By Cathy EnzHotelNewsNow.com columnist
Playing the pricing game can be a challenging task. According to game theory, originally developed in the 1940s by two Nobel Prize winning academics, success depends on knowing how to play the right game. One key to success in any game is to look forward and then reason backward to figure out the best action to take today, considering what your competition might do tomorrow. This perspective requires you, as a strategic thinker, to get in the head of your competitors and consider how they’re likely to play the game. Let’s look at a simple hotel-pricing game.
Assume we have two 100-room, limited-service hotels in direct competition, each with 3,000 rooms available for sale in the month of April (100 rooms X 30 days = 3,000 rooms available). The managers of the two hotels are trying to determine whether discounting will result in more net operating income for the hotel. The ADR for this segment was US$86.09, and the occupancy was 57.9 percent during the week of 22 March 2009, according to the STR Weekly Hotel Review.
Suppose each hotel has current ADR of US$86 and occupancy of 58 percent. Let’s also assume the hotels are in close proximity and have the same amenities. Additionally, they both have operating costs of US$40 per occupied room (this includes distributed and undistributed operating costs based on the 2008 STR Host survey). If each hotel is priced at its current ADR of US$86, given the US$40 operating costs and occupancies of 58 percent, each hotel would have a net operating income of US$80,040 [(US$86 – US$40) X (3,000 x 0.58)] in April.
Discounting by one competitor (win-lose)
The manager of Hotel A wants to lower prices to gain occupancy and is considering dropping rate to US$80 for the next month. If Hotel B keeps its rate the same, let’s assume Hotel A, the discounter, gains an additional 300 occupied rooms—240 rooms stolen from Hotel B and 60 rooms from new customers attracted by the lower rate. Hotel A now has occupancy of 68 percent, while Hotel B has occupancy of 56 percent. In this scenario, Hotel A has net operating income of US$81,600 [(80-40) x (3,000 X .68)]. The net operating income for Hotel B dropped to US$69,000 [(86-40) x (3,000 X .56)]. Although Hotel A has benefited from this discounting strategy for the month of April, it’s likely the manager of Hotel B also will drop price to gain occupancy and reduce the loss of income.
Both hotels discount (lose – lose)
Hotel B has lost occupancy and net operating income because of its competitor’s moves, and the most logical move is for the manager of Hotel B to drop price also. Looking at this likely move, if both hotels decide to discount their rates to stimulate demand by each dropping their price to US$80, the stealing of occupancy is a wash, and both hotels might gain 60 occupied rooms from new customers attracted by the lower rates. In this scenario, both hotels will have lower net operating income than had they maintained rate integrity. Net operating income for both hotels is now US$72,000 [(80-40) X (3,000 x .60)], assuming the market share steal is a wash, and they each raise occupancies to 60 percent because of more demand from new customers.
In game theory, we can create a payoff matrix (see below) that provides the net operating income (hence payoffs) for each hotel. The payoff for Hotel A is in the northeast corner of each box, and the payoff for Hotel B is in the southwest corner of the box. If we compare the payoff pairs, we begin to understand the dilemmas operators face when discounting relative to their comparative sets.
Playing the pricing game can be a challenging task. According to game theory, originally developed in the 1940s by two Nobel Prize winning academics, success depends on knowing how to play the right game. One key to success in any game is to look forward and then reason backward to figure out the best action to take today, considering what your competition might do tomorrow. This perspective requires you, as a strategic thinker, to get in the head of your competitors and consider how they’re likely to play the game. Let’s look at a simple hotel-pricing game.
Assume we have two 100-room, limited-service hotels in direct competition, each with 3,000 rooms available for sale in the month of April (100 rooms X 30 days = 3,000 rooms available). The managers of the two hotels are trying to determine whether discounting will result in more net operating income for the hotel. The ADR for this segment was US$86.09, and the occupancy was 57.9 percent during the week of 22 March 2009, according to the STR Weekly Hotel Review.
Suppose each hotel has current ADR of US$86 and occupancy of 58 percent. Let’s also assume the hotels are in close proximity and have the same amenities. Additionally, they both have operating costs of US$40 per occupied room (this includes distributed and undistributed operating costs based on the 2008 STR Host survey). If each hotel is priced at its current ADR of US$86, given the US$40 operating costs and occupancies of 58 percent, each hotel would have a net operating income of US$80,040 [(US$86 – US$40) X (3,000 x 0.58)] in April.
Discounting by one competitor (win-lose)
The manager of Hotel A wants to lower prices to gain occupancy and is considering dropping rate to US$80 for the next month. If Hotel B keeps its rate the same, let’s assume Hotel A, the discounter, gains an additional 300 occupied rooms—240 rooms stolen from Hotel B and 60 rooms from new customers attracted by the lower rate. Hotel A now has occupancy of 68 percent, while Hotel B has occupancy of 56 percent. In this scenario, Hotel A has net operating income of US$81,600 [(80-40) x (3,000 X .68)]. The net operating income for Hotel B dropped to US$69,000 [(86-40) x (3,000 X .56)]. Although Hotel A has benefited from this discounting strategy for the month of April, it’s likely the manager of Hotel B also will drop price to gain occupancy and reduce the loss of income.
Both hotels discount (lose – lose)
Hotel B has lost occupancy and net operating income because of its competitor’s moves, and the most logical move is for the manager of Hotel B to drop price also. Looking at this likely move, if both hotels decide to discount their rates to stimulate demand by each dropping their price to US$80, the stealing of occupancy is a wash, and both hotels might gain 60 occupied rooms from new customers attracted by the lower rates. In this scenario, both hotels will have lower net operating income than had they maintained rate integrity. Net operating income for both hotels is now US$72,000 [(80-40) X (3,000 x .60)], assuming the market share steal is a wash, and they each raise occupancies to 60 percent because of more demand from new customers.
In game theory, we can create a payoff matrix (see below) that provides the net operating income (hence payoffs) for each hotel. The payoff for Hotel A is in the northeast corner of each box, and the payoff for Hotel B is in the southwest corner of the box. If we compare the payoff pairs, we begin to understand the dilemmas operators face when discounting relative to their comparative sets.
Net operating income payoff matrix for price discounting
the net operating income in the payoff matrix shows, Hotel A can obtain a temporary benefit from discounting so long as Hotel B keeps its price high. If Hotel B matches the cuts of Hotel A, then both hotels will lose profit (US$8,040) establishing a new lower price point for both competitors. The unfortunate consequence of this price war is that both competitors lose. If both had maintained rate integrity, they both would have higher income. The effort to discount is most likely to result in a response from the hotel faced with a win-lose situation, resulting in everyone losing. This is a classic prisoner’s dilemma. While both hotels do poorly when they price at US$80, it’s easy to see how this decision is the most rational when faced with a competitor that lowers their price and grabs occupancy.
This simple example derived from game theory using payoff matrices helps illustrate that hoteliers in difficult times must be careful to not create win-lose competitive situations that provide temporary advantage but then lead to the only logical course of action for a competitor—a reduction in their rate, resulting in a lose-lose outcome.
This simple example derived from game theory using payoff matrices helps illustrate that hoteliers in difficult times must be careful to not create win-lose competitive situations that provide temporary advantage but then lead to the only logical course of action for a competitor—a reduction in their rate, resulting in a lose-lose outcome.
