Tourism Promotion, Increasing Returns and Domestic Welfare

Tourism Promotion, Increasing Returnsand Domestic Welfare

Hui Shi1 and Chuhui Li21School of Economics, Jiangxi University of Finance and Economics, China, and 2Department of

Econometrics and Business Statistics, Monash University, Australia

1. INTRODUCTION

TOURISM has been considered as a driving force for economic growth. According to the

estimates by the World Travel & Tourism Council (WTTC, 2012), tourism’s total contri-

bution in 2011 represented 9 per cent of GDP, 1 in 12 jobs, 5 per cent of investment and 5

per cent of exports globally. The relationship between tourism development and economic

growth has been well examined in the economics literature. Brau et al. (2007) have recog-

nised that tourism specialisation is a key factor for growth in small tourist countries during

the period 1980–2003. Lee and Chang (2008) have found solid evidence of the panel cointe-

gration relations between tourism development and GDP in both OECD and non-OECD coun-

tries. In addition, Balaguer and Cantavella-Jorda (2002), Dritsakis (2004), Gunduz and

Hatemi-J (2005), Kim et al. (2006), Nowak et al. (2007) and Katircio�glu (2009, 2010) have

investigated tourism as a long-run economic growth factor in Spain, Greece, Taiwan, Turkey

and North Cyprus, respectively. In their papers, a tourism-led-growth model is proposed, sug-

gesting that tourism could have similar influence on economic growth as exports. First, tour-

ism is a significant foreign exchange earner to support the purchase of capital goods used in

production. Second, tourism generates direct, indirect and induced effects in the economy.

Third, tourism creates more job opportunities and hence increases income. Forth, tourism

exhibits economies of scale by stimulating investments in human and physical capital, and

technology (Chansomsak, 1991; Shi and Smyth, 2012).

Many governments have the incentive to support and promote tourism as an engine of

economic growth. Recently, the Victorian government in Australia has launched an $8 million

tourism advertising campaign aimed at the Chinese tourism market to stimulate the state econ-

omy experiencing a downturn in the manufacturing industry. The demand for tourism goods

and services is determined by various factors such as disposable income, advertising, leisure

time and prices of related goods. Among those factors, promotion or marketing is an easier

way to affect tourists’ decisions to visit a tourism destination. Studies have been carried out

to find a positive relationship between tourism promotion and tourism demand (Crouch et al.,

1992; Divisekera and Kulendran, 2006). Tourism promotion provides information on destina-

tion characteristics and this information plays an important role in purchase decision making

over a long time. Without this information, potential tourists may visit alternative

destinations.

Compared to government promotional campaigns, the marketing effort of tourism operators

is so small to impede the development of tourism. Most tourism operators only focus on mar-

keting specific products; so, the effectiveness of raising the profile of a tourism destination is

trivial. Furthermore, the ‘free rider’ problem makes private firms unwilling to undertake pro-

motion activities (see Bonham and Mak, 1996; Blake and Sinclair, 2007). Government inter-

vention, to some extent, can overcome market failure and spread beneficiaries throughout the

whole tourism industry. Even with a low amount of government funding, such support could

© 2013 John Wiley & Sons Ltd 995

The World Economy (2014)doi: 10.1111/twec.12084

The World Economy

be crucial to the continued growth of this country’s tourism and related industries, especially

for those countries with monopoly power in tourism goods, such as Thailand, Fiji and Hong

Kong.

When a government runs a promotional campaign, to keep the budget balanced, it has to

impose a tax to finance it. So, we have to consider the impact of subsidy and taxation. First,

from the perspective of the whole economy, does the promotion of tourism have positive or

negative effects on the well-being of local residents? Second, there are different types of tax

to finance tourism promotion, which one is more efficient? These two questions are what we

are going to discuss in this paper.

Tourism promotion has two sides. It is a driver of economic growth, but it may bring some

negative effects to the economy. Dwyer and Forsyth (1993) illustrate that a country as a

whole can gain from tourism promotion but not to the extent of the gains to owners of tour-

ism resources. Many economists such as Hazari and Ng (1993), Nowak et al. (2003),

Wattanakuljarus and Coxhead (2008), and Chang et al. (2011) have studied the effect of a

tourism boom from the perspectives of externalities such as increased pollution, congestion

and income inequality, etc. They all state that tourism expansion immiserises domestic resi-

dents. Chao et al. (2006) use a dynamic general equilibrium model to explain that tourism

expansion lower resident welfare with de-industrialisation in the traded good sector. Recently,

Zeng and Zhu (2011) built a general equilibrium model to find that a smaller country may be

better off with tourism than the larger one.

Generally, government tourism promotion is either financed by commodity tax on tourism

consumption or income tax on residents. In some tourism countries, for example, India, tour-

ists are charged higher prices for tourism commodities as they can get free public goods or

their activities deteriorate the environment. Other countries, on the contrary, levy income tax

to support tourism. For example, Thailand spends about 3 per cent of total government budget

outlays on promotional programmes’ accounts each year. Economists have different views

towards tourism tax. Copeland (1991) argues that tax on tourism consumption may discourage

visitation and reduce tax revenue collected from tourists. In his 2012 paper, Copeland further

supports a subsidy on tourists due to a pricing externality affecting the overall inflow of tour-

ists. In contrast, Hazari and Nowak (2003) argue that tourists should always be taxed whether

in small or large economies, and taxation will not reduce revenue from tourists due to monop-

oly power in trade of tourism goods and services. Gooroochurn and Sinclair (2004) find that

taxing tourism is relatively more efficient than levying other sectors for Mauritius using a

computable general equilibrium analysis. Chang et al. (2011) support a positive tax surcharge

imposed on foreign tourists for government services funding. Shi (2012) argues tourism pro-

motion funded by income tax is not welfare-improving. Based on previous studies, we will

compare how commodity tax and income tax that are levied to fund tourism promotion affect

local residents’ welfare in this study.

