Tourism Economics
Handout on Market Failures and the Role of Government in Tourism
Market Failures and the Role of Government
Externalities
Imagine a transaction between a buyer and seller. Usually the only two people affected by that transaction are the buyer and seller. Externalities occur when someone other than the buyer or seller is affected by the transaction.
The key is that the trades that take place are those that make both parties better off. This is only optimal if the trade between the two parties affects only the two parties. If a third party, who has no influence over whether the trade takes place, is affected by the trade, then one must take into account the effect on the third person when determining what the optimal point is. In general, this does not happen in a market, hence when externalities are present, the optimal point is not reached.
Negative Externalities
A negative externality is when a third party is harmed, or bears a cost, because of a trade between two other people.
The most common example is all forms of pollution. A company that dumps waste in a river, a motorist who emit pollutants in the air, a poorly maintained building in a nice neighborhood, someone who plays loud music next door, the loss of species due to development, etc. are all negative externalities.
Some negative externalities of tourism might be …
(i)traffic congestion if tourists all come to a specific area
(ii)extra demand on resources, such as water
(iii)overbuilding in a particular region
(iv)pollution or littering by tourists
(v)negative cultural interaction between tourists and local residents
The problem of a negative externality is that neither the producers or consumers have to pay for this extra cost of producing the good. That is, if somehow producers could be forced to pay this cost then their private cost would reflect the true social cost and it would get factored into the decision on how much to produce. But since it is a cost they do not have to pay, it does not get factored in and overproduction occurs. That is, production is beyond the optimal amount from society’s perspective.
Positive Externalities
A positive externality is when a third party is benefited because of a trade between two other people.
The examples are probably fewer, but several come to mind. First, immunization from disease or virus makes it less likely others get it. R&D by one company can easily be used by another.
Some positive externalities in tourism might be …
(i)Improvement in recreation facilities
(ii)Improvement in infrastructure of airports, roads, etc.
(iii)Preservation of Heritage and Culture
(iv)Cultural exchange between tourists and local residents
The problem with a positive externality is that the extra social benefit of the good is not reflected in the willingness of consumers to pay for the good. Thus suppliers are not responding to what is best for society, but only what is best for consumers. So production will be lower than what is optimal for society.
The Root Cause of Externalities
Why do externalities exist? Answering this will help answer what can be done to solve the problem of externalities.
One answer is that externalities exist because third parties are affected. But that just restates the question. Why is it that third parties are affected in such a way that it does not show up in either the suppliers costs or consumer’s benefit?
In what follows we will look at some potential externalities and demonstrate that there should exist private solutions. That is, we will find that the voluntary trade can solve externalities. In this sense, externalities would not create a problem.
Such private solutions will work when the property rights of all individuals can be clearly established. For example, suppose we are considering the externality of a chemical company dumping waste into a river. The third parties are those living in a city downstream. If there is a property right to that river, then a private solution will exist. If the citizens have a right to that river, then they can enforce their rights and stop the chemical company. Alternatively, the chemical company could pay them enough (more than the cleanup costs) to let them dump their waste in it.
This is not to say that externalities never create problems, but it helps us to (1) identify the conditions under which they do create a problem and (2) helps us to identify potential solutions.
Solutions to Externalities
Recall the problem with externalities is that some cost/benefit of the good is external to the producer or consumers. So the solution will involve, in some way, trying to internalize the external costs or benefits.
Private Solutions
Consider the negative externality of a hotel that dumps waste into the sea, killing the fish that local fisherman would catch. Suppose the hotel values dumping the waste in the sea at 500 because that is how much it takes to clean up the waste.However, the fisherman value the opportunity to catch fish at 800, as that is their income when the fish population is healthy. In this case a simple cost-benefit analysis reveals the social optimum is for the hotel to not dump waste in the sea. But bargaining will achieve this. The fisherman could pay the hotel in amount more than 500, say 650, to stop dumping its waste in the sea and the hotel would accept. Notice though if the hotel values dumping the waste at 1000, the social optimum is for him to play the music loud. But this is what happens in bargaining, since the most you would offer is 800.
- Note that we implicitly assumed that the hotel can dump its waste in the sea. That is, it was assumed he has the legal right to play his music loud.
