Optimal choice of quality in hotel services

Annals of Tourism Research, Vol. 33, No. 2, pp. 456–469, 2006� 2006 Elsevier Ltd. All rights reserved

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OPTIMAL CHOICE OF QUALITYIN HOTEL SERVICES

Dolores GarcıaMarıa Tugores

Universitat de les Illes Balears, Spain

Abstract: A debate on the sustainability of mass tourist destinations and the need to reori-ent them towards the high quality segment has recently arisen. However, it has not yet beenstudied whether such a shift in the specialization pattern would result in an increase of effi-ciency. In this paper, a vertical differentiation duopoly model in which hotels compete inboth quality and prices is used. The market duopoly and the social planner solutions are com-pared, and different external costs are considered. It is found that efficient solutions allow forthe coexistence of both the high and low quality segments, and that an expansion of the for-mer does not necessarily improve welfare. Keywords: quality, externalities, imperfect compe-tition. � 2006 Elsevier Ltd. All rights reserved.

Resume: Choix optimal de qualite des services hoteliers. Un debat sur la durabilite desdestinations de tourisme de masse et le besoin de les reorienter vers le segment de hautequalites’est presente recemment. Cependant, on n’a pas encore etudie si un tel changementdans le modele de specialisation pouvait conduire a une augmentation d’efficacite. Dans cetarticle, on utilise un modele de duopole a differentiation verticale dans lequel les hotels sonten concurrence sur les plans qualite et prix. On compare le duopole de marche et lessolutions de planificateur social et considere les differents couts externes. On trouve queles solutions efficaces permettent la coexistence des segments de haute et de basse qualite,et qu’une expansion du premier n’ameliore pas necessairement le bien-etre. Mots-cles: qua-lite, externalites, competition imparfaite. � 2006 Elsevier Ltd. All rights reserved.

INTRODUCTION

During recent years, proposals suggesting reorientation of the tour-ism industry towards the high quality segment are gaining popularity,and they constitute the goal of certain policy tools. Such views are sup-ported by two different types of arguments, both developed in thispaper. The first one deals with the well-known idea that (tourism) firmscan benefit from larger profits when acting in differentiated markets.Throughout the paper, differentiation will be associated with quality.The second justification is usually based on environmental grounds.

The first point has to do with how the tourism industry may behaveunder different market structures, especially in the long run. The

Dolores Garcıa and Marıa Tugores are both Associate Professors at the Department ofApplied Economics, Universitat de les Illes Balears (07122 Palma de Mallorca, Baleares,Spain. Email <[email protected]>). The first author conducts research on environmentaleconomics, urban economics, and industrial organization; and the research interests of thesecond author are in tourism economics, industrial organization, and labor economics.

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GARCIA AND TUGORES 457

advantages for firms when participating in differentiated markets arerelated to the possibility of avoiding a fierce degree of competition,which ultimately leads in the long run to null profits. This would beat the base of the tourism product lifecycle model, widely discussedin the literature (Agarwal 1994; Butler 1980; Cooper 1997), which pre-dicts that mass destinations, typically non-differentiated, end up reach-ing ‘‘maturity’’ or a saturation phase, followed by a decline (Butler1997; Saveriades 2000; Smith and Krannich 1998). Alternatively tothe pattern of specialization based on mass tourism, which by defini-tion is associated to a very large number of tourists, the so-called ‘‘qual-ity tourism’’ represents a path in which competition is based on thedifferentiation of the product. This can be linked to the value of theprovided services or to the specificities of the cultural and natural envi-ronment, inter alia. Besides, it allows for the coexistence of higherprices and a relatively small number of tourists.

Likewise, recommendations to pursue higher qualities are defendedon social, cultural, and environmental grounds. Authors such as Cope-land (1991), Dwyer and Forsyth (1993), Forsyth, Dwyer and Clark(1995), and Frechtling (1994) argue that tourism creates certain unde-sirable effects accruing to residents not necessarily related to thisindustry. These effects constitute negative externalities. From this per-spective, it is claimed that specializing in high quality services, basicallybecause the number of tourists diminishes, contributes to reductionsin the level of congestion, crime, or the degradation of local naturalresources, compared to the mass tourism alternative. On the otherhand, the mass style may be crucial for the sustainability of tourismin the region. Thus, despite the popularity of proposals suggestingindustry reorientation, there is still much to be investigated for suchproposals to be accepted. This paper aims to analyze the role of localconsumers and the nature of the external effects in explaining bothoptimal qualities and size of the market.