International tourism involves the movement of tourists from one country to another, as

most natural scenery, traditional culture and architecture cannot be transferred from one place

to another like an ordinary commodity. During tourists’ visits, they consume tourism goods

and services which are only provided by the host country. As a result, those non-tradable

goods such as hotels, restaurants and transportation become partially tradable in the presence

of tourism. In an open economy, countries import and export goods and services to gain

something that would not be possible in Autarky. Heckscher-Ohlin (H-O) model studies

patterns of trade based on factor endowments between economies. This trade theory has been

dominant for a long period. However, with the development of modern trade, the H-O model

© 2013 John Wiley & Sons Ltd

996 H. SHI AND C. LI

cannot explain the large extent of exchange between similar economies. This pattern of trade

stresses the importance of product differentiation and makes a more advanced international

trade theory necessary. Krugman (1979) extends the Dixit-Stiglitz model of Chamberlinian

monopolistic competition to find non-comparative advantage trade is driven by internal returns

to scale. But Ethier (1982) later proposes that international returns to scale (external to firms)

lead to intra-industry trade. Fan (2005) finds that the degree of increasing returns is closely

related to intense intra-industry trade among economies. The fact that increasing returns con-

tribute international trade has been empirically tested by Antweiler and Trefler (2002).

In the presence of increasing returns, markets are imperfectly competitive. When we exam-

ine the efficiency of promotion in an open economy with imperfect competition, subsidy and

taxation will affect the variety of market goods and price and hence consumers’ welfare. With

monopolistic competition, we usually have under-production with price above marginal cost.

The reason for this inefficiency is caused by the combination of increasing returns and aver-

age-cost pricing of market goods. As market goods are sold at average costs, each consumer

takes the price as given and they will not consume more. In fact, if consumers buy more of

this good, the fixed cost of producing this good will be spread over a larger number of units,

which results in a lower average cost and hence lower price for every consumer. But the

effect of increasing returns is not taken into account by individual consumers; so, a promotion

may overcome under-production of monopolistic competitive firms to improve welfare. In this

sense, if the tourism industry exhibits increasing returns, government promotion of tourism

that encourages more people to consume tourism goods is welfare-improving. However, with

increasing returns in other non-tourism sectors, the funded tourism promotion may adversely

affect those sectors through consumption effect or industrial effect. Hence, the benefit/cost

ratio is useful to the economic assessment of promotion policy.

In a monopolistic competition with increasing returns, how to tax and subsidise efficiently

from the perspective of the whole economy has experienced a lot of discussion in the litera-

ture. Myles (1987) suggests that subsidisation of the manufacturing with increasing returns is

welfare-improving. In Besley’s paper (1989), the introduction of a specific commodity tax

may improve or reduce welfare in an imperfectly competitive setting depending on the time

frame, as taxes or subsidies affect the set-up costs relevant to the number of firms. Anderson

et al. (2001) compare the efficiency of indirect tax in different imperfectly competitive market

structures and argue that unit taxation will be more efficient than ad valorem taxation under

Bertrand competition. In contrast, Schr€oder (2004) finds that ad valorem taxation is welfare

superior to unit tax based on a Dixit-Stiglitz-type monopolistic competition model. Doi and

Futagami (2004) argue that goods with higher elasticity should be taxed more heavily to

maximise welfare. Ng and Zhang (2007) suggest to tax the industry with a lower degree of

increasing returns and to subsidise the other.

Based on previous arguments, in this paper, we will explore the implications of increasing

returns to analyse the welfare effect of tourism promotion funded by different types of taxa-

tion. We capture the relationship between tourism and the rest of the economy in a general

equilibrium setting. We will develop a model from the Dixit-Stiglitz model (Dixit and Stiglitz,

1977) of monopolistic competition to examine the market solution between the tourism indus-

try and the rest of the economy. The model incorporates the promotion into a firm’s profit

maximisation and an individual’s utility maximisation. This paper is an extension of the study

in Shi (2012) which examines the welfare effect of tourism promotion funded by income tax.

Shi’s paper focuses on the scale effect of tourism production by assuming homogenous non-

tourism goods; so, the market structure of non-tourism goods is not examined. In the current


TOURISM PROMOTION AND DOMESTIC WELFARE 997

paper, we will consider the effect of tourism promotion on the number of non-tourism goods

that is closely related to consumers’ utility. Moreover, we will compare the welfare effect of

tourism promotion funded separately by commodity tax (or tourist tariff) and income tax.

With an explicit utility function, we hope to acquire an analytical solution for the price level,

production quantities, the number of firms and finally, the domestic welfare under the two tax

instruments.

The result is acquired through simulation with the New Zealand–Australia data, which

has implications for trade between similar economies. An important result obtained in this

study is that promotion of tourism funded by either commodity tax or income tax is not

welfare-improving. An explanation is that government promotion shifts resources from the

non-tourism sector to the tourism sector, resulting in a smaller number of non-tourism

goods. With less competition in the non-tourism market, there will be a slight rise in the

monopolistic price. The adverse effect on the non-tourism sector may offset the benefit to

the tourism sector, making the promotion policy not optimal. However, we find that the

‘terms of trade’ will deteriorate only when the home country is relatively small in the

allocation of factor endowments. When a larger share of factor endowments is allocated

in the home country, ‘terms of trade’ will be improved. This contradicts to the finding

that a tourism boom will cause the domestic non-tourism sector to be less competitive in

the world market and lead to ‘de-industrialisation’, such as Hazari and Nowak (2003). We

also compare the efficiency of two tax instruments in supporting tourism promotion. In a

market structure of monopolistic competition stressing the importance of product differenti-

ation, commodity tax is relatively more efficient than income tax. The reason is that com-

modity tax reduces the number of non-tourism firms only through changing consumers’

preference while the income tax plays a negative role through lowering consumers’ prefer-

ence and income at the same time.

2. MODEL SPECIFICATION

We mainly consider an open economy with two countries, the home country and the

foreign country, identical in all aspects other than factor endowments. We lump all the

markets in an economy into two sectors – the tourism sector and the non-tourism sector.

