CHAPTER 3
THEORETICAL FRAMEWORK
The theoretical framework of the thesis is multidisciplinary in approach. First, tourism impacts and tourism in the Gross Domestic Product are pooled into the framework to better understand the impact of tourism in the whole economy. Finally, general equilibrium theories and the theoretical structure of an applied CGE model are briefly discussed to better understand the framework under which the tourism sub-sector interacts with the other sectors, sub-sectors and industries in the economy.
Tourism Impacts[1]
The impacts of tourism expenditure are generally considered under three headings. These are direct effects, indirect effects, and induced effects. Figure 1 summarizes these.
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Source: Ennew, 2003.
Figure 1. The effects of tourism expenditure
Direct Effects
The direct effects of tourism arise from expenditures by tourists, which immediately generate income for businesses and households, employment and revenue from taxation.
If we consider Figure 1, then initial tourism expenditure has a direct effect in the form of income to businesses for goods and services bought by tourists, wages to households in connection with tourism related employment and income to the government through tourism related taxation and fees. When tourists spend their income on imported goods (often food and drink but possibly also furnishings in hotels, salaries for overseas workers, etc), that expenditure is lost to the system (leakages via imports). Governments, households and most notably business, must then make purchases in order to provide tourism related goods and services. This is most apparent in the case of businesses that must purchase a range of different inputs to create the goods and services purchased by tourists. The initial tourism expenditure or visitor consumption can be classified into two sub-categories (i.e., visitor actual final consumption and tourism business expenses) as indicated in Figure 2.
Source: General guidelines for developing the TSA vol 1, WTO.
Figure 2. Component of visitor consumption
Indirect Effects
Indirect effects arise as the initial income received by households, government and local businesses is re-spent on activities necessary to provide the products and services purchased by tourists. In other words, in order to provide tourism related goods and services, governments, households and most notably business, must purchase a range of different inputs to create the goods and services purchased by tourists. Such kinds of effects are called indirect effects.
This indirect expenditure provides further income to other businesses, to households and to government (as well as further losses via imports); they in turn will re-spend the income received in order to buy necessary inputs and will provide income to other businesses, households and governments. Thus, the effect of the initial expenditure is multiplied throughout the economy.
Induced Effects
Induced effects are the changes in economic activity resulting from household spending of income earned directly or indirectly as a result of tourism spending. Governments and businesses will not spend all the initial expenditure to purchase tourism-related inputs, they will also spend some income on their own consumption, and this additional consumption expenditure is effectively being induced by the additional income received from tourism. This consumption expenditure in turn provides a source of income for other households, for government and for business. Like the other types of expenditure, there is a risk of leakages via spending on imports.
Tourism in Gross Domestic Product
Foreigners visiting other countries for the purpose of recreation and leisure have provided a source of income for the host countries. In many countries, tourist income has become the main source of foreign exchange. Over the decades, traveling and organization of tours have become formalized to generate a fully viable tourist industry with all the ancillary and supporting services (Hen and Low, 1990).
The contribution of tourist earnings in the GNP of a country is conceptualized in Figure 3. In terms of final demand, expenditure by tourists can be viewed as the exports of goods and services of the host countries and nonresidents’ expenditure. International trade in tourism occurs in the form of the tourists or consumers crossing the boundaries rather than the goods and services going over to them. Thus, records of travel expenditure may be captured in the national accounts relating to private consumption expenditure by nonresidents as well as in the balance of payments account. In the latter, the balance of travel explicitly identifies such surplus or deficits arising from more visitors from abroad or nationals traveling overseas, respectively (Hen an Low, 1990).
The effects of tourism on the balance of payments has two components (Airey 1978; Bryden 1973). One consists of effects within the home country, including the country’s own residents and visitors from overseas or inbound tourism. Apart from export earnings from overseas, the import content of servicing all tourists must be noted. The other is outbound tourism, that is, the tourist activities of residents which take place outside of the home country. However, such a separation has been questioned by some authors (Erbes 1973; Thuens 1976).
Presently, balance of payments statistics do not give a comprehensive picture of the impact of international tourism on the economy. The travel account reconciles expenditures made by overseas visitors in the home country and by residents of the home country abroad. It makes no reference to secondary effects like more imports from higher income arising from tourist activities and tertiary effects from flows of currency not initiated by direct tourist expenditure. Thus, the travel account only provides part of the picture. Some authors try to widen the coverage to include all readily identifiable international visitor expenditures (such as investment patterns, money spent on transport, and the training of foreign staff) to calculate the balance on the tourism account (Airey 1978; Bryden 1973).
Despite its limitations, the travel account provides one measure of involvement of a country in international tourism. It indicates the degree to which a country attracts overseas visitors when compared with the ability of foreign countries in attracting residents to travel abroad. The balance on the travel account is calculated by subtracting the expenditures by residents traveling abroad from the expenditures by overseas residents in the home country.
Figure 3. Tourism expenditure in gross domestic product
General Equilibrium Theory[2]
An economy under a general equilibrium framework operates in such a way that all markets in the economy are in equilibrium simultaneously. In a general equilibrium model, the number of consumers, producers and commodities is specified.
On the consumption side, each of consumers has an initial endowment of the N commodities and a set of preferences, resulting in demand functions for each commodity. Market demands are the sum of each consumer's demands. Commodity market demands depend on all prices, are continuous, nonnegative, homogeneous of degree zero (i.e., no money illusion) and satisfy Walras' Law (i.e., that at any set of prices, the total value of consumer expenditures equals consumer incomes).
On the production side, technology is described by either constant returns to scale activities or non-increasing returns to scale production functions. Producers maximize profits. When constant returns to scale is satisfied, zero profit conditions hold for all industries.
