Tourism, globalization, social externalities, and domestic welfare

Research in International Business and Finance 18 (2004) 141–149

Tourism, globalization, social externalities, anddomestic welfare

Chi-Chur Chaoa,∗, Bharat R. Hazarib, Pasquale M. Sgrob

a Department of Economics, Chinese University of Hong Kong, Shatin, Hong Kongb Deakin Business School, Deakin University, Malvern, Victoria 3144, Australia

Received 8 August 2003; accepted 12 December 2003

Abstract

One of the impacts of globalisation has been the growth in tourism and mobility of capital. Thispaper examines the welfare effect of tourism on the host economy with imperfect competition. Threechannels that affects domestic welfare by tourism are: social externalities accompanied with tourists,the terms of trade effect via rises in the non-tradable prices, and the resource movement effect tothe manufacturing sector. Owing to the positive terms-of-trade effect and/or the beneficial resourcemovement effect, the optimal levels of tourism occur at the situations that tourists bring negativesocial externalities to the economy.© 2004 Elsevier B.V. All rights reserved.

Keywords: Tourism; Globalization; Social externalities

1. Introduction

Globilisation and its impact have been examined widely in recent years. The term“globalisation” may be defined in terms of the mobility of goods, factors and/or consumers.The mobility of goods has always been the hallmark of trade theory. However, in recentyears there has been increasing mobility of factors, in particular capital and consumers.While the former represents factor mobility, the latter is defined as tourism. Consumerstravel from one country to another as tourists to enjoy and consume the private and publicgoods that the other country offers. Tourism has been growing at an extraordinarily high

∗ Corresponding author.E-mail address: [email protected] (C.-C. Chao).

0275-5319/$ – see front matter © 2004 Elsevier B.V. All rights reserved.doi:10.1016/j.ribaf.2003.12.001

142 C.-C. Chao et al. / Research in International Business and Finance 18 (2004) 141–149

rate (although there has been a setback to its growth since the 11th September attack on theUSA).

The tourism industry is one of the important earners of foreign exchange in many coun-tries. In the case of Hong Kong, tourism receipts totaled one billion US dollars in 1995 andaccounted for 8 percent of GDP. Promoting tourism domestically and internationally hasbeen a top priority for several governments. The importance of tourism in these economiesis easily gauged from concerns of a fall in tourism activity after the terrorist attack in theUSA on 11th September 2001. The purpose of this paper is to present a model to studythe contribution of tourism to resident welfare in a small open economy characterized byimperfectly competitive markets.

Foreign tourists mainly consume both public and private non-traded goods, such as localnightlife, restaurant meals, heritage and culture, and shopping opportunities. The anal-ysis of tourism on domestic economies has been generally based on models of perfectcompetition,1 in which an expansion of tourism can raise income only if the terms oftrade (tertiary non-traded goods) improve.2 However, there is no additional gain in wel-fare through reallocation of resources since production factors are efficiently utilized underperfect competition. However, imperfect competition prevails in the manufacturing sectorof several economies. In this case, a tourist boom, which alters the prices of non-tradablegoods, may result in reallocating resources to or from the manufacturing sector, thereby re-ducing or enlarging the degree of monopoly distortion. This gives an additional channel thataffects resident welfare of the host economy. Thus, the channel of imperfectly competitivemarkets should not be ignored in examining the impact of tourism.

In addition, most of the literature on tourism has been confined to the analysis of theterms-of-trade effect. In fact, foreign tourists may bring social externalities to domesticresidents. Different culture and lifestyles of foreign visitors can generate positive sentimentsto local people on the one hand, but massive tourists may turn local residents’ life intonightmares on the other hand. The social externalities of tourism on the host economy willbe incorporated in this paper.

The paper is organized in the following manner.Section 2sets up a general-equilibriummodel for a small open economy with tourism. The model consists of two features: imperfectcompetition in the manufacturing sector and the presence of social externalities generated bytourists on the demand side. The effects of tourism on domestic welfare will be examined inSection 3using this model. The associated optimal levels of tourism will also be identified.Section 4provides some concluding remarks.

