Pricing of Conditional Upgrades in the Presence of Strategic Consumers

Abstract

In this paper, we study a conditional upgrade strategy that has recently become common in the travel industry. After a consumer makes a reservation for a product (e.g., a hotel room), she is asked whether she would like to upgrade to a higher-quality (more expensive) one at a discounted price. The upgrade, however, is not fulfilled immediately. The firm fulfills upgrades at check-in if higher-quality products are still available, and the upgrade fee is only charged to the consumer if she gets upgraded. Consumers decide which product type to book and whether to accept an upgrade offer based on the anticipated upgrade probability. We model the consumers' decisions using a Poisson-arrival game framework with incomplete information and prove the existence of Bayesian Nash equilibrium. To further study the firm's optimal upgrade pricing strategy,we also analyze a fluid model which is the asymptotic version of the stochastic model. Our numerical studies validate that our theoretical results derived from the fluid model carry through to the stochastic model.

Our analysis identifies multiple benefits of conditional upgrades. First, the firm is able to capture more demand by offering conditional upgrades, Second, conditional upgrades enable the firm to improve its market segmentation by inducing more consumers to purchase higher-quality products. Third, conditional upgrades give the firm more flexibility in better matching fixed capacities to stochastic demands. For a firm that has the ability to optimize product prices, conditional upgrades can generate higher revenues than dynamic pricing.