First, in reference to the role played by residents, disparities existwith respect to the sign of tourism’s direct net effect on the local soci-ety. From an empirical point of view, some studies find that this indus-try causes a negative net effect on residents (Lindberg, Andersson andDellaert 2001; Teye, Sirakaya and Sonmez 2002), while for others theprevailing net effect is positive (King, Pizam and Milman 1993). Thissign ultimately depends on the extent to which the profits obtainedby firms remain in the region, on the degree of participation of resi-dents as consumers, and on the importance of the external effects.For a negative net effect to dominate, it is required that the aggregateexternal impacts result in costs that offset benefits for producers andlocal consumers. The theoretical analysis used here assumes that localresidents have been accounted for as the beneficiaries of the profitsmade by firms, as consumers (with a varying degree of participationin the market), and as the recipients of external effects. In any case,the determination of optimal policies should not ignore the effectson residents.

Second, the emphasis will focus on the negative externalities result-ing from tourism. It is not clear whether higher qualities marginally

458 OPTIMAL QUALITIES

cause less environmental and related costs than lower ones. Despite itsgeneral acceptance, there exists no tested evidence favoring the highquality strategy. There may be instances in which the external costsmay be larger if caused by a tourist using better facilities, includingmore extensive natural resources such as water or energy. In othercases, the opposite would be true, and tourists staying in lesser-qualityestablishments typically are thought to be more prone to generatenoise or public nuisances. This paper takes into account different pos-sibilities regarding these relationships, which constitute a key aspect toconsider when searching for policy recommendations.

The purpose of this paper is to study, from a theoretical perspective,the relationship between the pattern of specialization (namely, quality)and the induced welfare effects in affected communities, in order toidentify which circumstances justify devoting more resources to theupper segment of the industry as a desirable policy. To do that, a ver-tical differentiation model in which two hotels compete in quality andprice is used. Because of imperfect competition and because someexternalities exist, the market equilibrium is not the desirable outcomefor society. A social planner is interested in maximizing aggregate wel-fare, which includes profits obtained by firms, the appropriate con-sumer surplus for residents, and the negative external effects thattourism activities exert on the host community. These externalities,which can be related to the supplied quality levels in different ways,happen to play a key role in finding the efficient decision on thecharacteristics that establishments should offer.

QUALITIES AND PRICES IN THE HOTEL SECTOR

By analyzing the basic features of the theoretical model, a simple sce-nario with two hotels offering differentiated tourism services can beconsidered. Differentiation is related to the quality of the services pro-vided by the sector. Thus, a vertical product differentiation model isused, and establishments compete with prices. High and low qualitiesare respectively denoted by u1 and u2, with u1 > u2.

There is a continuum of tourists in the market. They differ in theirtastes, described by the parameter h 2 ½0; �h�, h being uniformly distrib-uted with unit density, where �h refers to the one endowed with thehighest taste for quality. All consumers of the product are representedby the utility function, U = hu � p. Their utility is zero if they do not buythe differentiated good. As expected, the utility reached by tourists forany given price p increases with quality, as does the willingness to payfor the service. In accordance with the literature on product differen-tiation, it is here assumed that consumers can buy at most one unit ofservices. Here h can be interpreted as the marginal rate of substitutionbetween income and quality: a higher h corresponds to a lowermarginal utility of income and hence a higher income (Tirole 1988).Under this interpretation, this is the analogue of the models whereconsumers differ by their incomes rather than by their tastes (Bonanno1986; Gabszewick and Thisse 1979, 1980; Ireland 1987; Shaked and


Sutton 1982, 1983). In this context, h could be understood as the levelof income that each potential tourist has.