These two sectors operate under the conditions of monopolistic competition and have dif-

ferent degrees of increasing returns. Here, tourism goods do not only mean scenic venues

but also mean goods related to tourism activities such as accommodation, restaurants and

transportation, etc. The home country produces and consumes tourism goods and non-tour-

ism goods, while the foreign country only specialises in non-tourism production. With

international trade between the two economies, the home country earns foreign exchange

from providing tourism goods and services to overseas visitors and imports more variety

of non-tourism goods, and the foreign country exchanges non-tourism goods for tourism

consumption. Each of them benefits from international trade by consuming more variety

of products. As the two countries have different endowments to produce goods, the

income for a representative individual in these two countries are w and w*. There are

M people in the home country and M* people in the foreign country. Each person is both

producer and consumer.

With M identical consumers in the home country, each of them has the following decision

for tourism and non-tourism consumption:



MaxU ¼�Xmi¼1

xiq

�aq�Xn

j¼1

yrj þXn�k¼1

ðyIkÞr�1�a

r

(utility function); (1)

s:t:Xmi¼1

pxixi þXnj¼1

pyjyj þXn�k¼1

pIykyIk ¼ w (budget function): (2)

A representative consumer in the foreign country has the following decision towards

available goods:

MaxU� ¼�Xm

i¼1

ðxIi Þq�b

q�Xn�

k¼1

yrk þXnj¼1

ðyIj Þr�1�b

r

(utility function); (3)

s:t:Xmi¼1

pIxixIi þXn�k¼1

pykyk þXnj¼1

pIyjyIj ¼ w� (budget function): (4)

In the utility and budget functions, variables xi and xIi represent consumption of the ithtype of tourism goods separately in the home country and the foreign country. yj and yIjare the consumption of the jth type of non-tourism goods in the two countries. yk and yIkare the consumption of the kth type of non-tourism goods in both countries.

pxi; pIxi; pyj; p

Iyj; pyk; and pIyk are the prices for tourism and non-tourism goods. With free

trade, the price in the domestic market should be equal to the price of imported goods,

that is, pxi ¼ pIxi, pyj ¼ pIyj and pyk ¼ pIyk. Parameter a is the preference for tourism goods

in the home country, and b is the preference parameter for tourism goods in the foreign

country, a; b 2 ð0; 1Þ. Parameters q and r indicate the elasticity of substitution between

each pair of consumption goods in the tourism and non-tourism sector for both countries

and q; r 2 ð0; 1Þ. Variable m represents the number of tourism goods in the market. n and

n* represent the number of non-tourism goods provided by the home country and the for-

eign country, respectively. Under the condition of increasing returns, each firm only pro-

duces one type of good. If there are two firms producing the same good, one of them

can always increase output to reduce price by utilising further increasing returns, thereby

driving the other firm out of the market. So, m, n and and n* also indicate the number

of firms in the tourism and non-tourism sectors in both countries. With international trade,

the variety of non-tourism goods available in any of the countries is expanded to the sum

of types provided by both countries. At the international equilibrium, the number of non-

tourism goods is endogenously decided by the capacity of market and scale of production,

with free mobility of endowments.

In the monopolistic competitive market, each consumer is a price taker and makes decision

for consumption of tourism and non-tourism goods. The first-order conditions of utility

function (1) subject to budget (2) are

aq�Xmi¼1

xqi

!aq�1

�Xnj¼1

yrj þXn�k¼1

yIk� �r" #1�a

r

�q � xq�1i ¼ kpxi; (5)



Xmi¼1

xqi

!aq

� 1� ar

�Xnj¼1

yrj þXn�k¼1

yIk� �r" #1�a

r �1

�r � yr�1j ¼ kpyj; (6)

Xmi¼1

xqi

!aq

� 1� ar

�Xnj¼1

yrj þXn�k¼1

yIk� �r" #1�a

r �1

�r � yIk� �r�1¼ kpyk: (7)

The solution to the optimisation problem for identical individuals in the home country is

xi0 ¼w�Pn

j¼1 pyjyj �Pn�

k¼1 pykyIk

pxi0ð Þ 11�qPm

k¼1 pxið Þ qq�1

� � ; (8)

yj0 ¼ w�Pmi¼1 pxixi �

Pn�k¼1 pyky

Ik

pyj0� � 1

1�rPn

j¼1 pyj� � r

r�1

� � ; (9)

yIk0 ¼w�Pm

i¼1 pxixi �Pn

j¼1 pyjyj

pyk0� � 1

1�rPn

j¼1 pyk� � r

r�1

� � : (10)

Assume that pxi0 ¼ pxi ¼ px; pyj0 ¼ pyj; pyk0 ¼ pyk; xi0 ¼ xi ¼ x; yj0 ¼ yj; yIk0 ¼ yIk . By symmetry,

we can solve the optimisation problem:

x ¼ w� npyjyj � n�pykyIkmpx

; (11)

yj ¼ w� mpxx� n�pykyIknpyj

; (12)

yIk ¼w� mpxx� npyjyj

n�pyk: (13)

The optimised consumption for tourism and non-tourism goods is similar for the foreign

country, which is to optimise utility function (3) subject to budget constraint (4):

xI ¼ w� � npyjyj � n�pykykmpx

; (14)

yIj ¼w� � mpxx� n�pykyk

npyj; (15)

yk ¼ w� � mpxx� npyjyjn�pyk

: (16)

From first-order conditions (5, 6 and 7), we have



a n yj� �rþn� yIk

� �r� 1� að Þ yj

� �r�1mx

¼ pxpyj

; (17)

a n yj� �rþn� yIk

� �r� 1� að Þ yIk

� �r�1mx

¼ pxpyk

: (18)

Combining equations (17) and (18), we have

yIk� �r�1

yj� �r�1

¼ pykpyj

¼ e: (19)

Here, e implies the ‘terms of trade’ between the two economies.

