[Sponsored Article] Add-on Policies under Vertical Differentiation: Why Do Luxury Hotels Charge for Internet while Economy Hotels Do Not? LIN, Song Marketing Science, Articles in Advance, pp1-16, 2017 Hotels, like any businesses, are motivated by profit. But a strange pattern has emerged when it comes to low-cost amenities such as Internet services. One survey found only 54 per cent of luxury hotels offered free Internet compared to 91 per cent of budget hotels. As Song Lin points out, this phenomenon seems counterintuitive and has not been explained satisfactorily by standard economic theory. “There are two seemingly inconsistent explanations. On the one hand, many embrace the view that luxury hotels charge for Internet ‘because they can’, meaning either because the consumers do not know about the charge before they book the room or because there is heterogeneity in consumers’ sensitivity to price. On the other hand, there is the argument that lower-end hotels offer the service for free to differentiate themselves. Neither of the arguments alone can consistently explain the disparate behaviour by the high-end and low-end hotels. I argue that these views can be unified through the idea of vertical differentiation between competitors,” he said. By this, Lin means that hotels not only compete with other hotels of the same quality but also of different quality, such as a four-star hotel versus a three-star hotel. There will be cross-over customers over whom they will compete. “With competitive pressure from a lower-quality rival, a higher-quality hotel faces a more elastic demand downward and thus tends to lower its room rate to attract more price-sensitive consumers. Since these consumers are less interested in paying extra for Internet service, the higher-quality hotel can charge a high Internet price to the other customers who are less price-sensitive. However, the consumers who do not pay that extra price are more valuable to the lower-quality hotel, which offers a low Internet price to appeal to them – as low as free of charge,” he said. Lin develops these ideas into a theoretical model that suggests higher-quality firms will want to sell an optional add-on, such as Internet service and local calls, to practice price discrimination under the presence of a lower-quality rival. But lower-quality firms have to trade-off discrimination and differentiation, resulting in an add-on policy more sensitive to the cost-to-value ratio. When the cost-to-value ratio is sufficiently low, the low-quality firms will prefer to not sell the add-on as optional – in other words, to offer it for free. This model was tested and confirmed using survey data from 25,179 American hotels from 2006 to 2013. Lower-end hotels were more likely to offer free Internet and local call services than higher-end ones. Moreover, the results were likely conservative because some higher-end hotels offered free Internet for basic services such as email, but charged for high-speed Internet. “Optional add-ons can intensify price competition over consumers who trade off a higher-quality base product versus a lower-quality base including an add-on. Hence, higher-quality firms are incentivised to commit to bundling, while lower-quality firms prefer to commit to not selling the add-on.” “Add-ons can further reduce lower-quality firms’ profits if consumers cannot observe the prices because this hold-up encourages consumers to switch to higher-quality rivals. This gives the lower-quality firms an incentive to advertise add-on prices, but not higher-quality firms to do so,” he said. The findings have broad implications for other industries that also offer add-ons and face vertical competition, such as cruise, airline, apartment rental, car rental, consumer electronics, and so on. “Marketing managers should evaluate add-on policies based on the positioning of the base good in the market and the cost and value nature of the add-on. They should be cautious regarding the negative impact of an optional add-on policy on long-term profitability under competition,” Lin concluded.