Question: Would it matter if the fishermen have the legal right to peace and quiet.
Answer: NO.
Case 1: The hotel values dumping waste at 500, the fishermen value a clean sea at 800. Since the fishermen have the rights, the hotel must pay the fishermen to dump waste. But the hotel will only offer up to 500, which is not enough. Again the social optimum is reached.
Case 2: The hotel values dumping waste at 1000, the fishermen value a clean sea at 800. Since the fishermen have the rights, the hotel must pay the fishermen to dump waste. But the hotel will only offer up to 1000, which is enough. Again the social optimum is reached.
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Hence it does not matter who the rights are initially assigned to. Bargaining between the two parties will lead to the social optimum.
Why Private Solutions/Bargaining May Not Work even when property rights are assigned
If transactions costs to bargaining are high, then this will dissuade people from bargaining. For example, consider case 1. The hotel values dumping waste at 500, the fishermen value a clean sea at 800. Suppose the rights are assigned to the hotel, but the process of bargaining costs the fishermen 400. In this case, the net value of a clean seato the fishermen is 800-400 = 400. In which case the fishermen cannot afford to pay the hotel enough to turn down his music.
Unfortunately for many externalities bargaining costs are very high. There are two reasons for this. First, the large quantity of offended parties may make bargaining very costly. Second, the difficulty in assigning property rights, such as for air, makes bargaining impossible.
Conclusion: Externalities only create a problem if either it is impossible to assign property rights and/or the bargaining costs are very high.
Public Policy
In such situations, the government can respond.
- Regulation (such as with pollution).
- Taxes and Subsidies (for example, Singapore charges you to drive downtown).
The above try to find the optimum point, particularly in the case of pollution. Let us assume that they know the optimal amount of air pollution.
Regulation: This mandates the all potential polluters can only pollute a given amount of the pollutant…e.g. 300 units of the pollutant.
Taxes: This charges producers whenever they pollute a particular amount…e.g. $100 for each unit of the pollutant. Effectively the tax gives the right to pollute as long as they pay $100/unit. So you can think of a firm as having a demand curve for the right to pollute. The demand curve is presumably based on how much it costs a firm to NOT pollute. The higher the cost of not polluting, the greater the demand for pollution rights. (Graph this for 2 different firms, and for the market).
While both will work to reduce the pollutant, there is a difference. First, with regulation you are exactly able to reach the desired amount of pollution. Though a tax will reduce the pollutant you will not know by exactly how much the pollutant will be reduced. This is because you do not know the demand for pollution rights. However, this may not be a big difference as the government could always adjust the tax to get to the right quantity of pollutant.
The second difference is more important. While regulation reduces pollution, there is another question of the most efficient way to reduce pollution. Producers face different cost of reducing pollutants. Some may have to invest in expensive machines, others may need only a slight adjustment in production methods. Clearly, as a society we would want those who can reduce at cheapest cost to be the ones reducing pollutants. A regulation that says all producers must reduce pollution to 300 units will not achieve that, but a tax will. Consider again the two firms with different demand for pollution rights. Facing the tax, one firm chooses little pollution, while others choose more pollution. Presumably the firm with the highest cost of reducing pollution prefers to pay more of the pollution tax. Hence a tax is probably a more efficient way of reducing pollution.
Common Resources
Note that common resources are like negative externalities that exist due to poorly defined property rights. Because I cannot prevent someone from using the road (i.e. not excludable), the road gets congested. Similarly, if a river is public, it is like a common resource. If so, then the company dumping its waste in a river cannot be excluded. We’ll return to common resources a little later. As a preview, the problem with common resources is similar to that of negative externalities. Recall that a good with a negative externality is overproduced. Similarly, the problem with a common resource is that it is used too much.
Consider a good that is rival, but non-excludable. To say it is rival means that if one person uses the good, others cannot. To say it is non-excludable implies that no one can be prevented from using the good. One example of a common resource is traffic on a busy highway. To all drivers, the roads are a common resource. They are non-excludable since no one is excluded from using them. However, they are rival. One person using the road reduces the benefit others get from the road by making it more congested. But because the road is non-excludable people will continue using it until there is no more space left on the road. That is, it is used to point of exhaustion. This is known as the “tragedy of the commons” and generally is true for any exhaustible resource. We state it generally as follows:
Tragedy of the Commons: A common resource will be overused to the point of depletion. That is, the resource is not conserved.