2. The model

Consider a small open economy that produces three final commodities, manufacturing(X), agriculture (Y) and non-tradable (Z), with the help of labour and capital. Assume thatthe economy exports agricultural goods and imports manufactures. While there are noimpediments on the exports, a quota (Q) is imposed on the imports of manufactures. By

1 SeeCopeland (1991)andHazari and Sgro (1995).2 SeeCopeland (1991)for a detailed discussion.

C.-C. Chao et al. / Research in International Business and Finance 18 (2004) 141–149 143

Fig. 1. Social externality function of tourism.

choosing goodY as numeraire, the domestic prices of goodsX andZ are denoted respectivelyby pX andpZ.

We assume that foreign tourists are interested in consuming local non-tradable goodsonly and their utility is denoted by:UT = vT (DZT), whereDZT is the consumption ofgoodZ. GoodZ can be considered as local nightlife, restaurant meals, etc. Letα be a shiftparameter of the demand function for tourism. The demand function for goodZ by touristsis therefore:DZT = DZT(pZ, α), with ∂DZT /∂pZ < 0 and∂DZT /∂α > 0. Here, an increasein tourism shifts out the demand for the non-tradable goods.

On the other hand, domestic residents consume all three goods and their utility function isassumed to be quasi-linear:U(DX,DY ,DZ, α) = u(DX)+DY+t(α)v(DZ), whereDi is thedemand of goodi.3 To yield the interior solutions, it is assumed thatu′(0) = v′(0) = ∞. Theshift parameter,α, on tourism in the domestic utility function captures social externalitiescaused by tourists. Foreign visitors bring different culture and lifestyles, which generatea positive externality to domestic residents. But the beneficial impact declines and due toconsumption congestion, it eventually becomes negative as a result of the presence of alarge number of tourists. This suggests thatt′(α) is positive whenα is small, and it becomesnegative whenα is large. The function oft(α) is depicted inFig. 1.

Due to quasi-linearity of the utility function, domestic residents can employ a two-stagemaximization procedure: first allocating (I − β) andβ of incomeI between traded andnon-traded goods, and then making consumption decisions within each group. For theconsumption of traded goods in the second stage, domestic residents demand goodsX andY to maximize:u(DX) + DY , subject topXDX + DY = I − β. This gives the demand

3 We follow Konishi et al. (1990)for using quasi-linear preference in a general-equilibrium model with imper-fect competition.


functions of goodsX andY : DX = DX(pX) andDY = DY(pX, I − β). Note that thedemand forX does not depend on income and all the income effect goes to the demand forY. This condition forces demands for both goods to be positive. In addition, in the secondstage, domestic residents also demand for the non-tradable goods to maximizet(α)v(DZ),subject topZDZ = β. This yields demand function for goodZ by domestic residents:DZ = DZ(pZ, β) = β/pZ, where∂DZ/∂pZ < 0 and∂DZ/∂β > 0.

In the first stage of the problem, domestic residents chooseβ to maximize total utility.This is accomplished by substitutingDX, DY andDZ derived in the second stage intoU(·) toobtain the indirect utility function:V(pX, pZ, I − β, β, α). DifferentiatingV(·) with respecttoβ and using the first-order conditions, we obtain∂DY /∂(I − β) = t(α)v′(β/pZ)/pZ, where∂DY/∂(I − β) = 1. This gives:β = β(pZ, α), with ∂β/∂α = −pZv′t′/v′′t and∂β/∂pZ =−(v′ + DZv

′′)/v′′.4 Sincev′ > 0, v′′ < 0 andt′ > (<)0, we have∂β/∂α > 0 whenα issmall whereas∂β/∂α < 0 whenα is large. Thus, a large number of tourists may crowd outdomestic residents in consuming the non-tradable goods.

In equilibrium, the market clearing condition for goodZ requires that its domestic supplyequals total demand from domestic residents and foreign tourists:

Z = DZ(pZ, β)+DZT(pZ, α) (1)

whereZ is the supply of the non-tradable goods in the economy. The price,pZ, of thenon-tradables is determined fromEq. (1).

