An Economic Analysis of the Tourism Industry - Implications of the Online Travel Intermediary

Informational asymmetry and fragmentation of capacity suppliers in the tourist industry provide travel intermediaries with market power. Market structure is characterized by over-capacity in off-peak seasons, high fixed costs and low variable costs, leading to product under-pricing. Forward sales of capacity at low contract prices surrender profits from consumer surplus to intermediaries enjoying oligopsony benefits. The creation of formal futures contracts in rooms and seats would permit operators to hedge demand uncertainty and retain more of the profits. Online intermediaries can serve the interests of domestic hotel operators through exploitation of databases to provide analytical solutions to capacity utilization and to develop demand balancing. π The contents of this paper in part or in whole are entirely those of the authors and do not represent the views and opinions of Sasin of Chulalongkorn University and any organization associated with the authors. Comments are welcome. All correspondence is directed to Pongsak Hoontrakul, Research Fellow, Sasin-GIBA, Chulalongkorn University, Sasa Patasala Building, 8 floor, Soi Chulalongkorn 12 (2), Phyathai Road, Bangkok 10330, Thailand. Private Tel. (662) 954 1689 ; Fax (662) 954 1690 ; Email : [email protected] URL : www.Pongsak.Hoontrakul.com An Economic Analysis of the Tourism Industry 2 “An Economic Analysis of the Tourism Industry Implications of the Online Travel Intermediary” by Peter Ryan and Pongsak Hoontrakul Although one of the most important industries in the world economy, tourism has not received serious attention from economists. The implications of tourism for developing economies are far more significant than for mature economies, yet virtually all nations recognize the importance of the industry. Development economics already includes tourism in addition to agricultural and industrial issues. Many of the features of the tourism industry resemble those in other long-studied areas of the economy, implying that similar analyses and solutions to problems should be applied. The direct influence of the airline industry on tourism provides a bridge between classical economic analysis and the less-studied aspects of tourism. In determining a policy for industrial development, governments must focus on the domestic retention of value from engaging in an activity. Typically, the majority of tourism revenues do not remain on-shore due to the structure of the industry and its participants. We identify the significant features of the travel and tourism industry and provide an economic analysis that will indicate opportunities for value creating strategies. This demonstrates the importance that a large, publicly recognized online travel intermediary can have for further development and increased domestic profitability of the tourism industry. The case of the Thai industry is used as a focus. This study provides direction for the strategy of such a travel intermediary by showing where the information available from online sources can be used to improve the design and pricing of services in the hospitality sector. It also gives a summary of how the information is to be used in analytical methods to optimize the sale of capacity in the sector under certain types of contracts. The presentation includes introductory material indicating the significance of the industry, and a summary of the value retention by the various players in the industry, both domestic and international. There is also a brief strategic analysis of the industry by comparison to modern trends in corporate development through the characterization of the role played by travel intermediaries in the traditional sense in contrast to that of an online intermediary, using its larger database and sophisticated planning tools. An enhanced role involves the design of tourism services, marketing, An Economic Analysis of the Tourism Industry 3 and financing initiatives. Next, there is an examination of the macroeconomic, microeconomic and financial issues involved in the industry and their implications for the creation of an effective online intermediary. Finally, a linear program is presented as an analytical tool to optimize the contracting policies of service providers. 1. Scope of the Tourism Industry Statistical aspects Current statistics on global tourism indicate that it is now the largest “export” industry, as it is for Thailand in particular. One measure of this gives $474.2 billion in annual global tourism revenues, as estimated by the World Tourism Organization, or over $600 billion when passenger transport is added. For Thailand, 323.5 billion Baht in tourism revenues constitute 6% of GDP as of 2002. Furthermore, the growth rate in revenues of 6% compared to the average GDP growth of 3.14% in the past five years implies that the potential share of GDP is even greater. (The share of GDP has risen from 4.66% in 1997 to 6% in 2002.) Of the latest sales volume of 323.5 billion Baht, however, it is estimated that only 30% is retained by Thailand, the remainder flowing to foreign hands. This figure contrasts with estimates as low as 20% for Caribbean nations (highly dependent on tourism but exposed to cruise liners) and as high as 60% in India. These retention rates result from “leakage” due to import of supplies and materials unavailable in the host country (international standards and tastes) and to export of financial flows (repatriation of profits earned by investors) plus overseas promotional expenditures. As well as leakage from the gross receipts of tourism, there are additional structural losses. Most of these are comprised of foreign carriers’ fares and foreign travel agents’ fees and profits. Increasing the share of domestic airlines and travel agents then can have a significant effect on increasing tourism revenues. Various studies have also questioned the net benefits of tourism at differing stages of development, which may be an issue of timing