A Game Theory Analysis of Pricing Strategies in
China’s Economy Hotel Industry
Jun Shan Jin Zhang
Business School Business School
Nankai University Nankai University
Tianjin, China Tianjin, China
[email protected] [email protected] summarize our paper with the conclusion section.
Abstract—Economy hotel is a relatively new concept, and
first appeared in China in the late 1990’s. After a rapid growth
in the 2000’s, the industry has become highly competitive and A. Chinese Economy Hotel Industry Overview
pricing strategy has become crucial for a company to succeed in The lodging industry in China consists of upscale luxury
such an industry. In this paper, we apply the game theory to hotels and common accommodations with economic
quantitatively analyze the competitive pricing strategies. Nash
facilities and generally lower rankings. Economy hotels are
equilibrium is characterized and other pricing issues such as
price discrimination are also discussed based on a leading small to medium sized hotels that provide quality rooms and
economy hotel chain in China. professional services to satisfy customers’ basic
accommodation needs at reasonable prices. A popular choice
Keywords—Pricing, Economy Hotel, Game Theory, China for budget-conscious travelers and business people, economy
hotel is becoming a promising industry.
I. BACKGROUND INTRODUCTION
In the economy hotel industry, homogeneous products are
Economy hotel is a relatively new concept, and first provided with narrow rate range: 51% of the hotel rooms
appeared in China in the late 1990’s. With a dramatic growth priced in the RMB150 to RMB200 per room night and 26%
in the 2000’s, economy hotel chains have been developing of the hotel rooms priced in the RMB200 to RMB300 per
rapidly to fulfill distinct customer needs for low room rate as room night. The different price ranges reflect the impact of
well as quality services. China Lodging Group operates a geographical differences in hotel locations rather than the
leading economy hotel chain in China, which has achieved product offerings. The average daily room rate has decreased
outstanding performance in the past few years. Since the annually by 2%-3% since 2005. Branded economy hotel
industry is highly competitive, pricing has become one of the chains have been developing rapidly since the early 2000’s.
crucial determinants for success. Therefore, the pricing Between 2005 and 2009, the number of branded economy
strategy of China Lodging Group constitutes the managerial hotels and hotel rooms grew at a compound annual growth
issue we are interested in. rate (“CAGR”) of 61.8% and 64.2%, respectively, according
The competitive strategies in hotel industry have been to the October 2009 Inntie Report [5] and China Budget
studied by many, such as [1] and [2]. In a recent research, [3] Hotel Report 2009-2010 issued by ResearchInChina [6].
is focused on the pricing strategy of the lodging industry. This growth is attributed to three main drivers: robust
These studies are mainly based on market in developed economic growth in China, increasing domestic business
countries, like U.S. and UK. However, either the existing travel and rapidly growing domestic leisure travel.
studies do not discuss the pricing issue explicitly, or do not
analyze the topic in a quantitative way. As for the research TABLE I. BRANDED ECONOMY HOTEL CHAINS
on emerging markets, [4] considers the franchising issue in 2005 2006 2007 2008 2009 CAGR
China’s hotel industry. Differently, our study will consider Num. 522 906 1698 2805 3575 61.8%
the pricing issue in the more specific economy hotel industry. of
Hotels
In this paper, we will firstly display a general picture of the Num. 56,854 98,817 188,788 312,930 412,840 64.2%
economy hotel industry in China, and then briefly introduce of
Rooms
China Lodging Group. We will build up an analytical model
CAGR stands for compounded annual growth rate.
by applying game theory and conduct insightful analysis on Source: Company Filings as of November 2010 and China Budget Hotel
the company’s pricing strategy, followed by some future Report 2009-2010
implications and possible limitations. Since the model
investigates a hypothetic and simplified market, we will also
discuss the impacts of other dynamics to further enhance the
rigor and completeness of our research. Lastly, we will
This work was financially supported by the Humanities and Social
Sciences Research Funds of Ministry of Education (No.10YJC630200) and
the Fundamental Research Funds for the Central Universities (No.
NKZXB10087).
k,(((
TABLE II. AVERAGE DAILY ROOM RATE (RMB) II. ANALYSIS OF DEMAND AND ELASTICITY
2005 2006 2007 2008 2009 CAD
Compared to ordinary star hotels, the low room rate is the
Home Inns 182 182 179 173 160 -3.2% major feature of economy hotels, as well as the main reason
Jinjiang 193 194 195 182 176 -2.3% for the industry's fast expansion. This competitive advantage
7 Days 182 163 158 160 160 -3.2% of low room rates caters to the growing domestic leisure
Average 185.6 179.7 177.4 171.6 165.2 -2.9% segment, particularly among group with limited budgets,
China 181 178 174 -2.0% such as students and other young travelers, business travelers
of small enterprises, and the elderly, etc. Therefore, economy
Lodging
hotels have won a foothold, and the demand for this broadly
CAD stands for compounded annual decrease. defined category is more inelastic.
