Economics of Tourism Larry Dwyer Peter Forsyth Andreas Papatheodorou Contemporary Tourism Reviews Series Editor: Chris Cooper ( ) Published by Goodfellow Publishers Limited, G Woodeaton, Oxford, OX3 9TJ http://www.goodfellowpublishers.com ISBN: 978-1-906884-28-4 Copyright © Goodfellow Publishers Ltd 2011 Design and setting by P.K. McBride 2 Economics of Tourism About the authors Dr. Larry Dwyer is Professor of Travel and Tourism Economics in the School of Marketing, Australian School of Business at the University of New South Wales, Australia. Larry is a founding member and President of the International Association for Tourism Economics. In 2007, Larry was appointed as a Fellow of the International Academy for Study of Tourism, the world’s peak academic tourism association. Dr. Peter Forsyth is Professor of Economics in the Department of Economics at Monash University, Australia. Most of his research has been on transport economics and especially the economics of air transport, and tourism economics. Peter maintains close links with the German Aviation Research Society.He has been a frequent speaker at the Hamburg Aviation Conference, and in 2005 he delivered the Martin Kunz Memorial Lecture. Dr Andreas Papatheodorou is an Assistant Professor in Industrial Economics with Emphasis on Tourism at the University of the Aegean, Greece. He is a Fellow of the UK Tourism Society and a member of the Executive Board of the International Association for Tourism Economics. In 2009 he was recognized as an Emerging Scholar of Distinction by the International Academy for the Study of Tourism. (G) © Goodfellow Publishers Ltd Economics of Tourism 3 1. Introduction Tourism has been a major growth industry globally for over five decades. Factors underpinning this growth include the growth of incomes and wealth, improvements in transport, changing lifestyles and consumer values, increased leisure time, international openness and globaliza- tion, immigration, special events, education, information and communication technologies, destination marketing and promotion, improved general and tourism infrastructure and so on (Matias et al 2007). Since there are economic consequences to all of these factors it is not surprising that research in the area of tourism economics has increased substantially during the same period. At the same time, the study of tourism economics has attracted relatively few research economists compared to other topics, such as energy and transport economists, within the mainstream discipline. Although indirectly related to tourism economics, we may argue that the serious study of the field began in the mid 1960s with the seminal book produced by Clawson and Knetsch (1966) on the Economics of Outdoor Recreation. Rather prophetically, the book dealt in detail with environmental issues, which are now considered of crucial importance in tourism economics. Four years later, Gray (1970) published a very enlightening book on the interrelation between international travel and trade. From then onwards, tourism gradually gained momentum among economists; interestingly, however, it was not until 1995 that Tourism Economics, i.e. the first academic journal dedicated to the study of tourism economics, emerged. As a comple- mentary development it is also worth noting the establishment of the International Associa- tion for Tourism Economics in 2007. Four major observations can be made about the state of research in tourism economics.  First, there are ongoing areas of research very much within the single disciplinary mainstream economic methodological framework. Obvious topics include demand modelling, forecasting, economic impact and industry analysis (Stabler et al., 2010).  Second, several areas of research in economics have emerged that were either non- existent two decades ago or were in their infancy. These include Game Theory, Chaos Theory and climate change economics. These have been applied to tourism.  Third, there are several research areas relevant to the wider context of tourism studies, that tourism economists have virtually ignored, or have relatively neglected. These relate to themes and issues and methodologies of analysis that have been recognized in other fields of the subject. These include ecological economics, poverty alleviation, and sustainable development.  Fourth, tourism economics has become increasingly quantitative over time, paralleling developments in the economics literature. Critics have argued that the emphasis on ‘positivist/post positivist’ epistemologies renders the economics of tourism less relevant than it might otherwise be in addressing real world issues and problems. As Jennings (2007) has argued, quantitative based research has become the ‘or- thodoxy’ for tourism economists and has prevented them from addressing tourism problems in a more holistic, interdisciplinary way appropriate to the complexity of tourism phenomena. Jennings’s view is that new and different methodologies and methods must be employed by tourism economists for theory development, to better serve the industry, and for policy for- mulation. Jennings’ review reflects the debate in the wider tourism literature concerning the (G) © Goodfellow Publishers Ltd 4 Economics of Tourism continued unwarranted adherence to positivist, quantitative oriented orthodoxy in the face of tourism’s complexity, rapidly changing characteristics and instability, quite different from its nature in the 1960s.). For some years now geographers (and new economic geographers) have taken up a political economy stance. Williams (2004), advocates a political economy perspec- tive wherein theoretical developments in the approach have relevance to issues in tourism as illustrated by issues such as commodification in the sector’s markets, its labour structures and processes and its regulation. A discussion of the issues that have been addressed in tourism economics for the past 50 or so years reveals that the range of issues addressed is perhaps much wider than the criticisms might imply. We highlight several topics for discussion below. 