Annals of Tourism Research, Vol. 33, No. 2, pp.

456–469, 2006
Ó 2006 Elsevier Ltd. All rights reserved
Printed in Great Britain
0160-7383/$32.00
www.elsevier.com/locate/atoures
doi:10.1016/j.annals.2005.12.010

OPTIMAL CHOICE OF QUALITY

IN HOTEL SERVICES
Dolores Garcı́a
Marı́a 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 been
studied 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 in
both 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 for
the 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. Ó 2006 Elsevier Ltd. All rights reserved.

Résumé: Choix optimal de qualité des services hôteliers. Un débat sur la durabilité des
destinations de tourisme de masse et le besoin de les réorienter vers le segment de haute
qualités’est présenté récemment. Cependant, on n’a pas encore étudié si un tel changement
dans le modèle de spécialisation pouvait conduire à une augmentation d’efficacité. Dans cet
article, on utilise un modèle de duopole à différentiation verticale dans lequel les hôtels sont
en concurrence sur les plans qualité et prix. On compare le duopole de marché et les
solutions de planificateur social et considère les différents coûts externes. On trouve que
les solutions efficaces permettent la coexistence des segments de haute et de basse qualité,
et qu’une expansion du premier n’améliore pas nécessairement le bien-être. Mots-clés: qua-
lité, externalités, compétition imparfaite. Ó 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 this
paper. The first one deals with the well-known idea that (tourism) firms
can 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 behave
under different market structures, especially in the long run. The

Dolores Garcı́a and Marı́a Tugores are both Associate Professors at the Department of
Applied Economics, Universitat de les Illes Balears (07122 Palma de Mallorca, Baleares,
Spain. Email <mtugores@uib.es>). The first author conducts research on environmental
economics, urban economics, and industrial organization; and the research interests of the
second author are in tourism economics, industrial organization, and labor economics.

456
 GARCÍA AND TUGORES 457

advantages for firms when participating in differentiated markets are

related to the possibility of avoiding a fierce degree of competition,
which ultimately leads in the long run to null profits. This would be
at the base of the tourism product lifecycle model, widely discussed
in 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 (Butler
1997; Saveriades 2000; Smith and Krannich 1998). Alternatively to
the 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 the
differentiation of the product. This can be linked to the value of the
provided services or to the specificities of the cultural and natural envi-
ronment, inter alia. Besides, it allows for the coexistence of higher
prices and a relatively small number of tourists.
Likewise, recommendations to pursue higher qualities are defended
on 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 this
industry. These effects constitute negative externalities. From this per-
spective, it is claimed that specializing in high quality services, basically
because the number of tourists diminishes, contributes to reductions
in the level of congestion, crime, or the degradation of local natural
resources, compared to the mass tourism alternative. On the other
hand, the mass style may be crucial for the sustainability of tourism
in the region. Thus, despite the popularity of proposals suggesting
industry reorientation, there is still much to be investigated for such
proposals to be accepted. This paper aims to analyze the role of local
consumers and the nature of the external effects in explaining both
optimal qualities and size of the market.
First, in reference to the role played by residents, disparities exist
with 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 and
Dellaert 2001; Teye, Sirakaya and Sönmez 2002), while for others the
prevailing net effect is positive (King, Pizam and Milman 1993). This
sign ultimately depends on the extent to which the profits obtained
by 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 aggregate
external impacts result in costs that offset benefits for producers and
local consumers. The theoretical analysis used here assumes that local
residents have been accounted for as the beneficiaries of the profits
made by firms, as consumers (with a varying degree of participation
in the market), and as the recipients of external effects. In any case,
the determination of optimal policies should not ignore the effects
on 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 its
general acceptance, there exists no tested evidence favoring the high
quality strategy. There may be instances in which the external costs
may be larger if caused by a tourist using better facilities, including
more extensive natural resources such as water or energy. In other
cases, the opposite would be true, and tourists staying in lesser-quality
establishments typically are thought to be more prone to generate
noise or public nuisances. This paper takes into account different pos-
sibilities regarding these relationships, which constitute a key aspect to
consider 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 to
identify which circumstances justify devoting more resources to the
upper segment of the industry as a desirable policy. To do that, a ver-
tical differentiation model in which two hotels compete in quality and
price is used. Because of imperfect competition and because some
externalities exist, the market equilibrium is not the desirable outcome
for 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 that
tourism 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 the
characteristics 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 be
considered. Differentiation is related to the quality of the services pro-
vided by the sector. Thus, a vertical product differentiation model is
used, and establishments compete with prices. High and low qualities
are respectively denoted by u1 and u2, with u1 > u2.
There is a continuum of tourists in the market. They differ in their
tastes, described by the parameter h 2 ½0; h, h being uniformly distrib-
uted with unit density, where h refers to the one endowed with the
highest taste for quality. All consumers of the product are represented
by the utility function, U = hu  p. Their utility is zero if they do not buy
the differentiated good. As expected, the utility reached by tourists for
any given price p increases with quality, as does the willingness to pay
for the service. In accordance with the literature on product differen-
tiation, it is here assumed that consumers can buy at most one unit of
services. Here h can be interpreted as the marginal rate of substitution
between income and quality: a higher h corresponds to a lower
marginal utility of income and hence a higher income (Tirole 1988).
Under this interpretation, this is the analogue of the models where
consumers differ by their incomes rather than by their tastes (Bonanno
1986; Gabszewick and Thisse 1979, 1980; Ireland 1987; Shaked and
 GARCÍA AND TUGORES 459