We now proceed to consider the production side of the economy. Labor and capital areused to produce three goods. Letw andr denote, respectively, the wage and rental rates.The production of goodX involves fixed cost,F(·), and variable cost,m(·)X. The presenceof fixed cost gives rise to economies of scale and also creates a barrier to entry. Withoutloss of generality of results, we consider the case of monopoly production ofX. The profitsof the monopolist are:π = pXX− F(w, r)−m(w, r)X. The inverse demand function forgoodX is given by:pX = φ(DX), withφ′ = ∂pX/∂DX < 0. Furthermore,pX = φ(X+Q)asDX = X +Q, whereX is the domestic supply andQ the level of the import quota ongoodX.5 The first-order condition for profit maximization is therefore given by:

φ(X+Q)+Xφ′(X+Q) = m(w, r) (2)

Eq. (2)states that in equilibrium marginal revenue (MR) equals marginal cost for producinggoodX. Hence, output of goodX can be determined fromEq. (2).We assume that perfectcompetition prevails in the markets of agriculture and the non-tradable goods. The produc-tion technologies of these represent constant returns to scale. Let the unit cost functions forproducing goodsY andZ be:g(w, r) andh(w, r). In equilibrium, unit cost must equal unitprice:

g(w, r) = 1, (3)

4 Note thatV(pX, pZ, I − β, β, α) = u(DX(pX)) + DY(pX, I − β) + t(α)v(β/pZ). Since the utility isquasi-linear, we have∂DY/∂(I − β) = 1 and hence∂2DY/∂(I − β)2 = 0. This condition is used in deriving∂β/∂αand∂β/∂pZ.

5 Due to the fixed quota restriction, the monopoly position of the domestic firm in sectorX can be maintained.SeeKrugman and Obstfeld (2000, Ch. 8).


h(w, r) = pZ (4)

These two equations form a Heckscher-Ohlin system: wage and rental rates,w andr, area function of the price of the non-tradables,pZ, and changes inw andr depend on relativefactor intensities [cf.Jones (1965)].6

To close the above model we need to consider factor markets. By Shephard lemma,first partial derivatives of cost functions yield factor demands. Hence, the full-employmentconditions for factor markets require that:

mw(w, r)X+ Fw(w, r)+ gw(w, r)Y + hw(w, r)Z = L, (5)

mr(w, r)X+ Fr(w, r)+ gr(w, r)Y + hr(w, r)Z = K, (6)

whereL andK are, respectively, the inelastically supplied endowments of labor and capitalin the host economy.7

The economy described in (1)–(6) consists of six unknowns,pZ, X, w, r, Y andZ, alongwith a shift parameter on tourism,α. Using the above model, we can examine the relationshipbetween tourism and domestic welfare for the host economy.

3. Tourism and domestic welfare

This section examines the impact of a tourist boom on domestic welfare. For this werequire expressions for changes in factor returns, the relative price of the non-tradablegoods and outputs. We begin with factor returns. Owing to the Heckscher–Ohlin structurein the production of goodsY andZ, the returns on labor and capital,w andr, are functionsof the non-tradable price,pZ. Letting “ˆ” denote the percentage change, from (3) and (4)we obtain:

r =(θLY

θ

)pz, (7)

whereθji denotes the cost share of factorj in sectori, and (θ≡ θLYθKZ−θLZθKY ) the factorintensity ranking between sectorsY andZ. Eq. (7)states that an increase in the price of thenon-tradables increases (reduces) the rental rate on capital when sectorZ is capital (labor)intensive relative to sectorY [i.e., θ > (<)0]. This is in line with the Stolper–Samuelsontheory.

We turn next to output responses in the production side of the economy. Totally differ-entiating (2), we obtain the change in goodX to be:

s(2 − es)X = −(bεθm

θLY

)r, (8)

wheres = X/(X+Q) is the share of domestic output in total supply of goodX, b = m/pXdenotes the ratio of marginal cost to the price of goodX, ε = −φ/DXφ′ represents the

6 See, for example,Beladi and Marjit (1992)for a three-sector model with perfect competition.7 It is of interest to mention the differences between tourism and immigration: both affect the demand side

but the latter also affects the supply side of the host economy. SeeKondoh (1999), Hazari and Sgro (2001)andMichael and Hatzipanayotou (2001)on international migration.


price elasticity of the demand, ande = −DXφ′′/φ′ expresses the percentage change inthe slope of the demand curve for goodX.8 In addition,θm = θmKXθLY − θmLXθKY is themarginal factor intensity between sectorsX andY, whereθmLX = wmw/m and so on.9 Wewill herewith assumeθm > 0 since the manufacturing sector is usually not only averagebut also marginal capital intensive relative to the agricultural sector. Furthermore, as shownin Appendix, stability of the model requireses < 2.