The taste parameter of the consumer indifferent between buying thehigh and the low quality good is defined as h1,2. The tourist is indiffer-ent between choosing a relatively good or poor hotel when the associ-ated utilities are the same. Then this taste parameter h1,2 is such that

h1;2 ¼p1 � p2

u1 � u2.

Likewise, the tourist indifferent between choosing the worse accommo-dations (hotel 2) and staying at home has the taste parameter h0,2, withh0,2 = p2/u2. For such person, staying at an establishment offering u2

implies a zero utility level. The demand functions can now be easilybuilt. Consumers for whom h 2 ½h1;2; �h� choose the establishment offer-ing u1, while those described by h 2 [h0,2, h1,2] choose the one supply-ing u2. The ones described by h 2 [0,h0,2] do not consume at all. Thisallows for the market not to be covered; in other words, some consum-ers do not buy any of the two provided services. The corresponding de-mand functions for the upper and lower segments can simply be foundby computing the differences �h� h1;2 and h1,2 � h0,2, respectively.

Regarding the supply side of the market, if there were only two ho-tels in the sector (1 and 2), each would compete with two strategic vari-ables, prices and the quality of the services they provide. It is likewiseconsidered that there exists a lower bound for u, so that ui > 0. Thiscan be interpreted as a minimum standard legal requirement, for in-stance. Each hotel incurs in a cost of production of the form

Ciðui; qiÞ ¼u2

i

2 qi , where qi is the output supplied. That is, variable costs

increase with u. This function of production costs is widely used in theindustrial organization literature (Champsaur and Rochet 1989; Gal-Or 1983; Mussa and Rosen 1978). The previous positive relationshipis straightforward, since the main burden of quality improvement fallson more skilled labor or more expensive raw materials and inputs, forinstance. Higher ranked hotels usually require a higher number ofworkers per tourist, more trained workers, more spacious rooms, andthe provision of certain facilities otherwise not available.

The Market Solution

Motta (1993) deals with market problems. Here, hotels 1 and 2 maketheir decisions in order to maximize their respective profits, and thenthe chosen qualities and prices are derived. Competition takes placein the market as described in the following two-stage game. At the first,the quality of the services is chosen by hotels. At the second, a compet-itive process occurs and they choose prices, and indirectly, the numberof beds, or quantities. The game is solved by backwards induction, anda subgame perfect Nash equilibrium is obtained. As will be shown,hotels choose to offer differentiated services.

Starting with the last stage of the game, prices are chosen in order tomaximize the profits made by hotels. For any given u1 and u2, profits ofestablishment i are given by the expression


Pi ¼ piqiðp1; p2;u1;u2Þ � Ciðui ; qiÞ.By computing the first derivatives with respect to prices, and once thecorresponding system of equations has been solved, p1 and p2 can beexpressed solely depending on the quality levels and the parameters.By substituting these price expressions back into the profit functions,again deriving profits with respect to u1 and u2, and solving the systemof equations corresponding to the first stage, the equilibrium marketsolutions can be found. Numerical computations have been performedusing the Mathematica program. Thus, for �h ¼ 1, the unique pairs ofqualities and prices which maximize profits are:

u�1 ¼ 0:81; u�2 ¼ 0:39

p�1 ¼ 0:45; p�2 ¼ 0:15:

The results can be summarized through the following statement.Under the assumption of variable costs increasing in u, the equilibriumof the game in which the duopolist hotels first choose qualities andthen prices is such that the hotel 1 (that in the upper segment) selectsu�1 ¼ 0:81 and hotel 2 the selects u�2 ¼ 0:39. The equilibrium prices andthe remaining equilibrium values for this competitive scenario areshown in the first column of Table 1.