Sutton 1982, 1983). In this context, h could be understood as the level

of income that each potential tourist has.
The taste parameter of the consumer indifferent between buying the
high 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
p  p2
h1;2 ¼ 1 .
u1  u2
Likewise, the tourist indifferent between choosing the worse accommo-
dations (hotel 2) and staying at home has the taste parameter h0,2, with
h0,2 = p2/u2. For such person, staying at an establishment offering u2
implies a zero utility level. The demand functions can now be easily
built. 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. This
allows 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 found
by 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 likewise
considered that there exists a lower bound for u, so that ui > 0. This
can be interpreted as a minimum standard legal requirement, for in-
stance. Each hotel incurs in a cost of production of the form
u2
C i ðu i ; q i Þ ¼ 2i q i , where qi is the output supplied. That is, variable costs
increase with u. This function of production costs is widely used in the
industrial organization literature (Champsaur and Rochet 1989; Gal-
Or 1983; Mussa and Rosen 1978). The previous positive relationship
is straightforward, since the main burden of quality improvement falls
on more skilled labor or more expensive raw materials and inputs, for
instance. Higher ranked hotels usually require a higher number of
workers per tourist, more trained workers, more spacious rooms, and
the provision of certain facilities otherwise not available.

The Market Solution

Motta (1993) deals with market problems. Here, hotels 1 and 2 make
their decisions in order to maximize their respective profits, and then
the chosen qualities and prices are derived. Competition takes place
in 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 number
of beds, or quantities. The game is solved by backwards induction, and
a 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 to
maximize the profits made by hotels. For any given u1 and u2, profits of
establishment i are given by the expression
460 OPTIMAL QUALITIES

Pi ¼ p i q i ðp 1 ; p 2 ; u 1 ; u 2 Þ  C i ðu i ; q i Þ.
By computing the first derivatives with respect to prices, and once the
corresponding system of equations has been solved, p1 and p2 can be
expressed 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 system
of equations corresponding to the first stage, the equilibrium market
solutions can be found. Numerical computations have been performed
using the Mathematica program. Thus, for h ¼ 1, the unique pairs of
qualities 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 equilibrium
of the game in which the duopolist hotels first choose qualities and
then prices is such that the hotel 1 (that in the upper segment) selects
u 1 ¼ 0:81 and hotel 2 the selects u 2 ¼ 0:39. The equilibrium prices and
the remaining equilibrium values for this competitive scenario are
shown 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 this
reason, the resolution of the social planner problem is considered
here. This could be understood as the decision that a government
would pursue in order to maximize the welfare of the population of
the 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)

