Tourism Investments Under Uncertainty: an Economic Analysis of “Eco-monsters”

1. Tourism InvestmentsUnder Uncertainty: an Economic Analysisof “Eco-monsters” Guido Candela Massimiliano Castellani Maurizio Mussoni Department of Economics University of Bologna and The Rimini Centre for Economic Analysis (RCEA)

2. “Ecological monsters” (Eco-monsters):European Agreement on Landscape(Law n. 14, 9th January 2006)

3. Eco-monsters: definition (1) From the economic point of view, an “eco- monster” can be defined as: • an investment not carried out until the complete accumulation of capital (uncompleted investment) • an unproductive intermediate good, which is a mere encumbrance on the landscape perception of a certain resort

4. Eco-monsters: definition (2) It is therefore an outcome of a wrong decision, which implies: • A market failure (the firm interrupts and abandons an investment) ending in an uncompleted capital accumulation • A public failure (the policy maker can not avoid the rising of “eco-monsters”) ending in an environmental damage

5. Environmental-social equilibrium BP’ (K*) = CA’ (K*) K* > 0 “Paga chi inquina”: taxes on private benefices BP > 0 Used for recovering environment If I > 0 but K° is uncompleted BP(K°) = 0 e BP’ = 0 CA(K°) > 0 Then BP = 0 Who does it pay for recovering environment? Eco-monsters: economic effectsBP(K) private benefice; CA(K) environmental social cost tax on private benefice

6. Eco-monsters: some examples • A factory initiated but not completed • A building stopped at the carrying structure • A tourism harbor abandoned before receiving the moorings • An hotel on the beach without rooms • An amusement park without entertainments • A tourism park without accommodation facilities • A golf course without holes

7. Motivation The aim of this work is to find out the conditions for which an “eco-monster” can be built as a bizarre (paradoxical), but legal, consequence of the rational choices of two agents: • a firm starting the realization of a plan (beginning an investment) by asking to the local policy maker the building permit • a policy maker with the competent and discretional authority of granting the permit to build

8. Related literature • Investment and uncertainty • Travaglini G., 1999, Investimenti reali e incertezza. Le opzioni reali e il mercato finanziario • Dixit A.K., Pyndick R.S., 1994, Investment Under Uncertainty • Pindyck R.S., 1988, Irreversible Investment, Capacity Choice and the Value of the Firm • Real options and game theory • Trigeoris L., 1996, Real Options, Management Flexibility and Strategy in Resource Allocation • Grenadier S.R., 2000, Game Choices: the Intersection on Real Options and Game Theory • Loomes G., Sudgen R., 1982, Testing for Regret and Disappointment in a Choice Under Uncertainty

9. Assumptions We use the simplest possible model: • Two risk-neutral agents (firm, policy maker) • Complete and symmetric information • Limited economic horizons • Null interest rate • Money valuable environmental damages • Final goods and factors of production markets which are independent and in perfect competition • Discrete deterministic variables • Binary (dichotomous) random variables

10. Framework • A stochastic framework, for costs and prices • A specific/irreversible investment from the firm/environmental point of view • Environmental damages (externalities) • The possibility for the firm to take up real options on the possibilities to undertake or to abandon the investment • One shot game, for the policy maker • Sequential game, for the firm

11. Economic/environmental investment In this work the following terms are used: • “reversible/irreversible” with reference to the environmental investment properties, which can cancel/not cancel the environmental damage effects • “specific/unspecific” with reference to the private firm investment properties of economic recoverability/unrecoverability (sunk costs)

12. Investments(Economic/environmental Effects)

13. Environmental dammages • If the capital is completed, it can produce/non produce negative environmental externalities C  0 (only if C = 0 there are not externalities) • If the capital is not completed and the investment is specific and irreversible, there will be an “eco-monster” with an environmental monetary damage c 0 (only if c = 0 the investment is reversible)

14. “Eco-monsters” If the capital is completed, it can produce/non produce negative environmental externalities C  0 (only if C = 0 there are not externalities) If the capital is not completed and the investment is specific and irreversible, there will be an “eco-monster” with damage: c  0 (only if c = 0 the investment is reversible)

15. Financial options: reference • Call option is a financial contract between two parties, the buyer and the seller of this type of option. The buyer of the option has the right, but not the obligation to buy an agreed quantity of a particular good or financial instrument (the underlying instrument) from the seller of the option at a certain time (the expiration date) for a certain price (the strike price). The seller is obligated to sell the good or financial instrument should the buyer so decide. The buyer pays a fee for this right. • Put option is a financial contract between two parties, the buyer and the seller of the option. The put option allows the seller the right but not the obligation to sell a good or financial instrument to the buyer of the option at a certain time for a certain price. The buyer has the obligation to purchase the underlying asset at that strike price, if the seller exercises the option.