2. Developments and Current Issues in Tourism Economics a. Tourism Demand and Forecasting Demand modelling, one of the most developed and rigorous areas of the economic analysis of tourism, is a long-established area of economic research and continues to be so. Research over the past four decades suggests that the range of factors affecting the demand for tourism is very large. The more prominent factors that have been included in destination demand modeling are income, (exchange rate adjusted) relative prices, transport costs, marketing and promotion activity, migration levels and qualitative factors time available for travel, trade and ethnic ties between the countries; destination attractiveness (for example, culture, climate, history, natural resources, tourism infrastructure; special events taking place at the destina- tion; natural disasters; and social threats such as political instability, health issues or terrorism) (Crouch 1994a, Lim 2006, Saymaan et al 2008). Of these factors, the bulk of studies indicate that income, and to a lesser extent price, are the most important (Crouch 1992). Still, the focus on income as an influence on tourism flows has been associated with a relative neglect of wealth as a determining factor (Alperovich and Machnes 1994). Thus, while the Global Financial Crisis (GFC) certainly reduced incomes on average for millions of people, perhaps the greatest effect was on their level of wealth due to the decline in value of their assets including superan- nuation payouts. While there has always been some recognition that wealth is important for some tourism markets eg. Seniors’ tourism, the issue needs more research (Sheldon and Dwyer 2010) Demand analysis has recently taken new directions, with greater attention being increasingly paid to the characteristics framework of demand (Lancaster 1966). This is also associated with the development of the hedonic pricing method (Rosen 1974, Sinclair et al 1990, Clewer et al 1992, Papatheodorou 2001, 2002) and discrete choice analysis (Louvier 2000). More recent studies evaluating a variety of tourism markets are using panel data techniques (Naudé and Saayman 2005, Van Der Merwe et al 2007, Saayman and Saayman 2008). When cross-sectional and time series data are combined, as in panel data analysis, greater insights are gained from the data. Panel studies offer all the advantages of a larger number of observations; that is, more informative data, less multicollinearity, more degrees of freedom and more efficient estimates. In tourism demand studies, panel data techniques allow the inclusion of the variables that are mostly static for one region (such as distance), but which differ between regions, which is not (G) © Goodfellow Publishers Ltd Economics of Tourism 5 possible with time series data only. Panel data is expected to play an increasingly important role in tourism demand analysis. Over time, the modeling of tourism demand has become more sophisticated and more complex and different contexts of study, different data sets, use of different variables and different mod- eling techniques preclude generalizations (Crouch 1994a, 1995; Lim 1999, 2006). Given the importance of a better understanding of demand for destination management, marketing and policy purposes tourism demand modeling may be expected to continue to be refined with more input from the econometrics literature (Song and Witt 2000, Li et al 2005, Song and Li 2008). Forecasting is especially important in tourism because it aids long term planning and is fun- damental to the conduct of modern business and destination management. It is particularly challenging because: the tourism product is perishable; tourism behaviour is complex; people are inseparable from the production-consumption process; customer satisfaction depends on complementary products and services; and tourism demand is extremely sensitive to natural and human-made disasters (Archer 1980, 1994). In a changing global tourism environment it is important, for both government policy development and business planning, to have reliable short-term and long term forecasts of tourism activity (Frechtling 2001). There are two broad approaches to tourism forecasting: qualitative tourism forecasting and quantitative tourism forecasting (Sheldon and Var 1985). The same as for the area of demand modeling the forecasting literature is increasingly incorporating ‘state of the art’ statistical techniques that are new to tourism research (Song and Turner 2006). Song and Witt (2000) were the first researchers to systematically introduce a number of modern econometric methods to tourism demand