of investment and return cash flows. Costs of building infrastructure added to congestion may well make expansion of tourism a short-term negative proposition. Nevertheless, tourism is generally accepted as being beneficial on the whole and specifically to economic development. In An Economic Analysis of the Tourism Industry 4 summary, the size of the actual and potential tourism market more than warrants efforts to increase both its gross and net revenues. The value chain and value retention The value chain in tourism can be summarized as formed by the end user or consumer, paying the total sales (above), linked by the carriers (largely airlines) to the hotels, resorts, restaurants, physical attractions and other members of the hospitality sector, with the linkage provided by the travel intermediaries, themselves either domestic or international. With 25% as a minimal target profit margin for a large intermediary, it is clear how significant is the share of the value chain captured by the intermediaries; of this the portion taken by domestic Thai agents is estimated to be minimal. (Insert diagram about here) The transfer of payments from consumers to the providers of goods and services in the tourism industry is filtered, at a cost, by the travel intermediaries. This filtration is viewed as a friction on the efficient transfer between the two parties, implying that a “tax” is imposed on users’ ability to afford and enjoy the goods and services provided, and with the “tax” reducing the profits of the service providers; or else it is a reasonable price reasonable price for valuable and necessary services that enhance the enjoyment of the product by the end users. The justification for the intermediary services comes from the existence of informational barriers between users and providers, plus the possibility that experienced travel consultants have built up capital, to be rewarded by charges for enhancing the tourism experience of average consumers. One concludes immediately that more efficient intermediaries in a competitive market can reduce the “tax” by improving the information flow. The technology of online services offers the benefits of lower overhead and centralized databases enabling the reduction of the “tax” and identification of opportunities for enhancement of tourist satisfaction through matching of needs and solutions. A further benefit is the opportunity for the intermediary to provide databased analysis of travel patterns allowing service providers to refine their offerings and pricing strategies. The implementation of IT applications to tourism results in value creation analogously to the realization in the 90’s of the benefits of the computer/internet revolution. The expected benefits of the computer for productivity enhancement were delayed until the potential was realized through the full deployment of communications networks; so too, the conventional use of computers An Economic Analysis of the Tourism Industry 5 to achieve ticket bookings can be greatly extended by merging this technology with database exploitation, now seen through CRM (customer relationship management). 2. The Role of the Travel Intermediary Increasingly in fully developed economies, corporations are recognizing that a fully vertically integrated production process results in lower return on capital. High labor costs make domestic production non-competitive. Consequently, successful corporations in Europe and North America are turning to out-sourcing of low-margin manufacturing operations. High-margin activity consists of the creative design of product and services, distributed using advertising and branding for the enlargement of market demand as well as sophisticated delivery channels. This process is further aided by arranging financing and structuring contracts to build markets and sales. This strategy has been implemented in established industries such as auto manufacturing (with parts production and assembly largely off-shore) and modern technologies such as computer software (code writing) and hardware (chip manufacturing); what were only recently viewed as high technology products are now seen as “commodities” to be produced in low-labor cost locations. Progress in developing nations is then seen as a response to developed nation initiatives. Instead of emulating and competing with developed nations in basic industries, developing nations have now taken over those basic, and even advanced, industries. In fact, they are encouraged to develop those industries in accordance with the needs of the corporations in advanced societies for production under an outsourcing program. In essence, developing nations are forced to follow the direction of more advanced nations, acting as branch plants. Challenging this process requires both financial and human capital in the developing nation. In the tourism industry, neither large financial capital nor unattainable creative resources are required to effect the challenge with the help of online travel agencies. The traditional role As a rule, the services provided by travel intermediaries have been centered on three areas – marketing, design and financing. A travel agency, by conventional advertising and increasingly by electronic publicity, attempted to attract customers for whom they would arrange travel by carrier and lodging at the destination. Advances led to attempts to channel the clients to appropriate destinations, aided by familiarity with An Economic Analysis of the Tourism Industry 6 repeat customer habits and client preferences. In general, the response to new clients was reactive, offering specific hotels and carriers that would meet the stated requests, primarily cost-based with attention to the level and type of facility needed. Increased use of computers helped to establish data bases on past customers, but small operators were unlikely to have the capacity to employ a sophisticated data base analysis system. Business enhancement lay in combining packages of carrier and hotel, sometimes enhanced by theme-based add-ons