Combining (7) and (8), we can express the change of goodX in terms of the non-tradableprice:

X

pz= −

[bεθm

s(2 − es)θLY

] (r

pz

)(9)

Eq. (9)states that when stability conditions are satisfied, the rental on capital and the outputof goodX move in the opposite directions as sectorX is assumed to be most capital intensive(i.e.,θm > 0).

As far as the change in the output of goodZ is concerned, we differentiateEqs. (5) and(6) to obtain:

λZ − λmX−[(λKYsL + λLYsK)

θLY

]r = 0, (10)

wheresL > 0 andsK > 0.10 Note thatλ(= λLYλKZ −λLZλKY) is the relative physical factorintensity between sectorsZ andY, and (λm = λmKXλLY−λmLXλKY) denotes the marginal factorintensity between sectorsX andY. By substitutingEqs. (7)–(10), we obtain:

Z

pZ= [λKYsL + λLYsK + bελmθm/s(2 − es)]

λθ, (11)

whereλθ > 0 andλmθm > 0 if we assume stability (shown inAppendix A). Hence,Eq. (11)states that the supply of goodZ is positively related to its price.Finally, we need to determinethe change in the price of the non-tradable goods. FromEq. (1), we have:

dpZdα

= (∂DZT/∂α+ ∂DZ/∂α)

{∂Z/∂pZ − [∂DZ/∂pZ + (∂DZ/∂β)(∂β/∂pZ)] − ∂DZT/∂pZ} , (12)

where∂DZ/∂α = (∂DZ/∂β)(∂β/∂α). Note that∂Z/∂pZ > 0 fromEq. (11), and∂DZ/∂pZ <0 and∂DZT/∂pZ < 0 by the demand relations. In addition, using the stability conditionsshown inAppendix A, we need that∂DZ/∂pZ + (∂DZ/∂β)(∂β/∂pZ) < 0 to obtain thepositive denominator in (12). Since∂DZT /∂α > 0, the sign of dpZ/dα depends largely onthe value of [∂DZ/∂α = (∂β/∂α)/pZ]. Whenα is small,∂DZ/∂α > 0 and hence dpZ/dα >0. That is, an increase in tourism raises the price of the non-tradable goods. On the otherhand, whenα gets large,∂DZ/∂α < 0. In this case, the value of dpZ/dα depends on therelative magnitudes of direct demand for goodZ by foreign tourists and domestic residents.If the increase in tourists’ demand is less than the demand reduction by domestic residents,we may have dpZ/dα < 0, hence, a deterioration in the tourist terms of trade.

8 Note thate > (<)0 when the demand function for goodX is convex (concave).9 The definition and use ofθm can be found inChao and Yu (2001).

10 Here,sL = (mwrrX + Fwrr + gwrrY + hwrrZ)/L andsK = (mwrwX + Fwrw + gwrwY + hwrwZ)/K.


We will use the above price and output effects to examine the welfare impact of an increasein tourism. The welfare of the domestic residents is represented by their indirect utilityfunction,V = V(pX, pZ, I−β, β, α), whereI[= wL+ rK+π+ (pX−p∗)Q] is domesticincome andp∗ denotes the given foreign price of goodX. Note that domestic income consistsof factor returns, profits and quota rents. Quota rents, (pX − p∗)Q, are returned to domesticresidents in a lump-sum manner. Therefore, the effect of tourism on domestic welfare canbe obtained by differentiatingV(·) and then using Roy’s identity to yield:11

dV

dα= Vα + (Z −DZ)

(dpZdα

)+ (pX −m)

(dX

dα

)(13)