The Efficient Solution

Now the efficient outcomes are computed under different assump-tions, and then compared to the market equilibrium outcome. For thisreason, the resolution of the social planner problem is consideredhere. This could be understood as the decision that a governmentwould pursue in order to maximize the welfare of the population ofthe region. The market equilibrium outcome can be improved for var-ious reasons. First, because hotels do not consider the welfare of con-sumers when making their decisions. Thus, in an economy where

Table 1. Market and Social Planner Outcomes without Externalitiesa

Market Competition SP Equilibrium (for a = 0) SP Equilibrium (for a = 1)

u�1 ¼ 0:81 uSP1 ¼ 0:80 uSP

1 ¼ 0:80u�2 ¼ 0:39 uSP

2 ¼ 0:40 uSP2 ¼ 0:40

q�1 ¼ 0:27 qSP1 ¼ 0:20 qSP

1 ¼ 0:40q�2 ¼ 0:34 qSP

2 ¼ 0:20 qSP2 ¼ 0:40

p�1 ¼ 0:45 pSP1 ¼ 0:56 pSP

1 ¼ 0:32p�2 ¼ 0:15 pSP

2 ¼ 0:24 pSP2 ¼ 0:08

P�1 ¼ 0:032 PSP1 ¼ 0:048 PSP

1 ¼ 0:0328P�2 ¼ 0:024 PSP

2 ¼ 0:032 PSP2 ¼ 0:0242

W *(a = 0) = 0.057 W SP(a = 0) = 0.08 –W *(a = 1) = 0.151 – W SP(a = 1) = 0.16

a For �h ¼ 1, c = 0.


residents are tourists, their welfare should be accounted for. Second,since tourism causes external effects to residents, they should also beconsidered.

As is common in the industrial organization literature, it has beenassumed that the social planner cares about the overall welfare, or totalsurplus, of the relevant population. This welfare function typically con-sists of the sum of the producer and the consumer surpluses. This gen-eral specification has been followed, but some specific features whichmay be relevant when referring to the industry have been incorpo-rated. The first distinction to be made has to do with the fact that onlyan a proportion of the consumers, or tourists, are local. The remainingones are foreigners (that is, the service is to be exported). Thus, thelocal social planner does not care about the surplus of non-residentconsumers. It would be expected that a is close to zero in small econ-omies, when tourists mostly come from other regions. At the nationallevel, for instance, the proportion of national tourists could be signifi-cant. The second distinction is related to externalities. As argued ear-lier, it is assumed that the consumption or the production of theservice generates net negative external effects suffered by local resi-dents, independently of whether they participate in the market as tour-ists. Examples of these negative effects could be noise, congestion inthe consumption of recreation activities, higher housing prices, orthe degradation and even loss of certain natural resources. Of course,numerous external benefits can be mentioned, such as the consump-tion of local public goods and investments provided by the hotel sec-tor, or the indirect positive effects benefiting many other sectors ofthe economy. But it is here assumed that in net terms external costsoutweigh external benefits.

With these two particularities in mind, the total surplus function canbe written down as:

W ¼ Pþ aCS� EXT;

where P denotes the aggregate profits made by hotels, or the producersurplus; CS the consumer surplus, with a representing the share of con-sumer surplus that goes to resident tourists, with 0 6 a 6 1; and EXTare the externalities caused by the consumption/production of thetourist service.

Aggregate profits simply correspond to the sum of profits of firms 1and 2, that is P = P1 + P2, which have already been used in the previ-ous subsection. Regarding the consumer surplus, it corresponds to thesum of the differences between the willingness to pay of each touristand the market price, for each market segment. The willingness topay is affected by the quality level of the tourism service as well as bythe taste parameter h. Then the consumer surplus can be simplified to:

CS ¼ 1

2ðq2

1u1 þ 2q1q2u2 þ q22u2Þ.

Different analytical possibilities may be considered for the external-ity component. For instance, it can be assumed that each unit of theprovided service generates a certain external cost, which may be


related or unrelated to quality. Let C EXT denote the externality func-tion, and i denote the market segment. The following negative exter-nality function has been chosen:

CEXTi ðui; qiÞ ¼ cub

i q i ;

where c and b are parameters, and c is assumed to be low enough sothat marginal total surplus remains positive. Total external costs in-crease with quantity, or the size of the sector. Besides, this functionalform permits the consideration of three different scenarios, dependingon the value of the parameter b. Thus, if b > 0, the external cost perunit of output is increasing in u. For b = 0, u is not related to theamount of the externality. Finally, if b < 0 the external cost per unitdiminishes as the u level increases.