Source: Company Filings as of November 2010
Nevertheless, most of China’s branded economy hotel
B. China Lodging Group Snapshot chains offer relatively homogeneous products, and could be
China Lodging Group (“CLG”) first entered the lodging constituted as close substitute for each other. As a result, the
industry in 2005, as an operator of mid-scale limited service demand for each economy hotel chain is more elastic. The
hotels and commercial property development and diminishing demand curve can be roughly illustrated through
management. In 2007, CLG transferred its business to the below curve for CLG, where its relative market share
operating and managing a multiple product economy hotel decreases with increasing room rates, for the past three years.
chain. With a leading position among the economy hotel
chains in China, CLG achieved the highest revenues
generated per available room (“RevPAR”), the highest
occupancy rate in 2008 and for the first half of 2009, and the
highest growth rate in terms of the number of hotel rooms
during the period from January1, 2007 to June 30, 2009,
according to the October 2009 Inntie Report [5].
As of December 31 2009, CLG operated 236 hotels in 39
cities in China, including 16 of the top 20 cities, where 78%
of its hotels and inns are located. The geographic coverage is
illustrated in Figure 1.
Figure 2 Market share of CLG
III. A GAME THEORY MODEL
Pricing strategy is one of the determinants of success in
China’s economy hotel industry. Hereafter we would employ
game theory in the context of oligopoly and construct a
model to illustrate the implications for CLG’s future pricing
strategies.
A. Model Specifications
To better apply our game theory model to CLG, we first
make the following assumptions to simplify the real-world
situation.
Duopoly Market: We assume a duopoly market - bind
Home Inns, Jinjiang Inn, and 7 Days Inn together as Player 2
which totally accounts for around 50% of market share, and
distinguish CLG as Player 1.
Market Shares as Payoffs: Branded economy hotel
chains started to gain wide market awareness since the early
Figure 1 Geographic coverage of CLG chains 2000’s, and between 2005 and 2009, the number of branded
economy hotels grew at a CAGR of 62%. Branded economy
Exposed to tremendous opportunities as well as fierce hotel chains are more likely to compete for a larger share
competition, CLG rivals Home Inns, Jinjiang Inn, Motel 168, when penetrating this market. We therefore employ market
7 Days Inn, GreenTree Inn, Super 8 Hotels, etc. share as a measure of payoff.
TABLE III. MARKET SHARES OF ECONOMY HOTEL CHAINS IN CHINA
Market Share (%) - Both players adopt the same strategy:
2007 2008 2009
Home Inns 19.7 18.9 19.9 Relative room rates for each player remain unchanged.
Jinjiang Inn 11.3 10.7 10.9 Hence the relative market share each player occupies should
7 Days Inn 6.6 7.9 8.8
also remain unchanged.
Subtotal Market Share 37.7 37.5 39.5 - One player maintains its room rates while the other
player changes its rates:
Player 1 Market Share 4.6 7.3 8.1
Player 2 Market Share 37.7 37.5 39.5
The player with lower relative room rates would expect to
capture a market share of x from the other player. The elastic
Total market share 42.3 44.8 47.6
demand of economy hotels implies such customer switch
Player 1 Relative Market Share 10.8 16.3 17.0 between players when relative room rates change.
Player 2 Relative Market Share 89.2 83.7 83.0 - One player increases room rates while the other
Source: Company filings and Appendix decreases room rates:
Strategy Sets: In our game theory matrix, each firm will
The player with lower relative room rates would expect to
formulate three pricing strategies: lower room rates,
capture a market share of 2x from the other player. The
Player 2
Strategy Lower Room Rates Room Rates Unchanged Higher Room Rates
Lower Room Rates A,B A+x , B-x A+2x , B-2x
Player 1
Room Rates Unchanged A-x , B+x A,B A+x , B-x
Higher Room Rates A-2x , B+2x A-x , B+x A,B
Figure 3 The pricing game in normal form
unchanged room rates, and higher room rates. customer switch is amplified by the larger room rate gap
between two players.
One-shot Game: We define one-year pricing strategy as
one round of the game. Our discussions will revolve a 2) Dominant Strategies and Nash Equilibrium
one-shot game, as many uncontrollable factors may induce
As can been seen in Figure 4, decreasing room rates is the
noises into our model in the longer term. These factors
dominant strategy for both players: regardless of the strategy
include prospective regulations imposed on the industry,
chosen by the other player, decreasing room rates is always
changing market structure, unpredictable economic climate,
the best response which returns a higher market share.
etc.
