Experienced revenue managers know that the value of their high-quality sleeping rooms will vary based on a number of factors. These factors include the day of week, season, and a guest’s reason for travel. All of those factors, however, relate to one simple truth:

“Different hotel customers value rooms differently, and are readily willing to pay different amounts for them.”

It’s pretty easy to forget that truth in the day-to-day business of establishing room rates, especially when it seems that so many buyers make their purchase decisions only on the basis of low price. In fact, sometimes even a hotel’s DOSM or its GM can subtly push rates lower in an effort to encourage sales and maximize RevPAR.
 
But one need look no further than the long lines of buyers accompanying the recent release of Apple's new iPhone 5 to know that customers who truly desire high-quality products will go to great lengths for the opportunity to buy those products; even if the products are sold at premium prices.
 
Certainly the most important factor in establishing appropriate prices for hotel rooms is a firmly held conviction that guests are indeed receiving tremendous value for the money. It is this simple truth some rooms sellers too often forget. Perceived value is the secret with Apple and it is why their customers become so loyal.
 
When revenue managers are firmly convinced that the prices they establish will offer terrific value to all customers these managers need to take full advantage of the fact that different customers value high-quality products differently. Doing that means properly utilizing differential pricing; the concept of charging different prices to different buyers based on each buyer’s willingness to pay the prices established by sellers. The trick, of course, is in knowing how to apply differential pricing correctly and in a customer-centric manner. Doing that helps build guest loyalty and enhances the opportunity for future room sales. It's a challenge that exists in all industries characterized by widely variable consumer demand, but fixed and highly perishable levels of capacity (think gas pipelines and electrical grids). In the service industries, examples include hotels, airlines, restaurants, theme parks and movie theaters.
 
Regardless of the industry, however, some observers of differential pricing tactics ask a question that is both fundamental and important: “How can an organization charge different prices for what is the same, or essentially the same, product or service?”
 
A related question is: “Is it right to do so?”
 
Within the hotel industry there may not be universal agreement on a proper answer to this question. Recall that differential pricing means offering different prices to different customers based on the customer’s buying preference. When applied properly, differential pricing entices customers to buy willingly. That's because the customer should perceive they are receiving an outstanding value for their money. Apple iPhone 5 buyers know they are paying premium prices. And that's just fine with them.
 
Differential and customer-centric pricing is not a pricing tactic that forces customers to buy products and services at prices they would prefer not to pay. That's a long-term recipe for failure. Properly applied differential pricing practices must be customer-centric and genuinely appeal to rooms buyers’ sense of value; not just the hotelier’s desire to optimize revenue.
 
Revenue managers can take specific steps to establish prices that creatively position their product and service offerings in ways that offer customers great value. They can also carefully define the criteria individual buyers must meet to qualify for these special pricing offers. Proof that hoteliers can succeed at this comes from the fact that it is already being done with great success in other segments of the hospitality industry.
 
To illustrate how differential pricing is being applied properly in the restaurant industry, consider a very popular pizza promotion, where a large restaurant chain seeks to build revenue by offering an “Any Size / Any Toppings Pizza for $10.00” sales promotion. The pizzas are priced low and can provide great customer value; however, the pizzas can only be purchased at this attractive price as a carry out item.
 
In a similar way, a golf course may choose to offer reduced green fees for players. But only if the players are willing to tee off before 8:00 A.M. or after 4:00 P.M. This differential pricing tactic is designed to encourage play during the course’s less busy time periods. The price offered seeks to communicate a unique value message to those golfers willing to play at slower times in order to gain the advantage of a reduced green fee.
 
In the hotel industry some, but not enough, examples of properly applied differential pricing strategies are common. One hotel chain, for example, offers seniors (e.g. those age 62 and over) savings of up to 50% on prevailing rates at participating properties in the continental U.S. and Canada. Room discounts offered to members of AAA, AARP or other organizations are additional examples of differential pricing tactics designed to communicate value to members of a specific group. In each of these cases, the pricing strategy targets a unique buyer group and offers all buyers in this group reduced prices not available to those who are not in the group.
 
Applying differential pricing is not as easy as it looks. And it doesn't look that easy. That's because the utilization of differential pricing is not without its many challenges. If, for example, some buyers are willing to pay more than others for the same item, what would keep those buyers who are allowed to purchase at a low price from immediately reselling to those buyers willing to pay a higher price? In many cases the answer, unfortunately, is nothing.
 
This resale practice, called arbitrage, is age-old and widespread in some industries. Arbitrage is simply the practice of taking advantage of the difference between prices charged to dissimilar target customers. It is easy to see that, in the hotel business, arbitrage has the potential to severely limit a revenue manager's ability to effectively optimize room rates. It can also have the effect of appearing to increase rooms revenue while at the same time actually reducing a hotel’s gross operating profit (GOP).
 
To better understand differential pricing and arbitrage, and to examine another industry’s tenacious efforts to prevent arbitrage, consider movie theater owners. In most cases theater owners offer discounts of 40% or more to matinee moviegoers. These customers are offered lower prices because they view movies during off-peak demand periods. Theater owners who charge different ticket prices based on when the movie is viewed are utilizing a pure and fairly simple form of differential pricing. They know, however, that steps must be taken to carefully control the ticket sales and collection process. If they did not, the theaters would have matinee-price buyers lining up to buy tickets only to turn around and sell those tickets to others who wanted to watch movies during prime (non-matinee) viewing times. If this happened, the profits made by the initial buyer could be substantial and guaranteed. That's why theater owners take great pains to differentiate between ticketholders who purchased tickets at matinee (reduced) prices and those who purchase at prime-time (non-reduced) prices.
 
The analogous hotel situation would be one in which rooms are purchased by specific buyers at a very low price, but with the express intention of those buyers to immediately resell the rooms to others at a higher price. It is important to recognize that, in this situation, the reseller takes none of the normal business risks borne by the hotel. This is especially the case when the entity engaging in arbitrage is not even required to actually purchase the product (room) initially, but rather is allowed to purchase a room at a lowered price only after it has arranged a resale at a higher price.

This harmful practice would be analogous to the movie theater owner offering to sell matinee-priced tickets to an ambitious buyer only after that buyer had already identified a prime-time theater attendee to whom the ticket could be resold at a higher price. Encouraging and promoting this practice would be an illogical act on the part of the theater owner because it works directly against his or her own best financial interest. A comparable practice would also work against the best interest of any hotel owner who permitted such a situation (and if you see any similarities between the classic practice of arbitrage and the role played by many Online Travel Agencies (OTAs) today you are correct…and you are not alone).
 
It is always true that differential pricing applied in a customer-centric manner is a powerful pricing tool. Practiced properly it is both ethical and works to the advantage of guests and hotels. Guests receive great value and hotels can optimize revenue. A risk inherent in differential pricing, however, is arbitrage.
 
While the finer points of product re-sellers and arbitrage can be debated, there is no doubt that arbitrage, regardless of the variable form it may take, always works to the great disadvantage of hotels. Always! As a result, revenue managers must educate themselves about the ways to avoid it. They can start to do that by taking a lesson on arbitrage prevention from movie theater owners. Theater owners don’t fill their prime-time seats with matinee ticket buyers. Matinee ticket buyers are not permitted to practice arbitrage; they can’t re-sell matinee tickets to prime- time viewers. That just makes good sense. And it is only one of many basic pricing lessons savvy hotel revenue managers must understand and learn to apply to the products and services they sell.