For the sake of illustration, examples capturing the three possibilitiesare given. Other things equal, young people are more prone to choosecheaper hotels, usually in the lower segment. They can be noisy. Un-fairly or not, a low quality tourist is usually thought to be noisy, behaveless politely, induce higher crime levels, or generate more litter, com-pared to a tourist staying in a highly rated establishment. This wouldcorrespond to the assumption of externalities decreasing in u. Thissituation is denoted with the superscript D (for decreasing).

Another possible relationship is the one in which the external costsdo not depend on the segment, but in the supplied quantity only (thissituation is denoted with the superscript C, for constant). In the case ofan overcrowded beach or restaurant, extra congestion caused by anextra tourist would be independent of the quality segment to whichit belongs. Then, the marginal external cost is unrelated to u.

Finally, the third possibility is the one in which the marginal externalcost increases with u (scenario denoted by the superscript I). This isalso a reasonable assumption. For instance, it can be considered thatproviding tourism services in the upper segment requires a higher con-sumption of natural resources, such as provision of air conditioning,green lawn, or a big swimming pool. These involve more consumptionof power and water. To the extent these resources may become scarceat demand peaks, higher costs may be imposed on residents. Anotherjustification is linked to the way in which consumption changes with in-come. For normal goods, higher incomes imply higher demands, andas a by-product, higher external costs. Thus, high quality tourists,prone to be wealthy, may increase the residents’ cost of living. Fromthis perspective, the way in which quality affects the negative externalityconstitutes an empirical matter, which is beyond the scope of thispaper. But the last two scenarios, corresponding to C and I, could beat odds with one of the arguments supporting the reorientation ofthe sector towards the upper segment.

The welfare or total surplus function ultimately depends upon theprices, the quality variables, and the parameters. The problem of the so-cial planner consists then in choosing the prices as well as the qualitylevels that should be implemented so that welfare is maximized. Thereare ways to solve this maximization problem. The first order conditions


of the problem are derived, and then the optimal values of the involvedvariables are found. The same sequence of decisions used in the resolu-tion of the market problem is pursued. Analytically, first optimal pricesare found, and then optimal qualities are solved using backwards induc-tion. Here the outcomes corresponding to the social planner scenarioare discussed in two cases, with and without negative externalities.

The absence of externalities is assumed first, and the superscriptSP is used to denote this social planner scenario. The problem hereconsists in choosing the value of the variables that maximizes socialwelfare. It is found that a maximum exists when:

uPS1 ¼

4�h5; uPS

2 ¼2�h5;

pSP1 ¼

4ð7� 5aÞ�h2

25ð2� aÞ ; pSP2 ¼

2ð6� 5aÞ�h2

25ð2� aÞ .

The second order conditions are verified for all vectors of prices andqualities that hereafter constitute maximums, for specific values of theparameters. Notice that the value of u1 doubles that of u2, and thatqualities are independent of the specific portion of the consumer sur-plus that goes to residents. This result generalizes to the case in whichexternalities are present, with u1 and u2 always independent of thea-parameter. With respect to prices, it is verified that the price of theservice provided in the upper segment always exceeds that of the lowersegment.

The comparison of the market and the social planner scenarios forparticular values of the parameters allows an easier perspective onthe results. In all instances, the taste parameter has been normalizedto 1, that is �h ¼ 1. With respect to a, only the extreme cases in whichthe consumer surplus totally goes to non-residents, or totally to localtourists, are considered. Table 1 summarizes the computed results.The first column includes information that corresponds to the marketequilibrium scenario developed before, where the total surplus valuehas been computed. When there are no resident consumers, totalsurplus simply coincides with aggregate profits of firms, while fora = 1, the whole consumer surplus is summed up.

The optimal values of u1 and u2 are not very different from their mar-ket equilibrium counterparts. It results that the social planner choosesa slightly lower high quality level, when compared to the marketscenario, and the lower value result is slightly higher. As a result, thegap decreases.

