A signaling theory of reservation cancellation policies

We examine the signaling effect of a hotel’s reservation cancellation policy. We find separating equilibria in which the refund rate indicates high quality. Consumers may cancel their hotel reservations due to unforeseen events. We examine two cases: one in which an unforeseen event may reduce the reservation holder’s valuation to zero if consumers have no other purpose and the other in which the valuation decreases but can be used for an alternative purpose. We show that a low refund rate for cancellations indicates high quality in the former case because a given refund rate is costlier for a high-quality hotel due to its larger volume of reservations. In the latter case, we show that a high refund rate can signal high quality because a given refund rate is less expensive for a high-quality hotel because of its lower cancellation rate.