Tour Operators. What do Tour Operators do? Internet and the economics role of Tour Operators

Tour Operators.

What do Tour Operators do? Internet and the

economics role of Tour Operators. 

1. Introduction

A tour operator typically combines tour and travel components to create a holiday. The most common example of a tour operator's product would be a flight on a charter airline plus a transfer from the airport to a hotel and the services of a local representative, all for one price. Niche tour operators may specialise in destinations, e.g. Italy, activities and experiences, e.g. skiing, or a combination thereof. The original raison d'etre of tour operating was the difficulty of making arrangements in far-flung places, with problems of language, currency and communication. The advent of the internet has led to a rapid increase in self-packaging of holidays. However, tour operators still have their competence in arranging tours for those who do not have time to do DIY holidays, and specialize in large group events and meetings such as conferences or seminars. Also, tour operators still exercise contracting power with suppliers (airlines, hotels, other land arrangements, cruises, etc.) and influence over other entities (tourism boards and other government authorities) in order to create packages and special departures for destinations otherwise difficult and expensive to visit.

The three major tour operator associations in the U.S. are the National Tour Association (NTA), the United States Tour Operators Association (USTOA), and the American Tour Association (ATA). In Europe, it is the European Tour Operators Association (ETOA), and in the UK, it is the Association of British Travel Agents (ABTA) and the Association of Independent Tour Operators (AITO). The primary association for receptive North American inbound tour operators is the Receptive Services Association of America (RSAA).

What is the future of tour operators after the advent of internet? Does the tourist vertical chain move towards des-intermediation, whereby consumers will access directly final suppliers, getting cheaper prices in a very comfortable way? Or, rather, usage of internet will simply change some of the practices in the industry while maintaining others, among which there is intermediation? The aim of this paper is precisely to provide a tentative answer to these questions on the future of the tour operator industry, by means of laying out its economic foundations.

To do so, our aim is to understand which has been the traditional role of tour operators in the intermediation of the tourist vertical chain and, then, we should be capable of foreseeing which of its functions, if any, will remain with internet (and other ICTS), and which others will disappear due to a new organization of the value chain of the tourist product.

 We review in section 2 why transaction costs in the tourist vertical chain have (apparently) often been lower with a TO, at least previous to the advent of internet. Summarising our exposition, TOs enhance and facilitate tight coordination thus reducing the costs of broken coordination in a market exchange. Also, TOs facilitate the search for information to tourists, regarding the characteristics of the several services that compose the package tour (flight, accommodation, etc). TOs do so by avoiding duplication of search effort by tourists and also by filtering information. Intermediation by a TO arises also because the tourist product is an ‘experience good’ rather than a ‘search good’. An ‘experience good’ (as opposed to a ‘search good’) is that whose quality can only be known by consumers after or during consumption.

Our focus throughout the paper are tour operators, even though intermediation in the tourist sector is also undertaken by travel agencies. In our analysis, we subsume travel agencies within tour operators role, considering them as a single intermediary. As it will become clearer below, it doesn’t affect the main message of our paper since travel agencies are much more likely than tour operators to be des-intermediated by internet experience good, and thus a tourist is uncertain, until vacation takes place, about the quality of the hotel where it stays; about the punctuality of flight, etc. Hence, one of the roles of a TO lies in providing credible information to the potential tourist on the quality of the tourist product. The TO can do so by means of building a reputation and a brand name for providing good quality packages.

Once we have identified the (traditional, pre-internet) rationale for the existence of tour operators according to the transaction cost theory of the firm, we should be able to analyse the impact of the advent of internet in the industry. Even though it has been long since the tourist vertical chain has incorporated several ICTs systems (such as computer reservation systems, CRS, and global distribution systems, GDS) to organise relationship among several agents (travel agents, airplane companies), internet has implied a major change because it allows a direct access of the final consumers to final suppliers. As a consequence, many practitioners and academics have forecasted the future des-intermediation of many vertical chains whereby final consumers will be able to bypass previous retailers, thus getting bargains because of lower prices that occur due to intensified competition. As a matter of fact, there is some evidence that some desintermediation has already taken place, and it is likely that some des-intermediation will continue to take place in the future. Such des-intermediation can be explained within the transaction cost theory of the firm because of the fact that internet greatly reduces both the search costs of potential tourists, and the costs of coordination between the tourist and final sellers, thus reducing the need for intermediation by a TO.