Therefore, the only Nash Equilibrium is that both players
Perfect Information: We assume that both players obtain decrease room rates.
perfect information about their own business so that they
The Nash Equilibrium implies that, both CLG and its
could identify sensible payoffs. Meanwhile, each player is
competitors should decrease room rates given each other’s
making decision simultaneously without knowledge of the
dominant strategy. Should we assume that the magnitude of
other player’s decision. Based on the information available,
rate fluctuation for both CLG and its competitors in the
both players would behave rationally for this one-shot game.
upcoming year is consistent with the average in the previous
So we can summarize the specifications into a normal form years, provided that the dominant strategy of its competitors
game as shown in Figure 3, where A denotes the relative is to decrease room rates by approximately 3% annually,
market share for Player 1 and B denotes that for Player 2. CLG should continue lowering its room rates by around 2%
annually in the near future.
Player 2
Strategy Lower Room Rates Room Rates Unchanged Higher Room Rates
Lower Room Rates A,B A+x , B-x A+2x , B-2x
Player 1
Room Rates Unchanged A-x , B+x A,B A+x , B-x
Higher Room Rates A-2x , B+2x A-x , B+x A,B
Figure 4 Nash equilibrium of the game
As shown in the payoff matrix, the three diagonal pricing
B. Theoretic Analysis
strategies give both players same market share split.
1) Three Basic Scenarios Therefore, players may intend to collude to increase room
The nine payoff combinations can be categorized into rates while maintaining the current market share for higher
three basic scenarios: revenues. However, collusion cannot be sustained because if
the other player increases room rates, a player would be P
tempted to keep or even decrease its room rates to increase
market share by cheating.
The Nash Equilibrium also verifies the continuously
decreasing room rate strategies of both players in the past
three years as shown in the Average Daily Room Rate table
above.
MC
IV. OTHER PRICING STRATEGIES
Aside from adjustments in room rates, other pricing D
dynamics, including customer loyalty program, price
Q
discrimination, complimentary services, seasonality pricing, (b)
and outsourcing may be factored into this single price model Figure 5 Illustration of different types of price discrimination
for higher revenues or market share. We elaborate on price
discrimination and seasonality pricing in this section.
B. Seasonality Pricing
A. Price Discrimination Hotels also charge different room rates according to
demand fluctuation. At peak season, for example during
Price discrimination is one of the most common pricing National Holidays, hotels could increase profits by charging
strategies adopted in the economy hotel industry. Compared higher prices than those in the off peak time. This can be
with a single price, price discrimination can extract more illustrated by the graph below.
consumer surplus. One type of price discrimination is
differentiated room rates for different geographical segments, P
as shown in Figure 5 (a). Factors such as consumption level, MC
economic development and centrality of the location lead to
PH
the different pricing level. Presumably, larger cities tend to
label higher room rates than second tier cities. Downtown DH
locations tend to charge more than uptown locations. Another
type of price discrimination is differentiated room rates for
PL MRH
various duration of stay in the hotel, as illustrated in Figure 5
(b). The willingness of customer to pay for an incremental
day of stay is diminishing, so the daily room rates charged MC
decline as a customer stays longer in the hotel.
MRL DL
In our game theory model, we mainly focus on the relative
pricing strategies to increase or decrease rates compared with QL Q* Q
current level. In fact, this generalized model can be localized
and filled with numerical data for any geographical area, in During peak seasons, travelers tend to spend extended
light of relevant information available. periods with their friends and families; thus hotel rooms will
P be in huge demand and filled up quickly. Assume marginal
cost is constant up to the point Q*, where the hotel is running
at full capacity. At this time, even if there is stronger demand,
the hotel cannot provide any additional room in the short run,
PL because the additional cost for providing an extra room
Larger Cities would be indefinitely high. Therefore, the hotel would charge
PS
a higher price to capture more consumer surplus when
operating at the full capacity. This pricing strategy is also
verified by empirical evidence. The online-reservation
MC DL
system of Hanting Inns & Hotels in Shanghai indicates that
MRL the room rates for normal days are only about 42% of those
MRS Smaller Cities
DS
for peak seasons. According to [8], the room rate for normal
QS QL Q days (19/11/2010) is RMB 109 per night whereas that of peak
(a) season (3/2/2011 Chinese New Year Festival) is RMB 259
per night. Hence it is reasonable for CLG to lower the room
rates during off peak time while charge higher rates during
peak season so as to maximize profits.
V. CONCLUSION
Thanks to the rapid growth of the economy hotel industry ACKNOWLEDGMENT
over the past few years, China Lodging Group has been The authors wish to thank the anonymous editor and
granted with great opportunities as well as real challenges. referees. The research of these authors was supported by the
Driven by the increasing trend of domestic travel resulted Humanities and Social Sciences Research Funds of Ministry
from the robust economy in China, the demand of economy of Education (No.10YJC630200) and the Fundamental
hotels has become increasingly stronger. Meanwhile, as a Research Funds for the Central Universities (No.
major player in the industry, China Lodging Group should NKZXB10087).
contemplate optimizing its pricing strategies to capture a
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