analysis. More recently, modern econometric methods, such as the autoregressive distributed lag model (ADLM), the error correction model (ECM), the vector autoregressive (VAR) model, the almost ideal systems approach (AIDS and the time varying parameter (TVP) models, have emerged as the main forecasting methods in the current tourism demand forecasting literature.. The technical illustration of these methods is in Song and Witt (2000) and Li, Song and Witt, 2006; Song and Li 2008). There is no single quantitative technique that gives best forecasting results in all contexts (Song and Li 2008). Qualitative tourism forecasts are based on the judgments of persons sharing their experience, practical knowledge and intuition. These judgments are found through polling, expert opinion, panel consensus, surveys, Delphi technique and scenario writing and are often used to moder- ate or “second guess” quantitative forecasts (Frechtling 2001). Qualitative forecasting is best applied when facing insufficient historical data; unreliable time series; rapidly changing macro environments; major disturbances; and when long term forecasts are desired. The choice of forecasting method depends on several considerations including: the level of accuracy required; the ease of use of the forecasting technique; the cost of producing the fore- casts compared with the potential gains from their use; the speed with which the forecasts can be produced; the time frame of the forecast; the quality and availability of data on which the forecast is to be made; and the complexity of the relationships to be forecast. Recently, attempts have been made to enhance tourism forecasting accuracy through forecast combination and forecast integration of quantitative and qualitative approaches (Faulkner and Valerio 1995; Blake et al. 2004). Forecasts need to be justifiable with the forecasting process transparent and (G) © Goodfellow Publishers Ltd 6 Economics of Tourism open to all to question and challenge. Combined forecasts tend to have greater explanatory power than single approach forecasts and tend to be more accurate and future research in this area should reflect an understanding of this (Song and Li 2008). At bottom, we simply do not know enough about consumer travel behaviour to give definite forecasts in many circumstances. Since tourism is subject to volatility, exogenous events of considerable magnitude and sudden changes in consumer behaviour, we can expect a con- tinuing emphasis on consumer behaviour as a topic in tourism research generally and tourism economics in particular (Sheldon and Dwyer 2010). b. Supply and Pricing The price that a tourism firm sets for its supplied products depends on the interplay of a number of factors that are internal and external to the firm. These include the firm’s objectives and ownership pattern, the market structure in which it operates, the degree of competition within the market and the firm’s position within the market, seasonality, government policy, the macroeconomic environment, the price of other goods, capacity constraints, the degree of per- ishability of its products and so on (Fyall and Garrod 2005). In the wider economics literature, competitive profit maximizing firms are acknowledged to apply a variety of pricing strategies including uniform pricing, price discrimination, bundling, tying, peak load pricing, and two part tariffs as well as non-marginal pricing strategies involving penetration pricing, markup pricing, non-profit goals, as necessary. Marginal pricing approaches of the type most used in economic analysis work best when the firm is well informed and able to make effective use of the in- formation available to it. Moreover, in the tourism industry generally, some firms may be less focused on maximizing profits than in achieving other objectives. Tourism firms can potentially adopt different pricing strategies according to their objectives (which may emphasize market share or lifestyle objectives). The pricing strategies adopted will have different implications for firm output, sales and profits. There is a real issue of whether firms can be characterised as profit maximisers. The issue is important since small businesses of the type that comprise the global tourism industry historically have operated with low profitability. While firms can compete through the use of pricing strategies they can also improve the quality of the characteristics of goods and services. Such quality improvements often enable the products to be sold for higher prices, effectively by making the demand curve more inelastic. Determining the importance of quality in firms pricing strategies is important (Mangion et al 2005). The hedonic pricing method has been used by tourism researchers to show how various supply- related factors explain the variation in overall accommodation and package tour prices, presenting tourism managers with an opportunity to enhance their strategic pricing through quality improvements and innovation (Sinclair et al 1990, Papatheodorou, 2002; Monty and Skidmore 2003). In general, the economic analysis of the structure of tourism supply is founded in industrial economics. Issues concerning tourism supply cover economic efficiency (mainly relating to productivity), employment, industrial structure, entrepreneurship and management and information communication