However, we believe that TOs still have a major role to play in the tourist vertical chain, specifically in the resolution of the quality uncertainty between buyers and final sellers. In spite of its tremendous possibilities in the exchange of information, quality uncertainty in internet does not disappear, and thus the need for an intermediary such as a TO remains. Thus, to our view, in the era of internet, the main rationale for a TO intermediation will be the provision of credible information on the true quality of the tourist product. Intuitively, however, the need for intermediation to solve the problem of asymmetric information between buyers and final sellers should be lower for large final sellers such as large hotel chains or established airplane companies (they themselves are capable of building a reputation for providing high quality services, and thus need not rely on the reputation of a TO); for final sellers that have a large proportion of repeat customers (repeat customers suffer to a lesser extent the problems of asymmetric information); and for low quality sellers (that have no need of an intermediary to signal their low quality). 

1.1.

Figure 1. The tour operator as an intermediary the essence of TOs, and thus will allow us to study the impact of ICTs, and specifically internet, on the vertical organisation of the tourist industry. For the moment we abstract from internet and analyse intermediation in the tourist chain, focusing on the pre-internet traditional vertical organisation with TOs. Then, in section 3 we do discuss the impact that internet and other ICTs have already had and will likely have on the sector. We address the role and the existence of TOs by means of the transaction cost (TC) theory that addresses and studies the boundaries of firms (Coase, 1937; Williamson, 1975). The basic point of TC theory of the firm is to ask why there are firms rather than simply markets. That is, why some transactions (such as, for instance, some input supply) are organised within firms, while others take place through the market exchange.4 The theory’s

answer lies in the acknowledgement that both firm and market transactions involve some transaction costs. These transaction costs are the costs of coordinating the activities required for the transaction to take place, the costs of motivating people and organizations involved, the cost of contracting and renegotiating, the costs of delivery of the good in exchange, etc.

Furthermore, as the difficulty of the transaction increases (for instance, as we will see

below, because of increasing asymmetric information between the parties), transaction costs increase and, thus, social surplus of the transaction decreases.

Then, TC theory predicts that any given transaction will be organized within a firm whenever it is efficient, that is, whenever the costs of internalising the transaction are lower than the costs of organising the transaction through the market (and vice versa); or, in other words, whenever the social surplus of internalising the transaction is larger than that of using the market. Furthermore, TC theory then proposes that for difficult transactions, transacting costs are lower when they occur within firm’s boundaries rather than through the market; that is, the social surplus of transacting within firm’s boundaries rather than through the market is higher when the difficulty of the transaction increases. In the figure 2 we illustrate this idea. As a matter of fact, there is a wide array of intermediate governance modes in between the market and the

firm, such as joint-ventures, long-term contracts, etc. Its analysis within the tourism industry lies outside the scope of this paper. 

Figure 2: The firm versus the market

Applying the TC framework to the analysis of the vertical organisation of the tourism

industry, we need to compare the transaction costs that arise when a tourist deals directly through the market with final suppliers (hotel, airplane companies, entertainments, transport from and to the airport, etc.), versus all transaction costs that arise when a tour operator intermediates and thereby packages all goods and services that compose the package tour and sells it to tourists (the final consumers). TC theory asserts that shopping will take place through a tour operator whenever it is more efficient (it has lower transaction costs) than having the consumer herself directly purchasing the tourist product to the multiple final suppliers.

When analysing the tourist vertical chain, we observe that the costs of organising

transactions through arm’s length (direct exchange between tourists and final suppliers) consist of:

• search costs,

• coordination costs,

• costs of quality uncertainty.

In the rest of the paper, we analyse transactions between a consumer (a tourist) and either a TO (when there is intermediation) or final suppliers (absent TO intermediation), and discuss in which ways and to what extent transaction costs are important. We are then able to discuss and support a rationale for intermediation in the tourist sector (intermediation by TOs reduces searching, coordination and informational costs), and discuss to what extent such a rationale is affected by the advent of internet and other ICTs. Before that, we must discuss an important assumption in TC theory, which is that of incomplete contracts.