u1 ¼ 0:81 uSP

1 ¼ 0:80 uSP
1 ¼ 0:80
u2 ¼ 0:39 uSP
2 ¼ 0:40 uSP
2 ¼ 0:40
q1 ¼ 0:27 qSP
1 ¼ 0:20 qSP
1 ¼ 0:40
q2 ¼ 0:34 qSP
2 ¼ 0:20 qSP
2 ¼ 0:40
p1 ¼ 0:45 pSP
1 ¼ 0:56 pSP
1 ¼ 0:32
p2 ¼ 0:15 pSP
2 ¼ 0:24 pSP
2 ¼ 0:08
P1 ¼ 0:032 PSP
1 ¼ 0:048 PSP
1 ¼ 0:0328
P2 ¼ 0:024 PSP
2 ¼ 0:032 PSP
2 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.
 GARCÍA AND TUGORES 461

residents are tourists, their welfare should be accounted for. Second,

since tourism causes external effects to residents, they should also be
considered.
As is common in the industrial organization literature, it has been
assumed that the social planner cares about the overall welfare, or total
surplus, 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 which
may be relevant when referring to the industry have been incorpo-
rated. The first distinction to be made has to do with the fact that only
an a proportion of the consumers, or tourists, are local. The remaining
ones are foreigners (that is, the service is to be exported). Thus, the
local social planner does not care about the surplus of non-resident
consumers. It would be expected that a is close to zero in small econ-
omies, when tourists mostly come from other regions. At the national
level, 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 the
service 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 in
the consumption of recreation activities, higher housing prices, or
the 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 of
the economy. But it is here assumed that in net terms external costs
outweigh external benefits.
With these two particularities in mind, the total surplus function can
be written down as:
W ¼ P þ aCS  EXT;
where P denotes the aggregate profits made by hotels, or the producer
surplus; 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 EXT
are the externalities caused by the consumption/production of the
tourist service.
Aggregate profits simply correspond to the sum of profits of firms 1
and 2, that is P = P1 + P2, which have already been used in the previ-
ous subsection. Regarding the consumer surplus, it corresponds to the
sum of the differences between the willingness to pay of each tourist
and the market price, for each market segment. The willingness to
pay is affected by the quality level of the tourism service as well as by
the taste parameter h. Then the consumer surplus can be simplified to:
1
CS ¼ ðq 21 u 1 þ 2q 1 q 2 u 2 þ q 22 u 2 Þ.
2
Different analytical possibilities may be considered for the external-
ity component. For instance, it can be assumed that each unit of the
provided service generates a certain external cost, which may be
462 OPTIMAL QUALITIES

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:

C EXT
i ðu i ; q i Þ ¼ cu bi q i ;