technologies (ICT). The traditional approach of market competitive structures and pricing has not figured strongly in tourism research until recently, particularly the concepts of oligopoly, duopoly and contestable markets that characterize certain tourism sectors (Papatheodorou, 2004; Stabler et al 2010). There has been research recently on tourism (G) © Goodfellow Publishers Ltd Economics of Tourism 7 sectors within the Structure-Conduct-Performance (SCP) paradigm, in particular the travel trade. The structure prevailing in any tourism market depends on numerous interlocking characteristics, amongst them: the number of sellers; the existence and extent of product differentiation; the cost structure; the presence of barriers to entry; and the extent of vertical and horizontal integration. The SCP paradigm is useful for gaining an overall picture of tourism markets, highlighting key features and capturing essential relationships (Davies and Downward 1998, 2006). Within this framework, the market structure within which a tourism firm operates is held to affect the firm’s conduct (decision-making processes), which, in turn, is held to affect the firm’s performance (potential to make profit, increase its market share and achieve efficiency). This linearity may also work in reverse. Public policy (government involvement and influence in the marketplace) affects basic demand and supply conditions in the market, influencing market structure, rewarding or disparaging conduct and, ultimately, conditioning performance. Important ways through which government may differentially affect tourism markets include taxes and subsidies, regulation, price controls, competition laws, and information provision to tourism stakeholders (Lei 2006). A good example of the above is provided by air transport. Over time, , governments have chosen to implement less restrictive regulation of air transport, and this has led to more competition, lower fares (especially as a result of the development of low cost carriers such as Southwest and Ryanair), and more travel (Papatheodorou, 2008). This provides a policy dilemma for governments in their regulation and/or support of both industries (i.e. transport and tourism). For example does a country wish to encourage tourism, and maximize economic benefits of tourism, by keeping taxes, on both aviation and ground tourism, low? Or does it wish to make use of its market power, and use foreign tourists as a source of revenue? Whichever of these options it chooses, it will need to determine at which level –aviation or ground tourism- such taxes are best levied. Furthermore, if there is already general taxation of tourism and aviation services, it will need to determine how best to counteract these if it wishes to keep taxes low. Aviation and tourism taxation need to be considered jointly- though they often are not (Forsyth, 2006). Research on the supply of tourism products has benefitted from attention to the supply side of tourism products and industries, which is documented in the Recommended Methodologi- cal Framework (TSA-RMF) (UNWTO 2008). The recommended framework for tourism statistics identifies tourism’s component products and industries through the concepts of Tourism Char- acteristic and Tourism Connected products and industries. Progress made in the development of the recommended framework of statistics has now opened up a suite of research opportuni- ties for tourism economists (Frechtling 1999). These include measuring tourism’s interrelation- ship with other industries as well as comparison of tourism activity with other major industries in terms of size, economic performance, employment, and contribution to the national and regional economy, and comparisons between regions, countries or groups of countries. Re- searchers now have a better opportunity to help tourism stakeholders to better understand the economic importance of tourism activity; and by extension its role in all the industries producing the various goods and services demanded by tourists. In this way tourism econom- ics can better serve as a tool for enhanced strategic management and planning for the tourism industry to achieve enhanced destination competitiveness in the context of broader policy agenda. (G) © Goodfellow Publishers Ltd 8 Economics of Tourism Among others, the framework should consider the effect of the continuing development of Information Technology (IT) on the structure of supply, particularly the intermediaries, deter- mining their competitiveness, efficiency, innovation and productivity. IT is essentially about such matters as competitiveness, efficiency, innovation diffusion, marketing and productivity, each of which is capable of being informed by economics. The oligopolistic nature of various tourism sectors shows that firms seek to control their supply chains through vertical and hori- zontal integration and through the formation of strategic alliances (Howarth and Kirsebom 1999, Morley 2003). Game theory seems to be an area of particular relevance to enhance our understanding of the behaviour and strategies of tourism suppliers in different tourism sectors, destinations and contexts (Evans and Stabler 1995, Taylor 1998). The tourism industry has experienced many financial crises over the years, yet there remain large knowledge gaps about the behaviour and strategies of firms