such as golf vacations. This suggests the benefits of taking a creative role in designing attractive packages for different clienteles; hence building scale implies placing resources in the design area. Initially, the role of the intermediary was to match the demand from clients to the inventory of passenger seats and hotel rooms accessible to the intermediary, identified by online connection to vendors. The intermediary then passed through the payment while extracting a fee from the supplier. This role has expanded for larger agencies acting as wholesalers or higher level intermediaries who will re-sell to travel agents or tour group operators in direct contact with clients; these wholesalers have booked allotments of rooms at reduced prices to them, which are then re-sold at a profit. The contractual allotment is a risk-reducing strategy for the supplier analogous to a commodity forward contract, but lacking the efficiency of forward and futures markets. An alternative arrangement is an allotment on a “best efforts” basis, which reserves capacity for agents with no firm commitment, effectively, granting an option to sell capacity to clients at a lower (exercise) price. “Free sale” arrangements with hotel operators sanction the travel agencies as agents to sell capacity within the available supply. Free sales to some degree and allotments to a greater degree limit the hotel operator’s ability to manage capacity and extract a higher price for the units, but help to guarantee revenues by increasing the probability of rentals. Online agency potential The initial impact of creating an online capability for a travel intermediary is the creation of a low overhead operation with the potential to transact business on a world-wide basis. Efficient systems permit rapid low-cost response to inquiries and execution of bookings, plus book-keeping efficiencies. Electronic data entry leads to a reduction in handling costs and a dynamic inventory system for accurate information on future availability. Furthermore, the spatial limitations of a “bricks-and-mortar” operation are eliminated, leading to a vast expansion in potential market. Scalability is An Economic Analysis of the Tourism Industry 7 relatively unrestricted, with only incremental hiring of personnel and the installation of larger servers needed to accommodate increased volume. Once the initial investment in software has been made, expansion is tied to the rate of market growth. Online operations create a comprehensive database of potential clients that identifies sales opportunities for directed marketing. Statistical analysis can identify trends and generate descriptive measures to aid in planning. Development of database analysis tools enables an intermediary to offer a new kind of service to hotel operators. Building on statistical patterns, the intermediary can provide information to hotels on predictable demand and recommend pricing strategies to increase hotel profits. This can be provided by the development of analytical packages to be used by the hotel in planning its capacity sales at different times of the year. A further enhancement would be the coordination of marketing initiatives that would lead to demand smoothing, made possible by the size of the intermediary and its reach to end users as well as the integrated perspective on capacity utilization in defined areas and periods. With a critical level of volume, the crucial element of diversification can be achieved allowing an intermediary to engage in risk-taking contracts with lower exposure than for individual hotel operators. At a certain level of operation, the intermediary can safely afford to accept allotments, to fill with a predictable demand. Hotel operators then create value by shifting demand risk to the intermediary. The experience gained between operators and the intermediary will lead to the development of more contracts for capacity sales. Effectively, the achievement of critical size by the intermediary implies greater ability to act as an agent for suppliers and results in enhancement of value for both suppliers and the intermediary. Increased scale and experience also enable an intermediary to launch packaging initiatives to a larger client base. The opportunity to exploit specific local attractions or experiences, such as golf, spas or cultural and artistic events and themes, can be developed. The online capability allows the intermediary to promote new attractions rapidly and broadly in response to changing conditions, in contrast to a conventional approach of design, printing and distribution of brochures by physical agencies. Advanced methods of presenting visual images can provide prospective clients with greater detail, providing confidence in quality and aiding sales. Combined with current capacity information, this helps to achieve seasonal demand balancing. The greater international reach and technical capabilities of online access would be particularly useful in promoting Thailand’s attractions to potential visitors An Economic Analysis of the Tourism Industry 8 in order to stimulate a broader and higher-valued range of demand. Panoramic images of natural attractions, of spa treatment and surroundings, or of the details of Thai artistry and craftsmanship would effectively present the experience to be expected on a theme-based visit. Such attractions appeal to higher-end tourists, offer services requiring few off-shore inputs and hence reducing leakage, stimulate domestic production, and provide alternatives to the established tourist patterns. Experience reveals that a major problem before achieving critical size is supply related. Business development depends on obtaining capacity. To the extent that suppliers are constrained from over-selling, they favor larger intermediaries with greater perceived marketing potential. This creates a vicious circle of restricting growth due to supply, causing supply restrictions. To breach this circle, the agency must commit to purchases of capacity without the protection of critical size.