where c and b are parameters, and c is assumed to be low enough so

that marginal total surplus remains positive. Total external costs in-
crease with quantity, or the size of the sector. Besides, this functional
form permits the consideration of three different scenarios, depending
on the value of the parameter b. Thus, if b > 0, the external cost per
unit of output is increasing in u. For b = 0, u is not related to the
amount of the externality. Finally, if b < 0 the external cost per unit
diminishes as the u level increases.
For the sake of illustration, examples capturing the three possibilities
are given. Other things equal, young people are more prone to choose
cheaper hotels, usually in the lower segment. They can be noisy. Un-
fairly or not, a low quality tourist is usually thought to be noisy, behave
less politely, induce higher crime levels, or generate more litter, com-
pared to a tourist staying in a highly rated establishment. This would
correspond to the assumption of externalities decreasing in u. This
situation is denoted with the superscript D (for decreasing).
Another possible relationship is the one in which the external costs
do not depend on the segment, but in the supplied quantity only (this
situation is denoted with the superscript C, for constant). In the case of
an overcrowded beach or restaurant, extra congestion caused by an
extra tourist would be independent of the quality segment to which
it belongs. Then, the marginal external cost is unrelated to u.
Finally, the third possibility is the one in which the marginal external
cost increases with u (scenario denoted by the superscript I). This is
also a reasonable assumption. For instance, it can be considered that
providing 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 consumption
of power and water. To the extent these resources may become scarce
at demand peaks, higher costs may be imposed on residents. Another
justification is linked to the way in which consumption changes with in-
come. For normal goods, higher incomes imply higher demands, and
as a by-product, higher external costs. Thus, high quality tourists,
prone to be wealthy, may increase the residents’ cost of living. From
this perspective, the way in which quality affects the negative externality
constitutes an empirical matter, which is beyond the scope of this
paper. But the last two scenarios, corresponding to C and I, could be
at odds with one of the arguments supporting the reorientation of
the sector towards the upper segment.
The welfare or total surplus function ultimately depends upon the
prices, the quality variables, and the parameters. The problem of the so-
cial planner consists then in choosing the prices as well as the quality
levels that should be implemented so that welfare is maximized. There
are ways to solve this maximization problem. The first order conditions
 GARCÍA AND TUGORES 463

of the problem are derived, and then the optimal values of the involved
variables are found. The same sequence of decisions used in the resolu-
tion of the market problem is pursued. Analytically, first optimal prices
are found, and then optimal qualities are solved using backwards induc-
tion. Here the outcomes corresponding to the social planner scenario
are discussed in two cases, with and without negative externalities.
The absence of externalities is assumed first, and the superscript
SP is used to denote this social planner scenario. The problem here
consists in choosing the value of the variables that maximizes social
welfare. It is found that a maximum exists when:
4h 2
h
u PS
1 ¼ ; u PS
2 ¼ ;
5 5
4ð7  5aÞ h2 2ð6  5aÞ
h2
p SP
1 ¼ ; p SP2 ¼ .
25ð2  aÞ 25ð2  aÞ
The second order conditions are verified for all vectors of prices and
qualities that hereafter constitute maximums, for specific values of the
parameters. Notice that the value of u1 doubles that of u2, and that
qualities are independent of the specific portion of the consumer sur-
plus that goes to residents. This result generalizes to the case in which
externalities are present, with u1 and u2 always independent of the
a-parameter. With respect to prices, it is verified that the price of the
service provided in the upper segment always exceeds that of the lower
segment.
The comparison of the market and the social planner scenarios for
particular values of the parameters allows an easier perspective on
the results. In all instances, the taste parameter has been normalized
to 1, that is 
h ¼ 1. With respect to a, only the extreme cases in which
the consumer surplus totally goes to non-residents, or totally to local
tourists, are considered. Table 1 summarizes the computed results.
The first column includes information that corresponds to the market
equilibrium scenario developed before, where the total surplus value
has been computed. When there are no resident consumers, total
surplus simply coincides with aggregate profits of firms, while for
a = 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 chooses
a slightly lower high quality level, when compared to the market
scenario, and the lower value result is slightly higher. As a result, the
gap decreases.
Quantities do depend on the share of consumer surplus benefiting
resident consumers. When all tourists are non-residents, and compared
to the market outcome, socially optimal quantities are smaller than the
market 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 a
monopolist seeking the maximization of total profits. This is because
welfare and aggregate profits coincide, and it is a well-known result
that the equilibrium choices when firms compete strategically are
464 OPTIMAL QUALITIES