From equation (19), a relationship between consumption of domestic and imported

non-tourism goods exists:

yIk ¼ yje1

r�1: (20)

Substituting equation (20) to equation (18) and combining with equation (19), we acquire

x ¼ apyjyj nþ n�er

r�1

� �1� að Þmpx : (21)

Remember equation (11) and let equation (21) equal to equation (11), we can rewrite the

decision variables for consumption of tourism and non-tourism goods as

yj ¼ w 1� að Þnþ n�e r

r�1ð Þpyj ; (22)

yIk ¼w 1� að Þe 1

r�1

nþ n�e rr�1ð Þpyj ; (23)

x ¼ awmpx

: (24)

Similarly, a representative consumer in the foreign country has the following decision for

consumption:

yIj ¼w� 1� bð Þnþ n�e r

r�1ð Þpyj ; (25)

yk ¼ w� 1� bð Þe 1r�1

nþ n�e rr�1ð Þpyj ; (26)

xI ¼ bw�

mpx: (27)

Now, let us consider the production side. Under the condition of increasing returns, we

model scale economies by assuming some fixed cost and constant marginal cost to allow



average cost bounded asymptotically by the constant marginal cost. Suppose the form of

producing x units of tourism goods is a1 + b1x. Here, a1 is the fixed cost of tourism pro-

duction, and b1 is the constant marginal cost. It is noted that the tourism sectors in many

countries nowadays have invested in better hotels and means of transportation to improve

the quality of tourism products. They also have employed new technology such as computer

reservation system and internet marketing to make it convenient to travel in the destination

countries. Non-tourism production has the same form. a2 and a2* are fixed cost of non-tour-

ism production in the home country and the foreign country. b2 and b2* are constant mar-

ginal cost of non-tourism production in the two countries. In this case, increasing returns

are internalised by firms. There is another source of increasing returns to scale, external to

firms, resulting from specialisation or spillover of knowledge, which makes firm’s cost

decrease with total industrial level of output. Ethier (1982) proposes ‘international’ returns

to scale. Such an expansion of economy depends on a greater division of labour in the

extended market rather than on geographical concentration of the industry. International

returns depend on an interaction of internal and external economies, which help to explain

intra-industry trade.

For a monopolistic competitive firm in the tourism sector, the first-order condition to

maximise profit with respect to output level or price is

MR ¼ pxi 1þ 1 @lnxi@lnpi

� �¼ MC ¼ b1: (28)

The own price elasticity of demand for good xi derived from equation (8) is implied as1

@lnxi@lnpi

¼ q� m

mð1� qÞ : (29)

Substituting equation (29) into equation (28), we get

pxi ¼ b1ðm� qÞqðm� 1Þ : (30)

A typical tourism firm sets price to maximise its profit:

pxi ¼ piXi � ða1 þ b1XiÞ: (31)

Here, Xi is the supply of the ith tourism good, and it is the sum of tourism goods

consumed by both countries at the equilibrium, that is,

Xi ¼ Mxi þM�xIi : (32)

Combining demand functions (24), (27) with market clearance condition (32) and profit

maximisation condition (30), (31), the general equilibrium value of variables can be obtained

as

m ¼ qþ 1� qð ÞðMawþM�bw�Þa1

; (33)

1 See Yang and Heijdra (1993).



px ¼ b1ðMawþM�bw�Þq MawþM�bw� � a1ð Þ ; (34)

xi ¼ a1qawðMawþM�bw� � a1Þb1ðMawþM�bw�Þ a1qþ 1� qð ÞðMawþM�bw�Þ½ � ; (35)

xIi ¼a1qbw�ðMawþM�bw� � a1Þ

b1ðMawþM�bw�Þ a1qþ 1� qð ÞðMawþM�bw�Þ½ � : (36)

All the above conditions also exist for non-tourism production in the home country. The

profit maximisation requires that

MR ¼ pyj 1þ 1 @lnðyj þ yIj Þ

@lnpyj

" #¼ MC ¼ b2; (37)

pyj ¼ pyjðyj þ yIj Þ � b2ðyj þ yIj Þ � a2: (38)

Similarly, for the foreign country, a non-tourism firm sets price to maximise its profit:

MR ¼ pyk 1þ 1 @lnðyk þ yIkÞ

@lnpyk

� �¼ MC ¼ b�2; (39)

pyk ¼ pyjðyk þ yIkÞ � b�2ðyk þ yIkÞ � a�2: (40)

To obtain the price elasticity of demand for non-tourism goods, we express the non-tourism

demand equation (9) as:

pyj0� � 1

1�rXnj¼1

pyj� � r

r�1

!yj0 ¼ w�

Xmi¼1

pxixi �Xn�k¼1

pykyIk; (41)

pyj0� � 1

1�rXnj¼1

pyj� � r

r�1

!yIj0 ¼ w� �

Xmi¼1

pxixIi �Xn�k¼1

pykyk: (42)

Adding up equations (41) and (42), we have

lnðyj þ yIj Þ ¼ ln w�Xmi¼1

pxixi �Xn�k¼1

pykyIk þ w� �

Xmi¼1

pxixIi �Xn�k¼1

pykyk

!

�Xnj¼1

pyj� � r

r�1

!þ 1

r� 1lnðpyjÞ: ð43Þ

From equation (43), we derive the own price elasticity of demand for non-tourism goods

produced by the home country as



@lnðyj þ yIj Þ@lnpyj

¼ n2 � 2nrþ rn2 r� 1ð Þ : (44)

Substituting equation (44) into equation (37), we can express price of non-tourism goods

supplied by the home country as

pyj ¼ b2 n2 � 2nrþ rð Þn� 1ð Þ2r : (45)

With the same method, we can acquire the own price elasticity of demand and price for

non-tourism goods produced by the foreign country and as

@lnðyk þ yIkÞ@lnpyk

¼ n�2 � 2n�rþ r

n�2 r� 1ð Þ ; (46)

pyk ¼b�2 n�

2 � 2n�rþ r� �

n� � 1ð Þ2r : (47)

As the number of non-tourism goods n and n* is endogenously determined, depending on

the total market demand and the scale of operation, the relative price of non-tourism goods

cannot be decided either. We consider the problem from the Autarkic equilibrium, the number

of non-tourism goods in the home country and the foreign country is given by

n ¼ rþM 1� rð Þ 1� að Þwa2

; (48)

n� ¼ rþM� 1� rð Þw�

a�2: (49)