In any exchange of a good or a service among two or more parties, a contract is agreed upon, whether explicit or implicit. A contract specifies the conditions of exchange, including price, quality of the good, time of delivery, etc. The objective of the contract (which may be tailor made to the transaction, standard; detailed or vague, etc.) is to protect each party from a possible opportunistic behaviour from the other party and, thus, to induce as much as possible social surplus from the exchange.

A complete contract would effectively avoid opportunistic behaviour from each party and, as a consequence, would allow social surplus to be maximum. A complete contract would specify all possible future scenarios in a precise manner, and then would describe without any ambiguity each parties obligation in each scenario; furthermore, and of the outmost importance, a complete contract would be enforceable. It should be clear, however, that these requirements for complete contracting are very demanding; as a matter of fact, contracts in real world are incomplete . It is difficult (too costly in general) to foresee and specify all future relevant contingencies; contracts leave many things unconsidered, and are open to ambiguity in interpretation; thus, contracts are not the perfect tools capable of precisely managing the development of a transaction. And this is precisely why the organisation of the tourist vertical chain is important. That organisation that minimises opportunistic behaviour and transaction costs of whatever kind, will be the organisation that we should expect to obtain.

In this paper we leave aside some issues that, even though important in TC theory, to our view are notcrucial in the analysis of the role that TOs play in the tourism industry (such as, e.g., asset specificity and the possibility of hold up). 
 

2.1 The tour operator as a coordinator

The tourist product consists of a series of services and goods whose consumption requires tight coordination among them. As stated by Inbound Holiday packages for the Gold Coast: “services include the coordination of all ground arrangements including hotels, motels, executive apartments, farm stay, airport transfers with meet & greet services, coach charter, stretch limousines, restaurants, golf, tours, car rental, cruises, interpreters, tour guides, educational tours for overseas students and conventions.”. All these (and possibly other) services and goods conform the tourist product, and for the tourist product to provide high utility (satisfaction) to the consumer, there must be tight coordination of all these services and goods along a series of dimensions, specially synchronically. Any misscoordination along these lines implies a serious break-up and a serious loss of utility for the tourist. Furthermore, in case of a break-up in the coordination, it should be quickly fixed in order to control for the damage and to be able to enjoy a reasonable vacation. Which is the efficient way to coordinate all (or some of) these components of the tourist

product? One possibility is for the tourist herself to contract with all final suppliers (hotels, etc) and ensure coordination by means of contracting the required characteristics and conditions of each of the goods and services. However, since contracts are incomplete such mechanism of coordination will be imperfect and open to error. As a matter of fact, the coordination of the several components (goods and services) of the tourist product are what Milgrom and Roberts) call ‘design attributes’: “coordination problems in which there is a priori information about how the parts of the decision must fit together and in which small failures of fit are very costly are said to have design attributes.”

Then, according to Milgrom and Roberts, a “centralized setting of design variables tends to reduce both the cost of errors and the amount of communication and search necessary to identify an optimal decision”.

In our framework, this implies that centralised coordination by the tour operator ensures a more efficient outcome, including a better solution of possible errors and misscoordination that might occur during the vacation. Thus, intermediation by a TO probably solves in a more efficient way the coordination requirements of the tourist product, rather than relying on the final consumer shopping around trying to coordinate by herself all the parts of the tourist product by means of a bunch of contract agreements. 

2.2 The tour operator and tourists’ search for information 

So as to obtain information about the prices, qualities and characteristics of the tourist

products, consumers (tourists) must undertake an expensive search process. The cost of search comprises the money, time and effort that potential buyers incur in obtaining the price, the characteristics and quality information for accommodation, flight schedules, etc.