16. Real Options A Real Option is the right, but not the obligation, of a firm to undertake some capital investment decision (to begin or to abandon it): • Call option, right to undertake an investment subject to a permit to be asked to the policy maker, for which it is necessary to pay ex-ante an exogenous lump sum tax • Put option, right to interrupt an investment during its lifetime and to sell the cash flows over the remainder of the investment for some salvage value • Our assumptions: it lasts 3 periods, it is renewable and not tradable (in contrast to financial option)

17. One shot game : the variables (1) • S > 0 –> costs on T = 1 (exogenous lump sum tax, or guarantee deposit, to be paid ex-ante if the building permit is granted) • D > 0 –> costs on T = 2 (firm loss for the possible investment interruption) • D’ –> investment salvage value on T = 2 • if the investment is unspecific then D’ > 0 • if the investment is specific then D’ = 0 • K > 0 –> costs on T = 3 (cost of the completed capital)

18. Timing (2) • The firm can ask a permit only every 3 periods interval (T = 0,3,6,…) • The investment is completed in 2 periods (on T = 3) • News (uncertainty) on price existing only on completed capital price (on T = 2)

19. The firm expected profit Where: • T is the information set at time T (about IT and  ) • 0 < τ < 1 is the rate of a building tax (exogenous proportional tax) which is levied una tantumex-post (on T = 3), but decided ex-ante (on T = 0), by the policy maker on the completed capital value  (building price)

20. The Governmentobjective function where αandβare weights measuring the social preferences (policy maker’s ideology) for the “budget variables” (taxes Sandτ) and for the “environmental variables” (externalities candC) This function can also be interpreted as the approximation of a separable and addictive social welfare function and can be interpreted in terms of a social net monetary benefit.

21. The Governmentobjective function (segue) In order to simplify the computation we divide each term by β and we obtain: whereγ = α / βmeasures the “partisan party effect” on the game equilibrium: • if α > β, then γ > 1 and the policy maker attaches more importance to the “budget variables” • if α < β, then γ < 1 and the policy maker attaches more importance to the “environmental variables”

22. The game (3)

23. General solution: The game equilibrium is obtained through (1) • Firm’s strategy Ye = – S(1 – p) + (D – D’)p(1– q) +[ H(1 –) – K]pq≥ 0 • such that firm reaches a minimum level (firm’s implicit price condition):  Hfirm S(1– p)– (D’ – D)p(1– q) + Kpq}:(1 – )pq}

24. General solution: The game equilibrium is obtained through (2) • Policy maker’s strategy we =S(1 - p)+(S - c)p(1 - q) + [ ( H+ S – C]pq≥ 0 • such that pm reaches a minimum level (policy maker’s implicit price condition)  Hpm – S + cp(1 – q) + Cpq}:  pq}

25. General solution: The game equilibrium is obtained through (3) • Final game equilibrium * ≥  Hfirm * ≥  Hpm  * ≥ max [ Hfirm ;  Hpm]

26. General solution: The game equilibrium is obtained through (4) • The rational conditions of a legal “eco-monsters” are also subject to an existence condition: S and τ must be upper and lower bounded in the following ways 0 < Smin(in order that we 0) < S < Smax(in order that Ye 0) 0 < min(in order that we 0) <  < max(in order that Ye 0)

27. Results (1) The equilibrium condition implies the conditions for the rising of a rational and legal “eco-monster”: • sufficient conditions –> the capital is not completed and the investment is irreversible (c > 0) and specific (D' = 0) • necessary conditions –> the completed capital price  is lower bounded such that * ≥ max[Hfirm;Hpm] • existence conditions –> the proportional building tax τ*(S) and the lump-sum tax S*(τ) must be upper and lower bounded such that Ye ≥ 0 and we ≥ 0

28. Results (2) It will not be built any “eco-monster” in the following cases: • a deterministic framework (independently from the completed capital externalities C  0) • a stochastic framework limited to the first period, i.e. if there will not be any uncertainty in the second period, such that the firm has not any incentive to exercise the put option (abandon the investment) • the investment is unspecific or reversible (independently from the completed capital externalities C  0)

29. Comparative static(tax change) Mutatis mutandis if firm < pm

30. Policy implications ofa taxes increase

31. Policy implications ofa taxes decrease

32. Partisan party effect

33. Conclusions (1) Policy implications: • in case of effective economic policy, the model allows to choose the building taxes (S and τ) like instrumental variables, in order to monitor the “eco-monsters” frequency • in case of ineffective economic policy, an efficient solution for the policy maker could be the introduction of Pigou taxes, i.e. taxes lying on the environmental externalities (c or C)

34. Conclusions (2) • the taxes allow a differentiated policy in order to incentive only some tourism investments: in some cases (i.e. when (firm > pm) the policy maker can fix a low value of the building taxes S andτ for unspecific and reversible investments, while it can fix a high value of S and τ for specific and irreversible investments • the model allows to evaluate the effects of the policy maker’s ideologyγ on the “eco-monsters” frequency: since γ does not affect the firm’s implicit price firm, when firm < pm then an increase in the importance attached by the policy maker to the “budget variables” causes an increase of the “eco-monsters” frequency