With free mobility of endowments between two economies, the scale of production of non-

tourism goods can be divided in any way between the two countries. We assume that the

share of allocative resources in the home country is h and the foreign country is 1�h, thenthe number of non-tourism goods supplied by the home country and the foreign country at

the international equilibrium will be

n ¼ rþ 1� rð Þ M 1� að ÞwþM� 1� bð Þw�½ �a2

h; (50)

n� ¼ rþ 1� rð Þ M 1� að ÞwþM� 1� bð Þw�½ �a�2

1� hð Þ: (51)

Substituting equations (45), (47), (50) and (51) into equations (22) and (23), we can

express the demand for non-tourism goods in the two countries as a function of exoge-

nous parameters q, r, a, b, a1, a2, a2*, b1, b2, b2*, w, w*, M, M* and h. As the equilib-

rium with international trade is determined by the allocation of resources between the two

economies, which is decided by the randomisation of h, we will discuss five different

possibilities:



1. h = 0, then n = r < 1, which implies a full specialisation existing between the two

economies. The home country only provides tourism goods and the foreign country

produces non-tourism goods.

2. 0 < h < 0.5. This is the case of partial specialisation with a smaller share of available

resources distributed in the home country.

3. h = 0.5. This means that two economies are even in factor endowments. The home

country uses half of the available resources in producing both tourism and non-tourism

goods, and the foreign country uses the other half to produce non-tourism goods.

4. 0.5 < h < 1. This is opposite to the second case, with more factor endowments

flowing to the foreign country.

5. h = 1; so, n* = r < 1. This is the other extreme case, meaning the home country

provides both tourism and non-tourism goods, while the foreign country does not

produce anything.

Each of the above cases yields a unique equilibrium, with number of goods and price

determined. Therefore, we can obtain the utility function and examine the social effect of

tourism promotion at each equilibrium.

3. WELFARE EFFECT OF TOURISM PROMOTION

Now, let us examine the situation with tourism promotion. Promotion shifts preferences by

providing consumers with additional information. With this information, tourists receive bene-

fit from travelling that would not take place otherwise. If the destination is recognised by

more people, this will help a country or a region earn a good reputation around the world, not

only propelling the local economy but also saving advertising expenses in the future.

We introduce government into the model, and let it impose tax to subsidise the tourism

promotion. We try to compare different types of taxation to find a more effective way to pro-

mote tourism. Generally, taxing tourists is a normal way such as bed tax from hotel and price

differentiation targeted on tourists. Government can use part of this tax revenue to promote

the whole tourism industry. Alternatively, some promotional funding is from income tax

directly. Individuals are consumers but also producers, they are the owners of profit; so, the

income tax mentioned here means tax on factor income including capital and labour. For

example, spending on promotional programmes accounts for about 3 per cent of total govern-

ment budget outlays each year in Thailand.

We assume that this tourism promotion is targeted on foreign market. So, the promotional

campaign will not change domestic consumers’ decision. We let the preference parameter for

foreign consumers change to b + c. The preference parameter for non-tourism goods will be

1�b�c. The tax rate is represented by t. The amount of tax revenue needs to be sufficient to

change the original preference parameter by c. Assume that c = Aln(1 + t). The parameter

A measures how effectively the tax-funded promotion changes preference. This function

implies there is no change in consumer preference if no tax is imposed, and the preference

parameter increases more with a higher tax but at a diminishing rate.

We mainly examine two types of tax – commodity tax and income tax.

1. Commodity tax: government levies a tax on tourism goods and uses the revenue to fund

tourism promotion for the whole tourism industry. In this situation, the price for tourism

goods will increase to pxi + t.



2. Income tax: government levies a tax on individuals’ income, then a representative con-

sumer’s income will change to w(1�t), as consumers are assumed to be the owners of

profit. With promotion and taxation, it is possible for firms to make profit or loss in the

short run. However, with monopolistic competition, free entry and exit will drive the

profit of a marginal firm to zero in the long run.

As the equilibriums in the previous section are too complicated to differentiate and com-

pare, we will conduct a series of simulations to examine the efficiency of tourism promotion

funded by these two types of taxation. We need to specify values for parameters q, r, a, b,a1, a2, a2*, b1, b2, b2*, w, w*, M, M* and h. Here, we let a = 0.2, b = 0.2, q = 0.5 and r =0.5. To compare the effect of two tax instruments on welfare only, we fix A = 2 to avoid dif-

ferent role of promotion in changing foreigners’ preference. The rest of exogenous parameters

are given with the real data using New Zealand and Australia as an illustration. These two

countries are close in geography and have signed the Australia New Zealand Closer Economic

Relations Trade Agreement (known as ANZCERTA or the CER Agreement). We assume the

home country as New Zealand and the foreign country to be Australia.

The data for parameters a1, a2, a2*, b1, b2, b2*, w, w*, M, M* are acquired from the Aus-

tralia Bureau of Statistics (ABS) and Statistics New Zealand. As tourism is not considered as

a specific industry in standard industry classification systems, New Zealand Tourism Satellite

Account 2011 provides an approximate estimate of the tourism industry share in gross value

added (GVA).

Capital and labour are assumed to be the only inputs, we use the gross fixed capital

formation to represent fixed cost a. With the share of tourism contribution in GVA, we can

calculate the gross fixed capital formation in the tourism sector and the non-tourism sector.

Gross fixed capital formation in the Australian non-tourism sector is acquired from the Aus-

tralian National Capital Account (ABS, cat. 5206.0). The marginal cost or variable cost b is

captured by average hourly wage. Average hourly wage for all industries in New Zealand is

available in statistics income tables. To acquire the labour cost in the tourism sector, we cal-

culate the total wage cost in the economy and multiply it with the tourism share to acquire

the tourism labour cost. Then, we divide the tourism wage by total tourism employment pro-

vided by Tourism Satellite Account 2011 to obtain the unit labour cost. We specify 38 work-

ing hours in a week. The result of a much lower hourly wage in the tourism sector is due to

more part-time and casual workers in this sector. The Australian wage rate is available in

labour force data at ABS. A representative individual’s income represented by average annual

income is calculated with national disposable income divided by estimated population. Data

are available for a period of 2003 to 2011 and are collected at current prices from national

accounts and demographic statistics of Australia and New Zealand. They are deflated with the

consumer price index to reflect the real value. To compare the production costs of two coun-

tries, we express the value of income, capital and labour in terms of the New Zealand dollar.

