Ms. McGuire, PhD

Revenue Management

Price Fairness: How to maximize revenues without gouging the guest

By Kelly McGuire, PhD, Director of Hospitality & Travel Global Practice, SAS, Institute

It is clear that revenue management practices can help hotels increase revenue, but successful revenue management counts on consumers being willing to pay different prices for essentially the same product, based on the hotel’s expectation of demand. Hotel managers have good reason to be concerned about negative consumer reaction to demand-based pricing. Research has shown that consumers will punish firms that they perceive to be acting unfairly in their pricing strategies by refusing to patronize them in the future(i). So, how can hotels balance the risk of negative consumer reactions with the benefits of variable pricing?

In a previous article in the HotelExecutive.com June 2011 Feature Focus series on 'Revenue Management: Maintain Rates & Avoid Price Wars', I alluded to research in my article "Private vs. Public Rates: How to Discount Without Starting a Price War" that provides advice for structuring pricing practices to minimize negative consumer reaction, while allowing the hotel to take advantage of revenue generating opportunities. The underlying theory about consumers’ reactions to pricing practices comes from Behavioral Economics, which is a branch of economics where researchers use social, cognitive and emotional factors to understand the economic decisions of individuals and institutions. These economists have determined the factors that influence consumer reaction to pricing practices and developed theories to explain consumer behavior in financial decision making. I’ll apply this theory to the revenue management pricing problem, and give some tips for hotel managers to avoid negative consumer reactions to pricing strategies.

Principle of Dual Entitlement

Consumers believe that they are entitled to a reasonable price, but that firms are also entitled to a reasonable profit(ii). They understand that the airlines may have to raise ticket prices when fuel prices increase or restaurants may have to charge more for lettuce when there is a drought in California. These are considered necessary for firms to maintain that “reasonable” profit. However, they react negatively to firms who try to take actions that result in “unreasonable” profits, seeing these as firms unfairly taking advantage of consumers. For example, raising the price of snow shovels during a major snow storm, or raising the price of a coke with the outdoor temperature would be considered “unreasonable” profit seeking.

Dual entitlement is the most dangerous principle for hoteliers that are looking to maximize revenue. Any unexplainable price increases run the risk of violating consumers’ sense of a “fair profit”, resulting in perceptions of price gouging. Hoteliers can combat this by providing a reasonable justification for any price that the consumer is asked to pay. In revenue management terms, this means creating rate fences, which offer consumers discounted prices but impose rules and regulations at each level of discount to balance the perceived value for the different market segments(iii). For example, the ability to cancel without penalty has value for a business traveler, but not for a leisure traveler who is less likely to cancel. The leisure traveler pays a lower price, but must pay ahead. To be perceived as fair, the fences need to be logical, transparent, upfront and fixed so that they cannot be circumvented.

Reference Price

A reference price is what the consumers expect to pay for a product or service, based on their own experience or what they hear from other consumers. The reference price is not based on any objective measures, simply what they consider “normal” based on their own experience(iv). They will compare any future prices they see to this reference price. If the current price is too high when compared to the reference price, they will consider the price unfair. While reference prices can change over time, the more exposure the consumer has to a reference price, the stronger that reference price becomes.

Reference price is why hotels find it so difficult to raise prices after long periods of deep discounting. The discounted price becomes the consumers’ reference price, and they will compare all future prices to that reference. If hotels raise prices too drastically, or too quickly, the consumers’ reference price expectation is violated, and they feel the firm is trying to take advantage of them. They will book with a competitor whose pricing is closer to their expectations.

Hotels need to be very careful about how and where they publish discounted rates, as the longer and more widely available these rates, the more likely they are to become the reference price. Rate fences and private rates can help maintain the reference price while generating needed revenue. Another way to get around the reference price is to obscure it by packaging the product with add on services that the consumer might not be familiar with. This could be spa treatments, meals, in-room amenities, theater tickets or internet access. These elements change the basic product such that consumers cannot rely as heavily on their previous experience for value judgments.

Prospect Theory

Prospect Theory describes decisions between alternatives when the decisions involve some risk (like financial decisions)(v). Researchers in this area evaluated how consumers make these decisions, and found that they don’t always behave rationally (in pure economic terms). For example, consumers always respond more positively to a gain over a loss, even when the economic value is exactly the same.

Therefore, price differences should always be framed as a discount as opposed to a surcharge (think about how you would react to a young person’s surcharge as opposed to a senior citizen’s discount). So, it costs $50 less to book ahead of time, rather than $50 more to walk in.

Familiarity

Perceived fairness of pricing practices increases as consumers become more familiar with these practices(vi). Practices that initially seem unfair may become more acceptable over time because consumers become accustomed to them.