The welfare impact of tourism inEq. (13)is captured by three distortions in the economy:social externality of tourism, non-tradability of goodZ, and monopoly in sectorX. Thesocial externality is represented by the first term,(Vα = vt′), in (13). This term dependson the value oft′(α), which is positive initially but declines to negative values whenαgets larger. The second term expresses the feature of goodZ: it is non-tradable but tourismmakes it tradable (i.e.,Z > DZ). Hence, a change in its price has a terms-of-trade effect.Nevertheless, the gain from tourism occurs only when the price of goodZ rises (i.e., aterms-of-trade improvement). In addition, in the third term ofEq. (13), the change in theprice of goodZ causes resource movements, thereby affecting the production of goodX.In particular, if resource reallocation expands the production of manufactures and henceshrinks the monopoly distortion, domestic welfare will be positively affected.

The detailed analysis of the impact of tourism on domestic welfare is, as follows:

(i) Suppose that the production of the non-tradable goodZ is most labor intensive. Whenαis small, we haveVα > 0, dpZ/dα > 0 by (12) and dX/dα > 0 byEqs. (7) and (9). Thesegive dV/dα > 0: an increase in tourism always improves domestic welfare. However,whenα is large, an increase in tourism may lower welfare because we may have:Vα < 0,dpZ/dα < 0, dX/dα < 0, and hence dV/dα < 0. In short, welfare increases and thendeclines asα gets larger. The following proposition is immediate:

Proposition 1. Consider an economy that attracts tourists by means of non-tradablegoods. An expansion of tourism can raise the price of the non-tradables, which in turnincreases resident welfare through its favorable impacts on social externality, terms oftrade and resource reallocation when the non-tradable sector is most labor intensive.However, when a large number of tourists present, those impacts may become negativeso that further expansion of tourism can be welfare reducing.

Since the welfare function is concave in this case, by setting dV/dα = 0 in (13) we can solvethe optimal level of tourism, denoted byαZ. Specifically, choosingt(α) = 1− aα+ bα1/2,we have:12

αZ = b2

4

{a− [(Z −DZ)(dpZ/dα)+ (pX −m)(dX/dα)]

v

}2

(14)

11 Marginal utility of income,∂V/∂(I − β), is equal to unity under quasi-linear preference.12 The turning point fort(α) is: αt = b2/4a2 so thatt′(α) > (<)0 asα < (>)αt .


Note that evaluated atαZ, we haveVα < 0 [i.e., t′(α) < 0, as depicted inFig. 1] whiledpZ/dα > 0 and dX/dα > 0 in (14). This suggests that at the optimal level of tourism, theloss of consumption congestion is exactly offset by the gains from an improvement in theterms of trade and an expansion in the production of goodX. It is also of interest to notethat because of the gap betweenpX andm, the presence of monopoly allows for a largeroptimal level of tourism, as indicated inFig. 1.

(ii) Suppose that the production of agricultureY is most labor intensive. Whenα is small,dpZ/dα > 0 by (12) but dX/dα < 0 and byEqs. (7) and (9), dV/dα > (<)0. On the otherhand, whenα is large, dpZ/dα < 0 but dX/dα > 0, implying dV/dα > (<)0. Owingto opposite movements betweenpZ andX, changes in welfare will be ambiguous. Bysetting dV/dα = 0, we can also obtain the optimal level of tourism, denoted byαY ,which is the same formula as in (14) but with a negative value of dpZ/dα or dX/dα.This gives a smaller optimal level of tourism:αY < αZ, as illustrated inFig. 1.

It is worthwhile to point out that in the absence of monopoly, an increase in tourismimproves welfare if it causes an improvement in the terms of trade via a rise in the priceof the non-tradables [cf.Copeland (1991)]. However, the welfare-improving result may nothold in this case when monopoly presents in the manufacturing sector. A rise in the price ofthe non-tradables increases their outputs, but at the expense of manufactures. This enlargesthe monopoly distortion in manufacturing, thereby mitigating resident welfare in the hosteconomy. We summarize this result in the following proposition:

Proposition 2. In the presence of monopoly in the manufacturing, an expansion of tourismcan aggravate the monopoly distortion although it raises the price of the non-tradables. Asmall optimal level of tourism is thus required when the agricultural sector is most laborintensive.