Exchange rates are sourced from the Reserve Bank of New Zealand.

After obtaining all data needed, we substitute them into general equilibrium variables to

undertake simulations over the period of 2003–2011. We are mainly interested in how variety

of goods and welfare change with different tax-funded promotion. The results of sensitivity

analysis with respect to tax rate and share of allocative resources h are shown in Figures 1–9.It is noted that the examined period has shown similar tendency; so, we choose to present the

results of year 2011 in the paper.



3

2.5

m 2

1.5

1

3

2.5

m 2

1.5

1

3

Commodity Tax

Income Tax

t = 0.1t = 0.4

t = 0.1t = 0.4

θ = 0.2θ = 0.8

θ = 0.2θ = 0.8

× 108

× 108

× 108

× 108 × 108

× 108

2.5

m 2

1.5

1

3

2.5

m 2

1.5

1

3

2.5

m 2

1.5

1

3

2.5

m 2

1.5

1

0 0 0.1 0.2 0.3 0.4 0.50.2 0.4 0.6 0.8 10.4 0.3 0.2t t

0.1 0

0.4 0.3 0.2t

0.1 0

00.5

1

θθ

0 0 0.1 0.2 0.3 0.4 0.50.2 0.4 0.6 0.8 1tθ

FIGURE 1Impact on Number of tourism Goods

0.4 0.3 0.2t

0.1 0

3

4

43.5

32.5

21.5

10.5

x x

43.5

32.5

21.5

10.5

x

2

1

3

4

x

2

1

00.5

1

θ

0.4 0.3 0.2t

0.1 0 00.5

1

θ

0 0 0.1 0.2 0.3 0.4 0.50.2 0.4 0.6 0.8 1tθ

0 0 0.1 0.2 0.3 0.4 0.50.2 0.4 0.6 0.8 1tθ

43.5

32.5

21.5

10.5

x

43.5

32.5

21.5

10.5

x

Commodity Tax

Income Tax

t = 0.1t = 0.4

t = 0.1t = 0.4

θ = 0.2θ = 0.8

θ = 0.2θ = 0.8

× 10–6 × 10–6

× 10–6× 10–6

× 10–6

× 10–6

FIGURE 2Impact on Consumption of tourism Goods



2

1.5

0.5

1

00.4 0.3 0.2 0.1 0 0

0.51

t

0.4 0.3 0.2 0.1 0t

θ

00.5

1

θ

× 107

× 107 × 107

n

2

1.5

0.5

1

0

× 107

n

2

1.5

0.5

1

0

n

× 1072

1.5

0.5

1

0

n

× 1072

1.5

0.5

1

0n

2

1.5

0.5

1

0

n

0 0 0.1 0.2 0.3 0.4 0.50.2 0.4 0.6 0.8 1tθ

0 0 0.1 0.2 0.3 0.4 0.50.2 0.4 0.6 0.8 1tθ

t = 0.1t = 0.4

t = 0.1t = 0.4

θ = 0.2θ = 0.8

θ = 0.2θ = 0.8

Commodity Tax

Income Tax

FIGURE 3Impact on Number of Non-tourism Goods Provided by the Home Country

0.4 0.3 0.2 0.1 0t

0.4 0.3 0.2 0.1 0t

00.5

1

θ

00.5

1

θ

6

6

5

4

3

2

1

0

4

2

0

n*

6

4

2

0

n*

n*

6

5

4

3

2

1

0

n*

6

5

4

3

2

1

0

n*

6

5

4

3

2

1

0

n*

× 106 × 106

× 106× 106

× 106

× 106

0 0.1 0.2 0.3 0.4 0.5t

0 0.1 0.2 0.3 0.4 0.5t

0 0.2 0.4 0.6 0.8 1θ

0 0.2 0.4 0.6 0.8 1θ

Commodity Tax

Income Tax

t = 0.1t = 0.4

t = 0.1t = 0.4

θ = 0.2θ = 0.8

θ = 0.2θ = 0.8

FIGURE 4Impact on Number of Non-tourism Goods Provided by the Foreign Country



a. Commodity Tax

With a tax levied on tourism consumption, the price for tourism goods rises by t. However,the tax revenue is used for tourism promotion in the foreign country. There will be more vari-

ety of tourism goods with more firms’ entry into the market due to short-run profit. Tourism