Examples of such costly information gathering are visits to travel agencies, which involve transportation and time costs, telephone calls, buying newspapers, etc

As we see in figure 3 below, individual search by each consumer will generate much duplication of search effort and search cost. Each potential tourist must visit or call each final supplier (hotel, bus company) and incur in the cost (e.g. in time) of searching and gathering information. Such duplication of effort . In here we focus on the organisation of the searching process, and not on the consequences of such searching costs might be minimised using intermediaries such as tour operators and travel agencies who collect, process and store all relevant information. The efficiency enhancing of intermediation by TOs and travel agencies in the search for information results simply from providing a centralized outlet for all sellers. Furthermore, this centralisation does not require that the same content be stored in both sellers’ and the intermediaries storage information, which would be a wasteful duplication. That is, TOs need not provide all same information that hotels and flight companies make available. Instead, the tourist product information available at the intermediary will have only the necessary information for potential buyers to make their purchase decisions. This way, tour

operators and travel agencies also filter information, which further increases the efficiency of the search process.

However, no matter how much information consumers receive from sellers prior to

purchase, they still have to trust what the sellers say about their products. Often sellers

(hotels, airplane companies) may not provide enough information for consumers to fully evaluate their products or services, or the information may be inadequate to judge whether sellers are reputable companies or fly-by-night operators. In light of this, a TO’s role in a search market extends beyond being an information depositary and distribution centre. This is the issue that we analyse in the following subsection. 

2.3 The tour operator and quality uncertainty 

Economic theory distinguishes between ‘experience goods’ and ‘search goods’. Search goods are those goods whose quality may be learned prior to consumption and, thus, prior to purchase. For experience goods instead, their quality is learned only from experience, during or after actual consumption of the good. It is immediate to notice that the tourist product, like most (if not all) services, is an experience good. The quality of the service in a hotel can only be ascertained during stay; quality of a flight (punctuality in the time of departure, etc.) is only known during the flight itself; the quality of meals is Buyers Sellers. 

Figure 3: Intermediation or des-intermediation in the search for information

Another example of experience good; and the same for all other goods and services that compose the tourist product. Thus, a crucial issue is the uncertainty that the tourist faces about the true quality of the tourist product prior to consumption, that is, prior to the vacation itself. In a rather more technical language, there exists asymmetry of information between the seller (hotel, airplane company) and the buyer of the tourist service, since the seller has better information than the buyer (the tourist) concerning the precise characteristics and quality of whatever tourist good or service in exchange.

Box 1. The ‘market for lemons’(Akerlof, 1970), applied to the tourist sector.

Suppose Alice, from Germany, is willing to go on vacation to the Balearic Islands. There are a priori two different types of hotel accommodation available. Type H with a high quality service, which she values in (for which she is willing to pay) 1000 €, and a type L with a low quality service which she values in (for which she is willing to pay) 500 €. There are a priori in the market a 50% of hotels offering the high quality service, and a 50% offering the low quality one. The cost of offering the high quality service is 800 €, whereas the cost of the low quality service is 400 €.

Alice does not know which hotel offers high quality or low quality service, this is private information of each hotel. There is thus a problem of asymmetric information: when booking some accommodation, she does not know whether the hotel offers high quality or low quality service. What she knows though is that there is a 50% chance that it is a type H hotel, and a 50% chance that it is a type L hotel.

As a consequence, her expected valuation of the stay is ½·1000 € + ½·500 € = 750 €. This means that at most she is willing to pay a price of up to 750 € for the accommodation. Otherwise, she would be paying more than what she values it in expected terms. The problem is that at a price lower than 750 € no type H hotel is willing to supply accommodation, since the cost of accommodation with high quality service is 800 €.

As a consequence, knowing this, Alice infers that the only hotels offering accommodation are type L with low quality service, which implies that she is only willing to pay a price up to 500 €.

Thus, it is immediate to see that the only Nash equilibrium is a price higher than 400 € and lower then 500 €, at which only type L hotels offer their service (type H hotels would abandon the market), and at which Alice goes on vacation. This is exactly what it means that ‘bad products drive-out good products’, and is the case of the ‘market for lemons’ that Akerlof first presented in his paper in the Quarterly Journal of Economics. It is well known in the economics literature that a consequence of such informational asymmetries may be a market failure: a transaction that would be a priori beneficial, value enhancing for all parts, might not take place. 7 This is what might happen in a situation of adverse selection (defined as that in which the seller has superior information than the buyer