The zero homogeneity of demand functions and the linear homogeneity of profits in prices (i.e., doubling all prices doubles money profits) implies that only relative prices are of any significance in such a model; the absolute price level has no impact on the equilibrium outcome. Equilibrium in the model is characterized by a set of prices and levels of production in each industry such that market demand equals supply for all commodities (including disposals if any commodity is a free good). Since producers are assumed to maximize profits, this implies that in the constant-returns-to-scale case no activity (or cost-minimizing techniques for production functions) does any better than break even at the equilibrium prices.
To illustrate how the general equilibrium model work, a simplified numerical example is presented.
Consider an economy with two final goods (manufacturing and non-manufacturing), two factors of production (capital and labor), and two classes of consumers. Consumers have initial endowments of factors, but have no initial endowments of goods. There are no consumer demands for factors (i.e., no labor-leisure choice).
Production Side
Production of each good takes place according to a constant-returns-to-scale, constant-elasticity of- substitution (CES) production function. The production functions for the example are given by
, i = 1, 2 (1)
where Qi denotes output of the ith industry, is the scale or units parameter, is the distribution parameter, Ki and Li, are the capital and labor factor inputs, and is the elasticity of factor substitution.
The factor demand functions derived from cost minimization for these production functions (1) are:
, i = 1, 2. (2)
, i = 1, 2. (3)
where PK and PL are the per-unit factor costs for the industry (See Appendix 4 for the derivation of (2) and (3)).
Consumption Side
Each consumer has commodity demand functions generated by maximizing a CES utility function subject to its budget constraint. The CES utility functions are given by
, i = 1, 2; c = 1, 2. (4)
where is the quantity of good I demanded by the cth consumer, are share parameters, and is the substitution elasticity in consumer c's CES utility function.
The consumer's budget equation is where P1 and P2 are the consumer prices for the two output commodities, and are consumer c’s endowment of labor and capital, and is the income of consumer c.
If this utility function is maximized, subject to the budget constraint, the demand functions[3] are:
, i = 1, 2; c = 1, 2. (5)
(See Appendix 5 for the derivation of (5)).
The solution to the model is characterized by 12 variables, the four prices P1, P2, PL, PK and the eight quantities , , , and K1, K2, L1, L2 which meet the required conditions for equilibrium.
Conditions for Equilibrium
The equilibrium conditions in this model are that market demand equals market supply for all inputs and outputs, and that profits are zero in each industry.
These can be written out more fully as following.
a. Demands equal supply for factors
(6)
(7)
where , , and are given by (2) and (3).
b. Demands equal supply for goods
(8)
(9)
where, , and are given by maximizing (4), subject to consumer budget constraints, and Q1 and Q2 are given by (1).
c. Zero profit conditions hold in both industries
(10)
(11)
Given the four commodity and factor prices, the demands for commodities by all consumers can be evaluated because factor prices determine consumer incomes (which give the position of each consumer's budget constraint), and commodity prices give the slope of the budget constraint. The factor requirements to meet commodity demands are given by (2) and (3). Equilibrium is therefore characterized by four prices PK, PL, P1, P2 such that equations (6)-(11) hold.
Computable General Equilibrium Models[4]
Computable General Equilibrium (CGE) models are basically large sets of demand and supply functions that cover every market in an economy. A typical CGE model can comprise markets for the household, government, business firms and foreign sector. (Pofgren, Harris and Robison 2001).
CGE models follow the Walrasian neoclassical general equilibrium approach; hence, they satisfy the basic assumptions of general equilibrium theory. Those models have clearly defined roles for the various agents in the economy. Firms use labor, land, capital and intermediate goods in the production of goods and services. It has a representative household that acts as a consumer of goods and services. Government buys goods and services, provides government services, and collects taxes. Finally, foreign agents interact with domestic agents through imports and exports.
The economic agents interact through markets. Their transactions determine, among others, sectoral outputs and prices. The economic agents interact through markets. Their transactions determine, among others, sectoral outputs and prices. When these variables are then aggregated, we can derive macroeconomic indicators like Gross Domestic Product and its components, Consumer Price Index, factor returns and employment.
Structure of Production
A basic assumption is that the production function is separable in input and output. Since the production function is separable, we can consider production into 2 stages. In the first stage, firms determine how much input should be employed and in second stage, firms determine how much output should be produced so that it can minimize its cost (Figure 4).
a. Input side. Function G which determines how much input should be used is broken into a sequence of nests.
- At the top level, commodity composites, a primary-factor composite and 'other costs' are combined using a Leontief production function.
- Each commodity composite is a Constant Elasticity of Substitution (CES) function of a domestic good and the imported equivalent.
- The primary-factor composite is a CES aggregation of land, capital and composite labor.
b. Output side. There are two Constant Elasticity of Transformation (CET) nests on the output side.
- The first determines the proportions of commodities produced by each industry.
- The second allows for some friction in switching output between local and export destinations.
Source: Horridge et al. (2001).
Figure 4. Structure of production
Structure of Consumer Demand
Figure 5 represents the structure of household demands. Like intermediate demands, domestic and imported variants of each good are combined using CES functions. Demands for the resulting composite goods follow the linear expenditure system, which is consistent with a Klein-Rubin utility function.
Source: Horridge et al. (2001).
Figure 5. Structure of consumer demand
Structure of Investment Demand
For each industry, investment demands follow a pattern similar to Figure 5, except that the Klein-Rubin nest is replaced by a Leontief function. Specially, (1) investment spending on commodity c by industry i is a CES composite of domestic and foreign components of c, and (2) an industry invests on commodity composite in fixed proportions.