Quantities do depend on the share of consumer surplus benefitingresident consumers. When all tourists are non-residents, and comparedto the market outcome, socially optimal quantities are smaller than themarket ones. However, when all tourists are assumed to be resident,quantities double compared to the case in which they are all non-resi-dent. In the first scenario, the efficient choice coincides with that of amonopolist seeking the maximization of total profits. This is becausewelfare and aggregate profits coincide, and it is a well-known resultthat the equilibrium choices when firms compete strategically are


sub-optimal. Instead, it can be shown that for a = 1, the social plannersets prices that coincide with the respective marginal costs of firms, andprofits equal zero. For other positive values of a inferior to 1, interme-diate results should be expected. And indeed, the social planner solu-tions yield higher welfare values than those derived from the marketequilibrium outcome.

Next, optimal qualities are found considering that externalities arepresent. The emphasis is on the assumptions on external costs, andhow the optimal choices of the social planner are affected. The socialplanner problem is solved exactly in the same way as in the previouscases, the only difference being the deduction of the externality com-ponent in the total surplus function. The resolution of the model withexternalities is omitted and the results are directly shown. They havebeen obtained with numerical computations. Again, calculations havebeen performed for �h ¼ 1. As for the c constant in the external costfunction, it has been assumed that c = 0.3. Other values are likewisepossible. Finally, the results are shown for three particular values of b(1, 0 and �1), each one illustrating scenarios I, C, and D, respectively,as already noted. Again, in the case of marginal external cost increas-ing in quality, total welfare is negatively affected both by the level ofproduction and the value of u; the case of constant marginal external-ities occurs when total welfare is negatively affected by the level of out-put, but unaffected by the u value; when total welfare decreases withquantity, but the per unit externality decreases as u increases, it isthe case of decreasing marginal external costs. Table 2 shows the com-puted values of the optimal variables for the case in which there are noresident consumers.

It can be observed that socially optimal qualities are higher when thevalue of the externality per unit is independent or decreasing with u.Only in case I, when there is a positive effect of u on the marginal

Table 2. Social Planner Outcomes with Externalities and Non-Resident Consumersa

Market Competition Increasing (I) Constant (C) Decreasing (D)

c = 0.3, b = 1 c = 0.3, b = 0 c = 0.3, b = �1

u�1 ¼ 0:81 uI1 ¼ 0:56 uC

1 ¼ 0:96 uD1 ¼ 1:16

u�2 ¼ 0:39 uI2 ¼ 0:28 uC

2 ¼ 0:83 uD2 ¼ 1:09

q�1 ¼ 0:27 qI1 ¼ 0:14 qC

1 ¼ 0:05 qD1 ¼ 0:05

q�2 ¼ 0:34 qI2 ¼ 0:14 qC

2 ¼ 0:05 qD2 ¼ 0:05

p�1 ¼ 0:45 pI1 ¼ 0:44 pC

1 ¼ 0:84 pD1 ¼ 1:05

p�2 ¼ 0:15 pI2 ¼ 0:20 pC

2 ¼ 0:73 pD2 ¼ 0:98

P�1 ¼ 0:032 PI1 ¼ 0:039 PC

1 ¼ 0:022 PD1 ¼ 0:018

P�2 ¼ 0:024 PI2 ¼ 0:022 PC

2 ¼ 0:022 PD2 ¼ 0:019

W *(b = 1) = �0.048 W I = 0.027 – –W *(b = 0) = �0.126 – W I = 0.010 –W *(b = �1) = �0.305 – – W SP = 0.011


external cost, both the high and the low quality levels decrease with re-spect to their market counterparts. Quantities decrease in all sectors,even in scenarios C and D. This suggests that the substitution for lowby high quality production would not be efficient, but that the produc-tion should be significantly diminished in any of the scenarios. In casesC and D, prices are higher, since outputs have diminished and qualitieshave risen. In these two cases, profits diminish for both firms. The intu-ition is that the reduction of total external costs exceeds the reductionin the producer surplus.

