ DE results in a differential equation that can be solved

for DE.

yþ f ðDEÞ ¼ ½EbaseðyÞ þ DE�=dð1 � xÞV ½ f 0ðDEÞxV þ l� ðb5Þ

To solve this differential equation, observe that a solution of the following form will work:

f ðDEÞ ¼ kDE ðb6Þ

where, k is a constant to be determined. By substituting (b6) into (b5) the value of k is

found.

k ¼1

2xV�lþ

ffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffil2

þ4x

dð1 � xÞ

s" #ðb7Þ

Thereafter, using (b2), and noting that from (b4) we can express the ratio y=V as a

function of k alone, the solution for x is obtained:

x ¼1

2�

xl

½�lþffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffiffil2

þ 4x=dð1 � xÞ

q�

ðb8Þ

Equation (b8) can be explicitly solved for x. The following solution is obtained after a

few intermediate steps:

xIM ¼ ð1 � lffiffiffid

pÞ=ð2 � l

ffiffiffid

pÞ ðb9Þ

From (b2) the value of E can be obtained directly:

E ¼ Vyð1 � 2xÞ=l ðb10Þ

and substituting x from (b9) yields

EIM ¼ yVffiffiffid

p=ð2 � l

ffiffiffid

pÞ ðb11Þ

From (b6), noting that f ðDEÞ y� y ¼ kDE we get

DE ¼ ðy� yÞ=k ðb12Þ

From equation (5) that e ¼ xyV=N ; we substitute the value of x to obtain

eIM ¼ yV ð1 � lffiffiffid

pÞ=ð2 � l

ffiffiffid

pÞN ðb13Þ


Finally, second order conditions are verified, and substituting all values into (b1)

PIM ¼ dy2V 2=2ð2 � l

ffiffiffid

pÞ2

ðb14Þ

Proof of Money Burning Scenario

We have from equation (4) that effort e exerted by employees depends on x and yy:

e ¼ xyyV=N ðc1Þ

If, when the real state is y, the firm announces x, yðyyÞ and yy; which is believed, the

expected profit is:

Pðyy; yÞ ¼ ð1 � xÞyV ½yyxV þ lE� � 12

E2 � yðyyÞ ðc2Þ

This is to be maximized by the firm with respect to E, x and yy: We get, as in the proof to

Proposition 1:

E ¼ yVlð1 � xÞ ðc3Þ

x ¼ ð1 � l2Þ=ð2 � l2

Þ ðc4Þ

For yy the following condition is obtained:

ð1 � xÞyVxV � y0ðyyÞ ¼ 0 ðc5Þ

For the claim to be believed, the yy satisfying the first order condition must be set to equal

to y, in other words, y ¼ arg maxyy Pðyy; yÞ: This is the required incentive compatibility

condition for truth telling: Pðy; yÞ �Pðyy; yÞ � 0 for all y; yy: Then condition (c5) is a

differential equation that can be solved to yield the appropriate y(y):

y ¼

Zyy

xð1 � xÞV 2ydy ¼ ðy2� y2

Þxð1 � xÞV 2=2 ðc6Þ

To see if the solution is a maximum we evaluate the Hessian. The terms

@2P=@E2; @2P=@x2; @2P=@yy2; evaluated at their solution points are respectively �1,

�2y2V2 and �ð1 � l2Þ=ð2 � l2

Þ2 which are all negative. We have shown, in the proof of

Proposition 1, @2P=@E2 @2P=@x2 � ð@2P=@E@xÞ2 > 0: The third principal minor can be


calculated to be �y2V 2ð1 � l2

Þ=ð2 � l2Þ; which is unambiguously negative. The required

condition for maxima is therefore satisfied.

The expected profit can now be calculated.

PMB ¼ y2V 2=2ð2 � l2

Þ � ðy2� y2

ÞV 2ð1 � l2Þ=2ð2 � l2

Þ2

) PMB ¼ ½y2þ ð1 � l2

Þy2�V 2=2ð2 � l2

Þ2

ðc7Þ


Documents

Internal Marketing at Continental Airlines: Convincing Employees that Management Knows Best