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 (e.g., Internet service) in addition to a base product (e.g., hotel rooms) under vertical differentiation (e.g., four‐ versus 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 lure consumers from higher‐quality rivals with a lower‐price add‐on. Equilibrium policies of lower‐quality firms are more sensitive to the cost‐to‐value ratio of an add‐on. If the ratio is sufficiently small, then they 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 cannot 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. The online appendix is available at https://doi.org/10.1287/mksc.2017.1028.