As well, quantities diminish under the assumption that larger u pro-voke larger per unit externalities (case I), but to a lesser extent. Theeffect on prices and profits is likewise less important. Table 3 showsthe computed values of the variables when residents not only bearthe externality, but also all tourism services are consumed by residents.

Logically, when a = 1 optimal quantities increase compared to thea = 0 assumption, since now the consumer matters. Because pricesare lower, they end up buying more units, and quantities increase,other things being equal. In aggregate, profits increase for both thehigh and the low quality firms. Of course, other intermediate valuesof a are possible. It can be shown that the equilibrium quantities,the resulting consumer surplus, and the total surplus monotonicallyvary with a. Again, the values of u1 and u2 are higher than in the marketoutcomes when the externality per unit is independent or decreasingwith u. Qualities are lower when accounting for a positive effect of qual-ity on the marginal external cost. Total quantities decrease in all of thecases.

Numerical simulations have been used in order to provide compara-ble values of the variables with those resulting from the market out-come. The values included in the above tables respond to those ofparticular parameters. However, simulations with alternative values of

Table 3. Social Planner Outcomes with Externalities and Resident Consumersa

Market Competition Increasing (I) Constant (C) Decreasing (D)

c = 0.3, b = 1 c = 0.3, b = 0 c = 0.3, b = �1

u�1 ¼ 0:81 uI1 ¼ 0:56 uC

1 ¼ 0:94 uD1 ¼ 1:16

u�2 ¼ 0:39 uI2 ¼ 0:28 uC

2 ¼ 0:83 uD2 ¼ 1:09

q�1 ¼ 0:27 qI1 ¼ 0:28 qC

1 ¼ 0:11 qD1 ¼ 0:10

q�2 ¼ 0:34 qI2 ¼ 0:28 qC

2 ¼ 0:11 qD2 ¼ 0:10

p�1 ¼ 0:45 pI1 ¼ 0:32 pC

1 ¼ 0:74 pD1 ¼ 0:94

p�2 ¼ 0:15 pI2 ¼ 0:12 pC

2 ¼ 0:64 pD2 ¼ 0:87

P�1 ¼ 0:032 PI1 ¼ 0:047 PC

1 ¼ 0:033 PD1 ¼ 0:025

P�2 ¼ 0:024 PI2 ¼ 0:023 PC

2 ¼ 0:033 PD2 ¼ 0:027

W *(b = 1) = 0.046 W I = 0.054 – –W *(b = 0) = �0.032 – W C = 0.021 –W *(b = �1) = �0.211 – – W SP = 0.022


b and c, have been proven and results are robust. Likewise, alternativespecifications of the external costs functions were used, with the mainconclusions of the analysis remaining unaltered.

These results suggest that overall efficiency of the tourism industrywould indeed improve if u1 and u2 were higher than those the marketprovides with imperfect competition when the marginal external costdecreases or is constant in u. But if the assumption of a marginal exter-nal cost increasing with u is plausible, the result is the opposite. Thus,recommendations suggesting that hotels should devote their efforts toimprove the quality of the tourism services they supply do not seem tobe at all times supported by theory. Such policy advice would not besupported in the scenario in which externalities are absent. It is shownthat optimal values of u practically did not change compared to themarket outcome.

Regarding the size of the sector, and considering all of the scenariosin which externalities were present, total quantities provided undermarket competition are too large compared to the efficient solution.The previous results could be summarized in the two following state-ments. First, when firms compete in quality and when externalitiesare present, a contraction of both the upper and lower segments gen-erally results in welfare improvement. Second, the market equilibriumqualities are sub-optimally low if the per unit external cost decreases oris independent of u. Instead, they are sub-optimally high when theexternality per unit is increasing in u.

The previous results suggest that few general claims can be made interms of policy recommendations with respect to the distribution ofqualities in the industry, at least when they are based on the environ-mental aspects of tourism. Policies directed toward stimulating theupper segment, compared to the market scenario, seem to be justifiedexclusively when the per unit externality decreases or does not varywith u. Even in these instances, the social planner solution allows forthe coexistence of both segments of the market: the high and thelow quality. When external costs are increasing with u, the governmentpolicy should instead encourage lower qualities.

