A Hidden Markov Model of Customer Relationship Dynamics

This research models the dynamics of customer relationships using typical transaction data. Our proposed model permits not only capturing the dynamics of customer relationships but also incorporating the effect of the sequence of customer-firm encounters on the dynamics of customer relationships and the subsequent buying behavior. Our approach to modeling relationship dynamics is structurally different from existing approaches. Specifically, we construct and estimate a nonhomogeneous hidden Markov model to model the transitions among latent relationship states and effects on buying behavior. In the proposed model, the transitions between the states are a function of time-varying covariates such as customer-firm encounters that may have an enduring impact by shifting the customer to a different (unobservable) relationship state. The proposed model enables marketers to dynamically segment their customer base and to examine methods by which the firm can alter the long-term buying behavior. We use a hierarchical Bayes approach to capture the unobserved heterogeneity across customers. We calibrate the model in the context of alumni relations using a longitudinal gift-giving dataset. Using the proposed model, we are able to probabilistically classify the alumni base into three relationship states and estimate the effect of alumni-university interactions, such as reunions, on the movement of alumni between these states. Additionally, we demonstrate improved prediction ability on a hold-out sample