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Hotel Economics: The Role of Supply and Demand in Setting Rates

22 August 2023
Hotels never struggle. You open your hotel and become instantly successful. If you build it, they will come. This is true, provided you have done your homework or feasibility study correctly. That study will show whether the hotel will succeed or be an eternal struggle. You do not have to do anything outside the box as a hotelier. You just have to tell the market you are open, add your rooms to distribution channels, and follow your competitors' rates. You will undoubtedly have the same occupancy and rate as your competition. For most independent hoteliers and mega-brands, this is good enough. Stop reading this post if you are happy with what you have.
Some hoteliers and owners want to beat the market. They are not satisfied with their fair share of the market. Instead, they want to steal market share to increase their profits and give the owners a higher return on investment. If you are one of those, this blog post is for you. The big question is how you beat the market. First, let's kill the myths that hotels follow the same economic theories as any other business. Here are the differences.

What Is the Law of Supply and Demand?

The law of supply and demand combines two fundamental economic principles describing how changes in the price of a resource, commodity, product, or service affect its supply and demand. The theory says that as the price increases, supply rises while demand declines. Conversely, as the price drops, supply constricts while demand grows.

Supply and Demand at the Destination

Let's examine if the theory can be applied to overnight accommodation at a destination.

Short-term perspective

The supply of hotel rooms in a market is fixed in a short-term and mid-term perspective, so the economic theory of the price mechanism of supply does not work in the hotel industry. It takes years to build a hotel, so supply changes come in batches and are not triggered by short-term price fluctuations. A short-term price increase will not create more supply. This part of the theory does not apply to hotels.
The demand for hotel rooms is not generated by a hotel but other factors, such as demand generators to visit a destination. A demand generator could be a beach, an alp, history/culture, a corporate headquarter, an artificial attraction like Walt Disney World, or festivals and other events. People want to do something at a destination and therefore need overnight accommodation. A price increase might decrease demand for overnight accommodation, but the willingness to pay for it is a function of how attractive it is to visit the destination. If there is a once-in-a-lifetime event for someone at the destination, the cost of overnight accommodation becomes irrelevant.
On the other hand, a price decrease will not increase demand for overnight accommodation if there are no good reasons to travel to the destination. Try to attract people to a typical summer destination, where the beach is the demand driver, in the winter. Even if hotels give away the rooms for free, it will, in the best case, only increase demand marginally. Hotels cannot create demand for overnight accommodation by decreasing the price.

Long-term perspective

From a long-term perspective, price increases will increase supply since more investors will build more hotels. The supply will increase, and prices will decrease to reach a new equilibrium level. In the long-term perspective, if hotel rates at a destination are too high, this might lead to fewer meetings, incentives, conferences, events, and headquarters relocation.

Supply and Demand at a Hotel

Let's examine if the theory can be applied to a hotel.

Short-term perspective

The supply, the number of rooms, is fixed and, therefore, the same if the demand is high or low. A higher rate will not increase the number of rooms in the hotel. A lower rate might lead to a seasonal closure of the hotel, which will decrease the supply of rooms.
The demand drivers at the destination generate the demand for overnight accommodation, so the hotel is limited to capturing as much as possible of the demand in competition with other hotels and overnight accommodation providers and cannot create additional demand.
The rate can be decreased to stimulate demand for a specific hotel, attracting more guests and filling up the hotel. However, if the total demand at the destination is low, a rate decrease at one hotel might lead to a price war, and all hotels will give away a lot of money since the number of guests traveling to the destination will not increase. Most revenue management systems change the rate to capture as much demand (revenue) as possible.

Long-term perspective

The long-term perspective is positioning the hotel based on the star rating, guest reviews, facilities, offerings, and general rate level. The positioning focuses on long-term strategy and has less to do with adjusting the daily rate.

What is a competitive hotel rate?

There is no such thing as only a competitive hotel rate since attracting guests to a hotel depends on many factors. The marketing mix, Product, Price, Promotion, and Place, is an easy-to-use framework to attract guests to a hotel. A well-thought-out marketing mix captures the preferred market segments at the destination.

Long-term perspective

The starting point is to define the ideal guest segments and their needs. The hotel must provide a product (guest experience) that attracts the target segments. The aim is to deliver a superior guest experience to the target audience so they are prepared to pay a premium price. In the long-term perspective, the hotel has to protect its target audience and not be tempted to use the price to attract any guest. Every non-ideal guest risks disturbing the most valuable guests and making the hotel less attractive to them.

Short-term perspective

A hotel that can deliver a superior guest experience to a well-defined target group and charge a premium rate cannot make rate adjustments too often. When the demand from the target segments is high, the hotel should increase the rate. However, the hotel should not lower the rates when demand is low from the target segments. Too low rates will devastate the hotel's perception and harm the hotel's brand and reputation.

Do not focus on occupancy

Hotels are too focused on occupancy. It is an inside-out thinking. Hotels are only thinking about themselves and how to sell the available capacity. A better way is to start with outside-in thinking. Hotels that put their customers and guests first will become more successful. A hotel business must optimize the total revenue mix to maximize profits. A hotel focusing on total revenue will likely find the optimum occupancy lower than 100 %.

Total revenue

There are two ways to maximize revenue; hotels can attract more guests and sell more to each guest. The hotel room is only one product and service in full-service hotels. From the hotel's perspective, a competitive hotel rate is a rate that will maximize the total guest spend during the stay. Hotels must be ambitious to maximize total revenue, not only hotel room revenue.