sub-optimal. Instead, it can be shown that for a = 1, the social planner

sets prices that coincide with the respective marginal costs of firms, and
profits 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 market
equilibrium outcome.
Next, optimal qualities are found considering that externalities are
present. The emphasis is on the assumptions on external costs, and
how the optimal choices of the social planner are affected. The social
planner problem is solved exactly in the same way as in the previous
cases, the only difference being the deduction of the externality com-
ponent in the total surplus function. The resolution of the model with
externalities is omitted and the results are directly shown. They have
been obtained with numerical computations. Again, calculations have
been performed for h ¼ 1. As for the c constant in the external cost
function, it has been assumed that c = 0.3. Other values are likewise
possible. 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 of
production 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 with
quantity, but the per unit externality decreases as u increases, it is
the case of decreasing marginal external costs. Table 2 shows the com-
puted values of the optimal variables for the case in which there are no
resident consumers.
It can be observed that socially optimal qualities are higher when the
value 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

u1 ¼ 0:81 uI1 ¼ 0:56 uC1 ¼ 0:96 uD

1 ¼ 1:16
u2 ¼ 0:39 uI2 ¼ 0:28 uC2 ¼ 0:83 uD
2 ¼ 1:09
q1 ¼ 0:27 qI1 ¼ 0:14 qC1 ¼ 0:05 qD
1 ¼ 0:05
q2 ¼ 0:34 qI2 ¼ 0:14 qC2 ¼ 0:05 qD
2 ¼ 0:05
p1 ¼ 0:45 pI1 ¼ 0:44 pC1 ¼ 0:84 pD
1 ¼ 1:05
p2 ¼ 0:15 pI2 ¼ 0:20 pC2 ¼ 0:73 pD
2 ¼ 0:98
P1 ¼ 0:032 PI1 ¼ 0:039 PC1 ¼ 0:022 PD1 ¼ 0:018
P2 ¼ 0:024 PI2 ¼ 0:022 PC2 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
 GARCÍA AND TUGORES 465

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 low
by high quality production would not be efficient, but that the produc-
tion should be significantly diminished in any of the scenarios. In cases
C and D, prices are higher, since outputs have diminished and qualities
have risen. In these two cases, profits diminish for both firms. The intu-
ition is that the reduction of total external costs exceeds the reduction
in 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. The
effect on prices and profits is likewise less important. Table 3 shows
the computed values of the variables when residents not only bear
the externality, but also all tourism services are consumed by residents.
Logically, when a = 1 optimal quantities increase compared to the
a = 0 assumption, since now the consumer matters. Because prices
are lower, they end up buying more units, and quantities increase,
other things being equal. In aggregate, profits increase for both the
high and the low quality firms. Of course, other intermediate values
of a are possible. It can be shown that the equilibrium quantities,
the resulting consumer surplus, and the total surplus monotonically
vary with a. Again, the values of u1 and u2 are higher than in the market
outcomes when the externality per unit is independent or decreasing
with u. Qualities are lower when accounting for a positive effect of qual-
ity on the marginal external cost. Total quantities decrease in all of the
cases.
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 of
particular 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

u1 ¼ 0:81 uI1 ¼ 0:56 uC1 ¼ 0:94 uD

1 ¼ 1:16
u2 ¼ 0:39 uI2 ¼ 0:28 uC2 ¼ 0:83 uD
2 ¼ 1:09
q1 ¼ 0:27 qI1 ¼ 0:28 qC1 ¼ 0:11 qD
1 ¼ 0:10
q2 ¼ 0:34 qI2 ¼ 0:28 qC2 ¼ 0:11 qD
2 ¼ 0:10
p1 ¼ 0:45 pI1 ¼ 0:32 pC1 ¼ 0:74 pD
1 ¼ 0:94
p2 ¼ 0:15 pI2 ¼ 0:12 pC2 ¼ 0:64 pD
2 ¼ 0:87
P1 ¼ 0:032 PI1 ¼ 0:047 PC1 ¼ 0:033 PD1 ¼ 0:025
P2 ¼ 0:024 PI2 ¼ 0:023 PC2 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
466 OPTIMAL QUALITIES

