Unbundling of Ancillary Service: How Does Price Discrimination of Main Service Matter?

Many firms provide ancillary services in addition to a main service to enhance the experience of consumers. Consumers need to purchase the main service in order to consume the ancillary service. For example, when taking a flight, consumers may need to transport bags or have a meal during the flight; when staying at a hotel, consumers may have breakfast or need internet connection. Ancillary revenue has become an important source of revenue generation in several industries. For example, according to IdeaWorksCompany (2015), airline ancillary revenue was $59.2 billion worldwide in 2015, which increased by 163% from the 2010 figure of $22.6 billion; $36.7 billion came from paid services such as onboard sales of food and beverage, checked baggage, premium seat assignment, and early boarding benefits; $22.5 billion came from non-fee activities such as sales of frequent flier miles to program participants and commissions earned on the sales of services such as hotel accommodations and car rentals. Hotels are also following the ancillary success from airlines. According to EyeforTravel (2015), over 50% of hotels made ancillary revenue a priority for 2015; in fact, 60% of hotels were already seeing ancillary services contributing 10% to total revenue, and nearly a third were seeing a 25% revenue increase because of ancillary services.

In many industries, consumers are heterogeneous in both their valuations for the main service and their valuations for the ancillary service, and firms may use one or more levers to extract consumer surplus. Firms in certain industries are more mature in using price discrimination for the main service. For example, whereas it is common airline practice that business travelers and leisure travelers pay different rates for the same type of seats, discriminatory pricing of room rates is not as common in hotel practice. For price discrimination to be feasible, the firm needs to be able to identify market segments and also needs to have the power to enforce the price discrimination scheme. In travel industries, the most important characteristic of market segmentation is that business travelers are more schedule-sensitive but less price-sensitive, while leisure travelers are less schedule-sensitive but more price-sensitive. Ideally the firm wants to charge higher prices to business travelers by using revenue management techniques. However, the use of revenue management is far less advanced in hotels compared to airlines. A 2015 survey conducted by EyeforTravel showed that only 20% of the 218 hotel and resort revenue managers who were surveyed had implemented a revenue management system (RMS).

At the same time, firms also want to extract more surplus from consumers by unbundling certain ancillary services and charging for them separately, while bundling other ancillary services and including their prices into the main service price. The decision of whether to unbundle or bundle the ancillary service depends on the demand attributes of the ancillary service, and is also affected by how efficiently the firm extracts consumer surplus using another lever—main service price discrimination.

In Cui et al. (2018), we investigate the interaction between the unbundling strategy of ancillary service and the firm’s use of main service price discrimination. Since the extent to which main service price discrimination is used differs across industries, we consider two types of firms: firms that do not price discriminate when selling the main service (the firm charges the same main service price to all consumers), and firms that price discriminate when selling the main service (the firm charges different main service prices to different consumer segments). For each type of firm, we study whether it is more profitable to unbundle or bundle the ancillary service. By comparing the results, we develop insights into how the firm’s ability to price discriminate when selling the main service affects its optimal ancillary unbundling strategy.

We find that for a firm that does not price discriminate when selling the main service, it is optimal to unbundle the ancillary service if a large enough fraction of consumers who highly value the main service also value the ancillary service. This suggests that this type of firm should charge for ancillary services that involve high correlations between consumers’ main service valuations and ancillary service valuations, and provide free ancillary services that involve low correlations. For example, hotels usually charge for use of the conference room (which is more frequently valued by business travelers) but do not charge for access to the swimming pool (which is more frequently valued by leisure travelers). Similarly, event (concerts, sports games) organizers usually charge additional prices for priority access to the venue and ancillary “VIP treatments” (e.g., limo service, alcoholic drinks), because the consumers who have higher intrinsic valuations for the event are more likely to value entering the venue earlier and request VIP services in a concert.

By contrast, for a firm that price discriminates when selling the main service, it is optimal to unbundle the ancillary service if a small enough fraction of consumers who highly value the main service also value the ancillary service. We find that this type of firm should charge for ancillary services that are valued by a small fraction of consumers, and provide free ancillary services that are valued by a large fraction of consumers. For example, airlines usually charge for in-flight meal service for domestic and short-haul international flights (which is needed by a small fraction of passengers) but offer complimentary meal service for long-haul international flights (which is needed by the majority of passengers). Similarly, conference organizers usually bundle ancillary services that are valued by most attendees (e.g., general reception) and unbundle ancillary services that are valued by a small fraction of attendees (e.g., special interest group events).

Therefore, when a firm starts to adopt price discrimination for the main service, it is important to reevaluate the ancillary unbundling strategy. If the firm is managing an ancillary service that involves a high correlation between consumers’ main service valuations and ancillary service valuations, a shift from unbundling to bundling may be needed. If the ancillary service involves a low correlation, a shift from bundling to unbundling may be needed. Firms in several industries, such as event organizers and hotels, are trying to implement price discrimination for their main service. Along with the adoption of main service price discrimination, it is important for these firms to identify which of their consumer segments values the ancillary service higher and adjust the ancillary unbundling strategy accordingly.

 

References

Cui Y, Duenyas I, Sahin O (2018) Unbundling of ancillary service: How does price discrimination of main service matter? Manufacturing Service Operations Management 20(3):455–466.

EyeforTravel (2015) 10 recommendations to get ancillary revenues rolling in 2015. Accessed June 26, 2016, http://www.eyefortravel.com/revenue-and-data-management/10-recommendations-get-hotel-ancillary-revenues-rolling-2015.

IdeaWorksCompany (2015) Airline ancillary revenue projected to be $59.2 billion worldwide in 2015. Press release (November 9), IdeaWorksCompany, Shorewood, WI, http://www.ideaworkscompany.com/wp-content/uploads/2016/04/Press-Release-103-Global-Estimate.pdf.

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