47.0901

p yp y p yp y

p y p y

47.09

47.09

47.09

47.09

47.09

47.09

47.09

47.09

47.09

47.09

47.09

47.0899 47.0899

47.0947.09

47.09

47.09

47.09

47.09

47.09

47.09

47.09

47.0947.0899 47.0899

47.0947.0947.0947.09

47.090147.0947.0947.0947.0947.09

0.4 0.3 0.2t

0.1 0

0.4 0.3 0.2t

0.1 0

00.5

1

θ

00.5

1

θ

t = 0.1t = 0.4

t = 0.1t = 0.4

θ = 0.2θ = 0.8

θ = 0.2θ = 0.8

0 0 0.1 0.2 0.3 0.4 0.50.2 0.4 0.6 0.8 1tθ

0 0 0.1 0.2 0.3 0.4 0.50.2 0.4 0.6 0.8 1tθ

Commodity Tax

Income Tax

FIGURE 5Impact on Price of Non-tourism Goods Provided by the Home Country

68.8754

68.875468.8753

68.875268.8751

68.87568.8749

68.875468.8753

68.875268.8751

68.87568.8749

68.875468.8753

68.875268.8751

68.87568.8749

68.8752

68.875

68.875468.8753

68.875268.8751

68.87568.8749

p y*

p y*

p y*

p y* p y

*

p y*

68.8754

68.8752

68.875

0.4 0.3 0.2t

0.1 0

0.4 0.3 0.2t

0.1 0

00.5

1

θ

00.5

1

θ

t = 0.1t = 0.4

t = 0.1t = 0.4

θ = 0.2θ = 0.8

θ = 0.2θ = 0.8

0 0 0.1 0.2 0.3 0.4 0.50.2 0.4 0.6 0.8 1tθ

0 0 0.1 0.2 0.3 0.4 0.50.2 0.4 0.6 0.8 1tθ

Commodity Tax

Income Tax

FIGURE 6Impact on Price of Non-tourism Goods Provided by the Foreign Country



2.5

21.5

1

0.5

0.4 0.3 0.2t

0.1 0

0.4 0.3 0.2t

0.1 0

00.5

1

θ

00.5

1

θ

2.5

2

1.5

1

0.5

y

2.5

21.5

1

0.5

y

y

2.5

2

1.5

1

0.5

y

0 0 0.1 0.2 0.3 0.4 0.50.2 0.4 0.6 0.8 1tθ

0 0 0.1 0.2 0.3 0.4 0.50.2 0.4 0.6 0.8 1tθ

2.5

2

1.5

1

0.5

y

2.5

2

1.5

1

0.5y

Commodity Tax

Income Tax

× 10–4 × 10–4

× 10–4× 10–4

× 10–4

× 10–4

t = 0.1t = 0.4

t = 0.1t = 0.4

θ = 0.2θ = 0.8

θ = 0.2θ = 0.8

FIGURE 7Impact on Consumption of Domestic Non-tourism Goods

0.4 0.3 0.2t

0.1 0 00.5

1

θ

0.4 0.3 0.2t

0.1 0 00.5

1

θ

yI

0 0 0.1 0.2 0.3 0.4 0.50.2 0.4 0.6 0.8 1tθ

0 0 0.1 0.2 0.3 0.4 0.50.2 0.4 0.6 0.8 1tθ

12

10

8

6

4

2

1210

8642

12

10

8

6

4

2

12

10

8

6

4

2

12

10

8

6

4

2

Commodity Tax

Income Tax

× 10–5× 10–5

× 10–5 × 10–5

× 10–5

yI y

Iy

I yI

yI

12108642

× 10–5

t = 0.1t = 0.4

t = 0.1t = 0.4

θ = 0.2θ = 0.8

θ = 0.2θ = 0.8

FIGURE 8Impact on Consumption of Imported Non-tourism Goods



consumption for the foreign country may increase or decrease, depending on the effectiveness

of tourism promotion. On the other hand, the commodity tax will affect the non-tourism sec-

tor indirectly. Tourism promotion redirects the preference away from non-tourism goods to

tourism goods and hence affects the equilibrium price and variety of non-tourism goods.

The effects of commodity tax on variables m, x, n, n*, py, py*, y, yI are shown in upper

graphs of Figures 1–8. From Figures 1 and 2, we can see that the number of tourism goods is

not affected by h but increases with t. An increase in foreigners’ preference (represented by

b + c) for the tourism goods increases the number of tourism goods m. With higher price and

more variety of tourism goods, the domestic demand for one type of tourism good falls.

The impacts on the non-tourism market are shown in Figures 3–8. It is noted that the num-

ber of goods rises with share of allocative resources. In the open economy with free trade,

factor endowments flow freely between the two countries. The equilibrium is determined by

the allocation of factor endowments or resources. When h 2 (0, 0.5), the share of allocative

resources is smaller in the home country, and the number of goods provided by the home

country n decreases with t slightly. When h 2 (0.5, 1), the home country has gained more

resources, then n decreases with t more quickly. The reason is that a tourism promotion

attracts more resources to tourism production, which has a larger effect on the non-tourism

market. Similar phenomenon exists for the number of non-tourism goods n* provided by the

foreign country. So, we can conclude that a tax on tourism goods reduces the variety of non-

tourism goods.

The share of allocative resources h also affects the price of non-tourism goods. With a

given tax rate, py decreases with h but py* rises with h. In a monopolistic competition, a lar-

ger number of firms imply a more competitive market and hence lower monopolistic price.

When h 2 (0, 0.5), py rises with t while py* does not have an obvious change. This will dete-

riorate the ‘terms of trade’, making non-tourism goods produced by the home country less

competitive. If h 2 (0.5, 1), there will be an opposite result with ‘terms of trade’ being

enhanced. The consumption for one type of non-tourism good is decided by price and variety.

As the home country earns more foreign income from tourism expansion, this can support

their consumption for non-tourism goods. Hence, y and yI both rise with t, but they change

faster with t when h 2 (0, 0.5) than when h 2 (0.5, 1).

Considering the overall effects, a representative consumer’s utility rises with h, given a

commodity tax rate t, as more resources are allocated in the home country with more differen-

tiated products. However, no matter what range h is in, utility falls with tax levied on tourists,

which implies the cost of tourism promotion exceeds the benefit brought by the promotion.

The result is shown in the upper graph of Figure 9. As the value of utility is too big in this

simulation and is always positive, for the convenience of calculation, we take log of the util-

ity to present a clear tendency.

b. Income Tax

The effects of income tax on variables m, x, n, n*, py, py*, y, yI are shown in the lower

graphs of Figures 1–8. Compared to commodity tax, an income tax has similar effect on the

number and price of tourism and non-tourism goods but with different extent, keeping all

other exogenous variables unchanged. Tourism promotion financed by an income tax increases

the number of tourism goods but also reduces the number of non-tourism goods, as a lower

disposable income reduces the consumption and hence downsizes the market. With a smaller

number of non-tourism firms, the market is less competitive; so, the prices py and py* both



rise with t. It is shown in Figure 2 that a higher income tax discourages consumer’s demand

for one type of tourism good more than a higher commodity tax. Furthermore, different from

commodity tax, an income tax makes demand for a typical non-tourism good y or yI fall

slightly, as is shown in Figures 7 and 8. This is because income tax results in a lower net

income and hence lower demand for non-tourism goods. From the perspective of the whole

economy, total welfare of a representative consumer also decreases with income tax. This is

shown in Figure 9.

c. Commodity Tax or Income Tax?