What this implies is that if we are relying on a common resource as a source of income, it will not be a sustainable source of income. That is, the resource will be depleted and income derived from it will not be sustained into the future. Hence whether or not tourism resources are common resources is a very important question in determining if tourism income is sustainable.
To see why this is true let us consider another example. Suppose there is a forest that is commonly owned; that is, everyone has access to it. Now suppose there are several timber companies that wish to cut down the trees for lumber. Perhaps the best way to manage the forest would be to cut down 10% of the trees every year and replant. That is, this plan would conserve the forest so that it is a sustainable source of income for years to come. However, if several companies have free access to the forest, will they cut down only 10% and replant. The answer is no. To see why consider an individual company. Is there any incentive to only cut down a few trees? No. If this company is the only one that cuts down more trees, there will still be more in the future. And if all the other companies feel the same way and have the incentive to cut down more trees, then there will not be any more in the future so the company better cut down as many as it can while there are still some left. If all the timber companies feel this way, the forest will be cut down. Moreover, no one will replant because there is no reason to believe that you will cut down the replanted tree in thirty years. Hence the forest is overused to the point of depletion; it is not conserved.
Now contrast this with a herd of cattle. Why doesn’t the owner of the cattle kill all his cattle in one year? Because his effort at conserving the herd is rewarded with future income. This is why cows, chickens, etc. are not on the endangered species list, but elephants (a common resource to poachers) are on the endangered species list. That is, since no one owns elephants, the poachers view them as a common resource. The poachers reason that there may not be many elephants left in the future so they better kill as many as they can before another poacher does. That is, they have no reason to sustain conserve the elephant herd.
Solutions to the Common Resource Problem
It is clear that one could solve the common resource problem by making it a private resource. For example, in our forest example above if the forest is sold off to timber companies, then each timber company can control access to the forest. They have an incentive to replant trees (since they know they will be the ones to cut them down) and cut down few enough to keep the forest sustainable.
Alternatively, we also saw the traffic congestion is a type of common resource problem. This suggests if the roads can be make excludable (i.e. private), then the owner/manager of the role can control access by charging for the right to drive on it. He can then charge an amount such that there is no congestion. Toll roads exist for this purpose. In fact, in Singapore traffic congestion in the city center was very bad. So they made it excludable by charging people to drive in the city center.
One inventive use of establishing property rights for common resources was with endangered elephants. The government of Zimbabwe sold the rights to kill elephants for their ivory. Hence the owners of the elephant herd have a strong incentive to keep poachers from killing the elephants and to ensure a healthy, sustainable heard. As a result, the elephant herd are growing, not falling, in Zimbabwe.
Thus common resources, like externalities, have as a potential solution the establishment of property rights. But also like externalities, this is not always possible. For instance, the tragedy of the commons was first noted by fisherman. The waters in a particular area were being over-fished to the extent that the fish population was declining. But how could one establish property rights to the fish? It would simply be too difficult to do such a thing. So the fishermen, seeing this problem, decided to regulate themselves by establishing a quota that each fisherman could catch. In this case the individuals most directly involved were able to solve the common resource problem through collective action. This is probably because there were few enough fishermen that they could get together and decide on an appropriate action. However, what if there are many people involved? Then it may be too difficult to coordinate their activities and so government action may be needed. In this case the government could control access to the common resource and fine those who use the common resource too much. One example is to consider a public, picnic area as a common resource. Because no one owns the area, anyone can do anything to the area. For instance they may leave trash and such in this picnic area. A government solution may be to control access to the area and charge for its use, and then use the proceeds to pay someone to keep it clean. Or the government could simply fine people when the litter.
Application to Tourism
Recall that if we are relying on a common resource as a source of income, it will not be a sustainable source of income. That is, the resource will be depleted and income derived from it will not be sustained into the future. Hence whether or not tourism resources are common resources is a very important question in determining if tourism income is sustainable. So we must answer the question of whether the resources in tourism are common resources.