4. Concluding remarks

One of the impacts of globalisation has been the growth in tourism and capital mobility.Tourism has also contributed significantly to many economies. Using a general-equilibriumframework, this paper is able to identify three channels that affect the impacts of tourism ondomestic welfare. Specifically, these three channels are: social externalities accompaniedwith tourists, the terms of trade effect via rises in the non-tradable prices, and the resourcemovement effect to the manufacturing sector. Due to the positive terms-of-trade effect and/orthe beneficial resource movement effect, the optimal levels of tourism occur at the situationsthat tourists bring negative social externalities to the economy. That is, to maximize residentwelfare, a trade-off between social externalities and economic development occurs. Thisquestion deserves further investigations. For instance, consider aNiskanen (1977)govern-ment that has her own set of concerns in resident welfare and non-economic objectives suchas social externalities. The weights chosen for social externalities in forming governmentwelfare may give different results on the optimal levels of tourism obtained in this paper.


Acknowledgements

The work described in this paper (for Chao) was supported by a grant from the Re-search Grants Council of the Hong Kong Special Administrative Region, China (ProjectNo. CUHK4201/02H).

Appendix A

The dynamic adjustments for the goods markets are as follows:

X = η{φ(X+Q)+Xφ′(X+Q)−m(w, r)},pz = ρ{DZ(pZ, β)+DZT(pZ, α)− Z(pZ)},

where a dot over a variable denotes the time derivative, andη andρ are the speeds ofadjustments. Linearizing the above equations around the equilibrium values, we can obtainthe trace and determinant of the system:

trace= −(2 − es)θLY + pZ

{[∂DZ

∂pZ+

(∂DZ

∂β

) (∂β

∂pZ

)]+ ∂DZT

∂pZ− ∂Z

∂pZ

},

determinant= −(2 − es)θLYpZ

{[∂DZ

∂pZ+

(∂DZ

∂β

) (∂β

∂pZ

)]+ ∂DZT

∂pZ− ∂Z

∂pZ

}

For stability, we need a negative trace and positive determinant. This gives:es < 2,λθ > 0andλmθm > 0, whereλ = λLYλKZ − λLZλKY, θ = θLYθKZ − θLZθKY, λm = λmKXλLY −λmLXλKY, andθm = θmKXθLY − θmLXθKY. In addition, we need to impose that∂DZ/∂pZ +(∂DZ/∂β)(∂β/∂pZ) < 0.

References

Beladi, H., Marjit, S., 1992. Foreign capital and protectionism. Can. J. Econ. 25, 233–238.Chao, C.C., Yu, E.S.H., 2001. Trade liberalization in oligopolistic competition with unemployment: a general

equilibrium analysis. Can. J. Econ. 30, 479–496.Copeland, B.R., 1991. Tourism, welfare and de-industrialization in a small open economy. Economica 58, 515–529.Hazari, B.R., Sgro, P.M., 1995. Tourism and growth in a dynamic model of trade. J. Int. Trade Econ. Dev. 4,

243–252.Hazari, B.R., P.M. Sgro, 2001. Migration, Unemployment and Trade. Kluwer Academic Publishers, Boston.Jones, R.W., 1965. The structure of simple general equilibrium models. J. Pol. Econ. 73, 557–572.Kondoh, K., 1999. Permanent migrants and cross-border workers: the effects on the host country. J. Reg. Sci. 39,

467–478.Konishi, H., Okuno-Fujiwara, M., Suzumura, K., 1990. Oligopolistic competition and economic welfare. J. Public

Econ. 42, 67–88.Krugman, P.R., Obstfeld, M., 2000. International Economics: Theory and Policy, fifth ed. Addison-Wesley.Michael, M.S., Hatzipanayotou, P., 2001. Welfare effects of migration in societies with indirect taxes, income

transfers and public good provision. J. Dev. Econ. 64, 1–24.Niskanen Jr., W., 1977. Bureaucracy and Representative Government. Aldine Press, Chicago.

Documents

Tourism, globalization, social externalities, and domestic welfare