Comparing the welfare effects of tourism promotion funded by commodity tax and income

tax, we find that both types of tax reduce a consumer’s utility, which means a tax-funded

0–0.2 –1.5

–2.5

–1

1–2

–3

–0.4–0.6–0.8

0.5 0.5

0.5

0.4 0.3 0.2 0.1 000.4 0.3 0.2 0.1 0 0

0.5

1

t tθ θ

∂ In

U/ ∂

t

∂ In

U/ ∂

t

Commodity tax Income tax

FIGURE 10The Extent of Taxation Affecting Welfare

Commodity Tax

24

24

23.5

23

22.5

22

21.5

21

23

In U In

U

24

23.5

23

22.5

22

21.5

21

In U

24

23.5

23

22.5

22

21.5

21

In U

24

23.5

23

22.5

22

21.5

21

In U

22

21

Income Tax

0.4 0.3 0.2t

0.1 0 00.5

1

θ

24

23

In U

22

210.4 0.3 0.2

t0.1 0 0

0.51

θ

0 0.2 0.4 0.6 0.8 1θ

0 0.1 0.2 0.3 0.4 0.5t

0 0.2 0.4 0.6 0.8 1θ

0 0.1 0.2 0.3 0.4 0.5t

t = 0.1t = 0.4

t = 0.1t = 0.4

θ = 0.2θ = 0.8

θ = 0.2θ = 0.8

FIGURE 9Impact on a Representative Consumer’s Welfare



promotion is not welfare-improving. Although tax is used to finance tourism promotion, which

brings more profit to the tourism sector and stimulate the economy with multiplying effect,

the adverse effect to the rest of economy is evident. A policy towards the tourism sector shifts

resources away from the non-tourism sector. Especially for an economy with a smaller share

of allocative resources, tourism promotion may make the domestic non-tourism industry less

competitive in the world market with deteriorating ‘terms of trade’. In addition, less variety

of non-tourism goods follows with tax-funded tourism promotion. As tourism is a relatively

small sector in an economy, the benefit of more variety of tourism goods is offset by the loss

from fewer choices of non-tourism goods (Figure 10).

Knowing that tourism promotion funded by either commodity tax or income tax is not wel-

fare-improving, we need to compare which tax has less negative effect or more efficient if

promotion is a preferred policy. Figure 10 shows how fast an individual’s utility changes with

tax rate. With all other things unchanged, a domestic consumer’s utility falls with income tax

in a larger extent than with commodity tax. Under a structure of monopolistic competition

with product differentiation, commodity tax has a smaller adverse impact on the non-tourism

sector than the income tax, especially in the variety of goods. The reason is that commodity

tax affects the non-tourism market only through changing consumers’ preference while

income tax affects the non-tourism market negatively through a mixture impact of consumers’

preference and income.

4. CONCLUSION

This paper analyses the welfare effect of publicly funded promotion of the tourism industry

and compares the efficiency of two types of taxation – commodity tax and income tax in

funding tourism promotion. The analysis is conducted in an open economy setting with two

economies and two goods. We develop a general equilibrium model from the Dixit-Stiglitz

model of monopolistic competition to examine the market solution for the tourism and non-

tourism sector with tourism promotion. Under the condition of increasing returns, tourism pro-

motion on foreign visitors is a way of extending market and enlarging product differentiation.

However, the policy of tourism promotion may affect the non-tourism sector which also

exhibits increasing returns. In an open economy with free trade, the international equilibrium

related to tourism and non-tourism markets with tourism promotion is determined by the allo-

cation of factor endowments between the two economies. To acquire analytical solutions

under the equilibrium, we conduct a series of simulation with the example of New Zealand

and Australia. We obtain three significant results to complement the previous research on

tourism expansion.

First, tourism promotion funded by either commodity tax or income tax reduces welfare.

This result is based on imperfect competition with the condition of increasing returns in both

productions, which is related to the number of market goods. In the examined case, tourism

promotion targeting foreign tourists increases the number of tourism goods. However, the

number of non-tourism goods falls from this campaign, as resources are shifted away from

the non-tourism sector with higher profit made by tourism firms. As the tourism sector is rela-

tively small in the whole economy, the cost of tourism promotion overcomes the benefit to

the tourism sector.

Second, it is worthwhile to notice that if the home country has a smaller share of allocative

resources, the ‘terms of trade’ for the home country is deteriorating with the promotion



policy, making the domestic non-tourism sectors less competitive in the international market.

On the contrary, the ‘terms of trade’ is improved with a larger share of resources allocated.

Last but the most important, commodity tax (or tourist tariff) is more efficient than income

tax in the examined market structure. In a monopolistic competition with product differentia-

tion, commodity tax has a smaller adverse impact on the non-tourism sector than income tax.

With the importance of product differentiation stressed, the number of goods is decided by

the market size and scale of production which depends on availability of factor endowments

and barriers to entry, see equations (50) and (51). Scale of production can be determined with

each possibility of allocative endowments and exogenous fixed cost. Taxation plays a role in

product variety through market size. The difference is that the commodity tax only changes

consumers’ preference to narrow the market, while the income tax reduces non-tourism mar-

ket through lowering consumers’ preference and income at the same time.

The straightforward conclusion regarding the welfare effect of tourism promotion based on

an explicit utility function with product differentiation is an important complement to previous

study in the literature. Through simulation with the New Zealand–Australia data, the conclu-

sion has implications for intra-industry trade between similar economies, which is more gen-

eral in modern trade. It is noted that promotion has double-sided effects on the economy. Due

to huge short-run flow-on impact on the economy brought by tourism promotion, there is a

high incentive for government to become involved in the marketing campaign. But in the long

run, the adverse effect to the rest of economy is evident, especially the manufacturing sector.

Hence, results obtained in this study provide justifications for policymakers in the assessment

of promotional campaigns.

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Tourism Promotion, Increasing Returns and Domestic Welfare