Add-on Policies under Vertical Differentiation: Why Do Luxury Hotels Charge for Internet Whereas Economy Hotels Do Not?
Mr. Song LIN
Sloan School of Management
Massachusetts Institute of Technology
That higher-end hotels are more likely than lower-end hotels to charge for Internet service is a seemingly counter-intuitive phenomenon. Why does it persist? Solving this puzzle sheds light on product policy decisions for firms selling an add-on to a base good: Should they sell the add-on as optional, or sell it as standard, or not sell it?
I propose that vertical differentiation plays a role, and show that the role of an add-on may be different for vertically differentiated firms. A firm with higher base quality sells an add-on as optional so that less-price-sensitive consumers self-select to buy the high-priced add-on. Although a lower-quality firm also has an incentive to screen consumers, it is incentivized to lower its add-on price to lure consumers who may buy the higher-quality base good without the add-on. This trade-off renders its policy sensitive to the cost of providing the add-on. When the cost is small, the lower-quality firm sells the add-on as standard, whereas the higher-quality firm sells it as optional. Using a dataset on hotel Internet policies, I find supporting evidence for the theory. Surprisingly, the theory predicts that selling an optional add-on intensifies competition, in sharp contrast to standard conclusions found in the literature. As a result, firms have an incentive to commit to not to sell the add-on as optional.