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

This paper examines firms' product policies when they sell an add-on (Internet service) to a base good (hotel rooms) under vertical differentiation (four- vs. three-star hotels). Theoretical analysis uncovers the differential roles of add-ons for vertically differentiated firms. A firm with higher base quality always sells an add-on as optional so that higher-taste consumers self-select to buy it. This incentive to price discriminate applies to a lower-quality firm who, however, has to lower the add-on price to lure consumers considering the higher-quality base good without the add-on. If providing the add-on is not costly, the lower-quality firm may sell it as standard. This equilibrium potentially explains the puzzle that lower-end hotels are more likely than higher-end ones to offer free Internet service. Empirical examination of a sample of hotels that are likely to be in a monopoly or vertical duopoly market provides suggestive evidence for this prediction. Surprisingly, an optional add-on can intensify competition, in contrast to standard conclusions in the literature. If both firms sell an optional add-on, they will price aggressively to compete for consumers who trade off the higher-quality base versus the lower-quality base good plus the add-on. Although selling the add-on as optional is unilaterally optimal, equilibrium profits may reduce - a Prisoner's Dilemma outcome.