More interestingly, even when qualities should be made higher, theactivity in both segments of the market should be diminished. Thus,the recommendation should not be a shift of resources from the lowerto the upper segment; rather, the optimal policy should discourageactivity in both segments. That is, if one considers the welfare of all eco-nomic agents, and not only hotels, the optimal policy should seek thereduction of the accommodation capacity of the sector.

CONCLUSION

Proposals suggesting the reorientation of the tourism industry to-wards the high quality segment are gaining popularity, and they aresometimes defended on environmental grounds. This paper investi-gates some of the conditions that should be present so that such policyrecommendations remain valid. To do so, a partial equilibrium analysis


has been used in which the surplus for resident consumers and nega-tive externalities arising from the tourism are explicitly considered,since they play a key role when determining the efficient levels of qual-ities and quantities that hotels should offer.

A theoretical framework with a vertical differentiation model inwhich two establishments compete has been considered. In the marketoutcome, it turns out that two differentiated segments exist in equilib-rium. The social planner problem was first solved by considering thatthere are no externalities affecting the welfare of residents. The resultin this case is that the high quality chosen by the social planner isslightly lower compared to the market scenario, while the low one isslightly higher. Adding resident consumers to the welfare function log-ically provokes an increase in the optimal output levels. While in themarket solution, the hotel in the lower segment provides more produc-tion, in the social planner solution quantities to be provided by eachfirm are equal. Of course, total welfare is sub-optimal in the market sce-nario. According to these outcomes, policies interested in increasingquality levels would not be justified. But increasing the relative sizeof the upper segment would indeed constitute an advisable policy goalwhen residents participate in the market as consumers.

The introduction of externalities into the welfare function changesresults. Optimal qualities should be higher than those resulting frommarket competition if the per unit external cost decreases or is inde-pendent of u. However, this result is reversed if the external costs in-crease as hotels are better rated, meaning that optimal qualities aresmaller than their market counterparts. In all scenarios, the social plan-ner solution allows for the coexistence of both segments of the market:the high and the low quality. However, even when higher standards arerecommended for both segments, the activity in the market should bediminished. Thus, according to these results, an appropriate policywould not stimulate the shifting of resources towards the uppersegment, but rather it should dissuade activity in both segments.

Several policy recommendations arise from this study. For those des-tinations in which the reception of a large number of tourists exertsoutstanding net negative externalities on residents, the recommenda-tion would be twofold. First, the supply of a differentiated tourism ser-vice should be kept, and so the upper and lower segments shouldcoexist. Second, the number of beds in both the lower and upper seg-ments should be reduced. Thus, those policies which gradually substi-tute low quality capacity with high would not be justified. If they keepbeing used, the substitution should not take place on a one-to-onebasis. This is especially true when the local community scarcely parti-cipates from the producers’ and consumers’ surpluses.

More research is needed in the field of the policy instruments inorder to achieve the social planner outcome. As shown, this type ofintervention should take into account the way in which quality pro-vokes external costs. Empirical research providing more evidence onthe net impacts of tourism on residents and enlightening the relation-ship between external costs and the characteristics of the specializationin particular regions would also be a very useful extension. It would


help in determining which of the three presented scenarios is morerealistic.

Acknowledgments—The authors gratefully acknowledge helpful comments received on earlierdrafts from Aleix Calveras and from assistants at the X Encuentro de Economıa Publica heldin 2003 and the XIX Jornadas de Economıa Industrial convened in 2004. Dolores Garcıaacknowledges financial support from the Spanish Ministry of Science and Education andfrom FEDER through grant SEJ2004-00143. Marıa Tugores acknowledges financial supportfrom the Government of the Balearic Islands through grant PRIB-2004-10142.

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Submitted 4 May 2003. Resubmitted 22 June 2004. Resubmitted 3 March 2005. FinalVersion 23 June 2005. Accepted 28 October 2005. Refereed anonymously. CoordinatingEditor: David A. Dittman

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Optimal choice of quality in hotel services