Add-On Policies Under Vertical Differentiation: Why Do Luxury Hotels Charge for Internet Whereas Economy Hotels Do Not?

Abstract

This paper examines firms' product policies when they sell an add-on (e.g., Internet service) in addition to a base product (e.g., hotel rooms) under vertical differentiation (e.g., four- vs. three-star hotels). I show that the role of an add-on differs; higher-quality firms prefer to sell it as optional to discriminate consumers, and lower-quality firms trade off discrimination and differentiation, trying to lower the add-on price to lure consumers from higher-quality rivals. In equilibrium, lower-quality firms' policies are more sensitive to the cost-to-value ratio of an add-on. If the ratio is sufficiently small, firms sell it to all consumers, potentially explaining why lower-end hotels are more likely than higher-end ones to offer free Internet service. Contrary to consensus in the literature, 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 incentivized to commit to bundling, while lower-quality firms prefer to commit to not selling it. Add-ons can further reduce lower-quality firms' profits if consumers do not observe the prices because holding up consumers ex post encourages them to switch to higher-quality rivals, which then become better off. Therefore, lower-quality firms are incentivized to advertise add-on prices, and higher-quality firms are not.