under financial stress. The implications for new product development, investment, marketing, and staffing are not well understood. Likewise, the strategic options to help firms remain viable during economic down- turns are not well researched. Additionally, little is known about the impacts of financial and economic crises on event sponsorship, business meetings and corporate travel. Historical ac- counts and case studies of tourism stakeholder responses to previous economic recessions may also provide valuable lessons for the future (Smeral 2010). c. Measuring Tourism’s Economic Contribution, Impacts and Net Benefits It is widely acknowledged that both domestic and international tourism make an ‘economic contribution’ to a destination, that tourism has positive and negative ‘economic impacts’ and that it brings ‘benefits and costs’ to a destination. While often used in the literature, these terms are generally not well understood by researchers. The economic contribution of tourism refers to tourism’s economic significance - to the contri- bution that tourism related spending makes to key economic variables such as Gross Domestic (Regional) Product, household income, value added, foreign exchange earnings, employment, and so on. Given the development of Tourism Satellite Accounts (TSA) worldwide it can be expected that more research will be undertaken on tourism’s economic contribution to a des- tination. TSA allow the tourism industry to be better included in the mainstream of economic analysis. Tourism’s total economic contribution (both direct and indirect) measures the size and overall significance of the tourism industry within an economy. The research literature may now be expected to contain more studies that compare and analyse the contributions that tourism and its component industries make to key variables such as GDP, value added and employment. TSA provide policy makers with insights into tourism and its contribution to the economy providing an instrument for designing more efficient policies relating to tourism and its employment aspects. As a result of basing more of their research in analysing data from TSA, the outputs of tourism economists should become even more relevant to the information needs of destination managers (Frechtling 1999, Jones, Spurr 2006, Jones and Munday 2007). TSA can also be used to develop performance indicators such as measures of productivity, prices and profitability for the tourism industry as a whole as well as performance in individ- ual sectors (Dwyer, Forsyth and Spurr 1997), measures of tourism yield, and also estimates of tourism’s carbon footprint (Dwyer et al 2010). Tourism researchers now have the data to explore the performance of individual tourism sectors or of the entire tourism industry relative (G) © Goodfellow Publishers Ltd Economics of Tourism 9 to that of other industries, domestically and internationally. TSA are not in themselves modeling tools for economic impact assessment. Tourism economists have a role to play in keeping other researchers and destination managers aware of the distinction between ‘economic contribu- tion’ and ‘economic impact’. Economic contribution measures the size and overall significance of the industry within an economy, while economic impact refers to the changes in the economic contribution resulting from specific events or activities that comprise ‘shocks’ to the tourism system. Over the past four decades a substantial number of economic impact studies have been published based on multipliers estimated from input-output models. These have generally fo- cussed on the effects of tourism demand shocks to nations (Archer 1977, Archer and Fletcher 1996), subregions (Archer 1973), and special events (Burns et al 1986, Crompton et al 2001). Unfortunately, researchers, destination managers and tourism policy makers often ignore the limitations of multipliers based on Input Output (I-O) modelling, despite their limited policy relevance for tourism (Briassoulis1991). Economy wide effects must be taken into account in determining the impacts of increased tourism expenditure on a destination. An expanding tourism industry tends to ‘crowd out’ other sectors of economic activity. The extent of these ‘crowding out’ effects depends, in turn, on factor constraints, changes in the exchange rate, the workings of labour markets and the macroeconomic policy context (Copeland 1991). The study of the economic impacts of tourism shocks has recently undergone a ‘paradigm shift’ as a result of the use of CGE models in place of I-O models. CGE models can be tailored to allow for alter- native conditions such as flexible or fixed prices, alternative exchange rate regimes, differences in the degree of mobility of factors of production and different types of competition. Thus, a number of useful papers have been published using CGE modelling to estimate the economic impacts of shocks associated with inbound tourism (Adams and Parmenter 1995,1999;Dwyer et al. 2003); the economic impacts of tourism crises (Blake et al. 2003a; Pambudi et al. 2009); the economic impacts of special events (Dwyer, Forsyth and Spurr 2005; Blake 2005); evalua- tion of economic policy (Blake and Sinclair 2003); and tourism effects on income distribution and poverty reduction (Blake, Arbache, Sinclair and Teles 2008;Wattanakuljarus and Coxhead 2008). While