b and c, have been proven and results are robust. Likewise, alternative
specifications of the external costs functions were used, with the main
conclusions of the analysis remaining unaltered.
These results suggest that overall efficiency of the tourism industry
would indeed improve if u1 and u2 were higher than those the market
provides with imperfect competition when the marginal external cost
decreases 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 to
improve the quality of the tourism services they supply do not seem to
be at all times supported by theory. Such policy advice would not be
supported in the scenario in which externalities are absent. It is shown
that optimal values of u practically did not change compared to the
market outcome.
Regarding the size of the sector, and considering all of the scenarios
in which externalities were present, total quantities provided under
market 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 externalities
are present, a contraction of both the upper and lower segments gen-
erally results in welfare improvement. Second, the market equilibrium
qualities are sub-optimally low if the per unit external cost decreases or
is independent of u. Instead, they are sub-optimally high when the
externality per unit is increasing in u.
The previous results suggest that few general claims can be made in
terms of policy recommendations with respect to the distribution of
qualities in the industry, at least when they are based on the environ-
mental aspects of tourism. Policies directed toward stimulating the
upper segment, compared to the market scenario, seem to be justified
exclusively when the per unit externality decreases or does not vary
with u. Even in these instances, the social planner solution allows for
the coexistence of both segments of the market: the high and the
low quality. When external costs are increasing with u, the government
policy should instead encourage lower qualities.
More interestingly, even when qualities should be made higher, the
activity in both segments of the market should be diminished. Thus,
the recommendation should not be a shift of resources from the lower
to the upper segment; rather, the optimal policy should discourage
activity in both segments. That is, if one considers the welfare of all eco-
nomic agents, and not only hotels, the optimal policy should seek the
reduction 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 are
sometimes defended on environmental grounds. This paper investi-
gates some of the conditions that should be present so that such policy
recommendations remain valid. To do so, a partial equilibrium analysis
 GARCÍA AND TUGORES 467

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 in
which two establishments compete has been considered. In the market
outcome, it turns out that two differentiated segments exist in equilib-
rium. The social planner problem was first solved by considering that
there are no externalities affecting the welfare of residents. The result
in this case is that the high quality chosen by the social planner is
slightly lower compared to the market scenario, while the low one is
slightly higher. Adding resident consumers to the welfare function log-
ically provokes an increase in the optimal output levels. While in the
market solution, the hotel in the lower segment provides more produc-
tion, in the social planner solution quantities to be provided by each
firm are equal. Of course, total welfare is sub-optimal in the market sce-
nario. According to these outcomes, policies interested in increasing
quality levels would not be justified. But increasing the relative size
of the upper segment would indeed constitute an advisable policy goal
when residents participate in the market as consumers.
The introduction of externalities into the welfare function changes
results. Optimal qualities should be higher than those resulting from
market 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 are
smaller 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 are
recommended for both segments, the activity in the market should be
diminished. Thus, according to these results, an appropriate policy
would not stimulate the shifting of resources towards the upper
segment, 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 exerts
outstanding 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 should
coexist. 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 keep
being used, the substitution should not take place on a one-to-one
basis. 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 in
order to achieve the social planner outcome. As shown, this type of
intervention should take into account the way in which quality pro-
vokes external costs. Empirical research providing more evidence on
the net impacts of tourism on residents and enlightening the relation-
ship between external costs and the characteristics of the specialization
in particular regions would also be a very useful extension. It would
468 OPTIMAL QUALITIES

help in determining which of the three presented scenarios is more

realistic.

Acknowledgments—The authors gratefully acknowledge helpful comments received on earlier

drafts from Aleix Calveras and from assistants at the X Encuentro de Economı́a Pública held
in 2003 and the XIX Jornadas de Economı́a Industrial convened in 2004. Dolores Garcı́a
acknowledges financial support from the Spanish Ministry of Science and Education and
from FEDER through grant SEJ2004-00143. Marı́a Tugores acknowledges financial support
from 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. Final
Version 23 June 2005. Accepted 28 October 2005. Refereed anonymously. Coordinating
Editor: David A. Dittman