Why Economic Theory Does Not Work

I have mentioned here before how unrealistic economic theory is — in particular, how business has to avoid competitive pressures when faced with a high fixed-cost structure. This study describes how the hotel industry lets rooms remain vacant, even when the price would be higher than the marginal cost.

Kalnins, Arturs. 2006. “The U.S. Lodging Industry.” Journal of Economic Perspectives, 20: 4 (Fall): pp. 203-18.

214: “A hotel faced with the prospect of empty rooms has an incentive to start trimming prices. Hotels may find this incentive especially strong because most lodging guests pay a substantial premium over the hotel’s marginal cost per room. Yet hotels may ignore this incentive if cooperation or (tacit or explicit) collusion are the norm in their market. According to a popular hotel management text, the difference in cost between an occupied room and an empty room ranges from $20 per night for economy motels to $75 for luxury hotels [Rutherford, Denney G. 2002. Hotel Management and Operations, 3rd Edition. Wiley: New York, p. 323)]. Yet the average daily rates actually paid by customers across the United States are $52 for the economy tier and $144 for the luxury tier (Standard and Poors, 2005). An internal analysis at a full-service upscale chain (typically four AAA diamonds) suggests that the marginal cost of an occupied hotel room is even lower: $15 at a typical airport location and $20 in a major city’s downtown. The chain’s flagship property in Manhattan incurs the highest marginal cost at $35. Only one hotel manager has been willing to reveal marginal cost per occupied room directly in our interviews. The general manager of a mid-tier (three AAA diamonds) chain property in Santa Monica, California, with an average daily rate of over $100 told one of my students that his hotel would see a short-term benefit from filling excess capacity even if he received as little as $25. Nonetheless, he emphasized that his hotel never discounts-even if rooms would go empty-because he believes that it would lower the perception of the property’s value in the long term.”

215: “Do circumstances exist in which the price of a hotel room might drop to marginal cost? The strongest pressure for marginal cost pricing should occur in the evening just before the rooms “perish.” To investigate directly the possibility that hotels may lower prices at the last minute to fill excess capacity, I hired two students to call 167 hotels in the evenings, asking “How much is a room for tonight?” and then “Can you go any lower than that?” On average, the 161 hotels with vacancies quoted prices more than double the marginal cost for the hotel’s quality tier based on the estimate of the Rutherford (2002) textbook. Ninety of these hotels stuck to their original prices, even though the alternative was almost certainly an empty room. In some cases, the students pointed out that other hotels in the vicinity had vacancies and lower prices, but this changed no one’s answer. The price reductions offered by the remaining 71 hotels were typically no more than 10 percent.” [Details of this survey can be found in Appendix 2, which is appended to the on-line version of this article at ahttp://www.e-jep.org]

214-5: “Seventy (all chains) of the 167 hotels subsequently reported to the Smith Travel Research database their occupancies for the exact dates on which we called. Thirty of these reported occupancies below the national break-even threshold of 53 percent discussed in the introduction. Only ten of these 30 hotels offered a discount, while 12 of 40 above the threshold did so, implying that level of occupancy is not related to the willingness to lower prices. However, occupancy on one particular day may be an outlier. Therefore, I also retrieved the average occupancy from all of 2005 for these 70 hotels, which I note is correlated 0.70 with the occupancies for the night of the call. Using this benchmark, 20 hotels reported occupancies of less than 53 percent. Ten of these 20 consistently poor performers gave discounts, while only twelve of the 50 reporting occupancies above break-even were willing to discount. This pattern suggests some relationship between poor performance and willingness to discount at the last minute — although the evidence is weaker than I had anticipated before conducting the experiment.”

215: “Owners and general managers appear unwilling to give their employees much leeway to lower prices. More research is required to determine why. Similar to Ausubel and Deneckere’s (1989) logic for the case of durable goods and to the Santa Monica manager’s opinion mentioned above, hotels that rely on repeat business may refuse to haggle and discount because it could hurt their future bottom line as their customers become accustomed to last-minute haggling. But hotels that do not rely on repeat business may well free-ride and continue to discount because they will gain business today and will not see those customers again. Alternatively, perhaps the hotels were afraid that our callers were really employees of other hotels wishing to detect defection from a tacit or explicit agreement. Also, since social ties and norms are an important part of the local hotel community, who would like to be known within a group as possessing little integrity, even of the pricing variety?”

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