CGE models are particularly helpful to tourism policy makers who seek to use them to provide guidance about a wide variety of ‘what if?’ questions, arising from a wide range of domestic or international expenditure shocks or alternative policy scenarios, economic impact analyses do not provide the right information for policy formulation. The measured impacts on economic activity of most tourism shocks, such as increases in tourism expenditure, may normally be expected to be much greater than the net benefits which they generate for the community (or in other words, the measure of the extent to which they make the community better off). Recognizing this, some CGE models (Blake 2005, Blake et al. 2008, Dwyer et al, 2006) are explicitly designed to include a measure of resident welfare. Consistent with economic theory, Blake et al (2008) measure a change in welfare by equivalent variation (EV), which indicates how much the change in welfare is worth to the economy at the pre-simulation set of prices. This measure takes the results from what may be quite complex effects of a simulation on a household and produces a single value to describe how much better (or worse) off the economy is as a result of such effects. Tourism economists now have an added opportunity to inform tourism stakeholders on the net benefits associated with tourism development. (G) © Goodfellow Publishers Ltd 10 Economics of Tourism Surprisingly, perhaps, despite the progress in concepts and applications of cost benefit analysis in the economics literature, this area is relatively neglected in tourism economics. d. Investment and Innovation Strong, continuing tourism investment is vital to a strong, successful tourism industry. Apart from the increase in capacity and profits that accrue to individual firms and the tourism sector in general from successful investment, the perceived national and regional benefits that come from a more favourable tourism investment climate include economic growth; job creation; utilisation of domestic resources, particularly renewable resources; skills acquisition; expansion of exports; development of remote areas of the country; and facilitation of increased owner- ship of investment by the nation’s citizens. Unfortunately these outcomes of investment are often taken for granted by researchers and insufficiently examined in particular cases. The importance of tourism investment became particularly evident during the recent Global Financial Crisis. Declining asset values impacted on the ability of firms to fund debt or invest and many capital projects (including fleet expansion, hotel projects, attractions etc) were shelved due to financing difficulties. Credit availability and de-risking of bank balance sheets stifles the volume of tourism investment needed to support tourism growth over time with its attendant economic effects. The source of capital financing is an important issue in tourism investment decision-making, since it can substantially affect a tourism project’s overall costs. We need greater understanding of the sources of finance available to support tourism invest- ment including the extent of distortions that exist in different economies to restrict its volume. Various theories of the basis of firms financing decisions have been proposed in the wider finance literature. These include the Pecking Order and Trade-off theories as well as right- fi- nancing and the Market Timing Hypothesis (Frank and Goyal 2008). There are opportunities for tourism economists to explore the implications of these different perspectives to increase our understanding of the conditions that support successful tourism investment. Tourism industries worldwide (eg, airlines, rail services, public transport) display the problems associated with regulated infrastructure such as inadequate investment, excessive investment, poor service quality, over servicing, high cost operation, and ineffective use of available capac- ity. These problems also appear with tourism infrastructure. The positive side is that in many destinations the problems are being diagnosed, and regulation is being better designed to take account of the problems that have developed... The extent of environmental constraints on the development of tourism infrastructure is an area in need of the attention of researchers. Consideration of the trade-offs that must be made between economic and environmental at- tributes is a crucial task to achieve sustainable development of the tourism industry. Infrastructure industries are often complex ones which pose a number of public policy prob- lems which need to be addressed- for example, they are often monopolies, and governments will wish to limit the use of their market power. Infrastructure projects, which often involve large, capital intensive investments, often have large environmental impacts, (for example air- ports) which mean that obtaining approval for them is a drawn out process. There are various economic problems associated with ensuring the supply of tourism infrastructure, These include investigation of the changes that have been taking place in the institutional structure of infrastructure- the move from public to private provision; the congestion problem which impedes the efficiency of infrastructure provision; problems in government regulation of (G) © Goodfellow Publishers Ltd