The good news for hoteliers is that consumers’ are becoming quite familiar with revenue management pricing practices and consider them to be fair and acceptable(vii). As revenue management has become commonplace in hotels, and with the help of campaigns like Expedia’s Unpublished Rates commercial featuring Pauley Perrette, consumers are becoming well-educated in variable pricing practices.

Familiarity, Brand Class and Information

Taylor and Kimes’ 2010 study on perceived fairness in hotel pricing(viii) showed that familiarity was the most important factor affecting the perceived fairness of pricing practices. They also looked at the role of brand class (three, four or five star), and found that class did not influence perceived fairness at all. This is great news for luxury hotel managers who have been concerned that variable pricing might damage their brand perception. The final finding from that study was that information was important in fairness perceptions. However, it is not enough to just let customers know that hotel rates vary, they need information on the factors that will influence the rate changes (such as day of week, length of stay, advanced purchase)(ix).

Based on our brief lesson in Behavioral Economics, here are six tips that hoteliers can use to ensure their pricing strategies do not result in negative reactions from customers:

1. Have confidence. All signs are pointing to consumers accepting variable pricing practices in hotels without negative consequences, so routine revenue management actions are likely very safe. You should be careful about how you introduce dramatic changes or new programs, however.

2. Discounts, not surcharges. Whenever possible, frame pricing as discounts rather than surcharges. You get a reduced rate if you book ahead of time, take a room without a view or pay in advance.

3. Build logical rate fences. Rate fences help you ensure limited access to discounts, but also protect you from unfairness perceptions. 21 day advanced purchase, association memberships, room locations or amenities are all good ways to build incremental business without risking negative reactions.

4. Protect the reference price. Avoid making discounts widely available, or publishing them extensively over time. The more exposure the general public has to a discount, the more likely it will become the reference price, and you’ll have difficulty raising your price when conditions warrant. Use rate fences, such as private channels, to help protect the reference price.

5. Hide the core product. If you fear that the reference price for the consumer is lower than you’d like, bundle the core product with add-on services that provide value, but change the offering.

6. Be Transparent. Provide as much information as possible to your consumers about your pricing strategy. Train your staff to remind the consumers why they are paying the price they are paying. This will help not only with fairness perceptions in the short term, but to build familiarity over time, leading to even greater acceptance.

7. Read some of the references in this article to learn more. Ok, I said six tips, but if you are interested in learning more, all of the references listed below are really good places to start. I also highly recommend Dan Ariely’s book “Predictably Irrational” as a very accessible overview of research in behavioral economics.

References:

i. D. Kahneman, J.L.Knetch and R.H. Thaler (1986) “Fairness and the Assumption of Economics” Journal of Business, Vol 59 pp. S285-S300
R.H. Thaler, (1985) “Mental Accounting and Consumer Choice,” Marketing Science, Vol. 4, No. 3, pp. 199-214
ii. Kahneman, Knetch and Thaler op. cit and Thaler op. cit
iii. R.B. Hanks, R.P. Noland, and R.G. Cross, (1992) “Discounting in the Hotel Industry: A New Approach,” Cornell Hotel and Restaurant Administration Quarterly, Vol. 33, No. 3, pp. 40-45
iv. Kahneman, Knetch and Thaler op. cit and Thaler op. cit
v. Kahneman, Daniel, and Amos Tversky (1979) "Prospect Theory: An Analysis of Decision under Risk", Econometrica, XLVII, 263-291
vi. Campbell, Margaret C. (1999b), “Perceptions of Price Unfairness: Antecedents and Consequences,” Journal of Marketing Research, 36 (2), 187-199
vii. S.E. Kimes and B.M. Noone, (2002) “Perceived Fairness of Yield Management: An Update,” Cornell Hotel and Restaurant Administration Quarterly, Vol. 43, No. 1, pp. 28-29.
viii. Wayne J. Taylor and Sheryl E. Kimes (2010) “How Hotel Guests Perceive the Fairness of Differential Room Pricing,” Cornell Hospitality Report Vol. 10, No. 2
ix. Choi, S., & Mattila, A. s. (2005, November). Impact of Information on Customer Fairness Perceptions of Hotel Revenue Management. Cornell Hotel and Restaurant Administration Quarterly, 46(4), 444-451.

Kelly McGuire leads the Hospitality and Travel Global Practice for SAS, Institute. In this role, she is responsible for driving the offering set and setting strategic direction for the practice. Before taking on this role, she was the industry marketing manager for Hospitality and Gaming at SAS. Ms. McGuire works with product management, sales and R&D to ensure that SAS solutions meet the needs of the market. She is responsible for the outbound messaging regarding SAS’s Hospitality and Travel capabilities, particularly in the areas of revenue management and price optimization. Ms. McGuire works closely with IDeaS Revenue Solutions, a SAS company, helping to integrate IDeaS revenue management solution with SAS’s marketing solutions. Ms. McGuire, PhD can be contacted at 607-216-5800 or Kelly.McGuire@sas.com Extended Bio...

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