Pricing of Conditional Upgrades in the Presence of Strategic Consumers

In this paper, we study a conditional upgrade strategy that has recently emerged 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 her product 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 charged to the consumer if and only if she actually gets upgraded. Consumers decide which product type to book and whether to accept an upgrade offer or not based on the anticipated upgrade probability. We find that conditional upgrades create value by improving demand-supply matching for the firm. The firm can use the conditional upgrade channel to flexibly manage capacity allocations and reoptimize demand segmentation. For a firm that takes product prices as given, offering conditional upgrades is effective in compensating for the firm's lack of ability in setting prices optimally. For a firm that has the ability to optimize product prices, conditional upgrades generate higher revenues than dynamic pricing.