Modeling Cities with Congestion and Agglomeration Externalities: the Efficiency of Congestion Tolls, Labor Subsidies, and Urban Growth Boundaries

Under review for publication in the Journal of Urban Economics, September 2014 ABSTRACT: This paper develops a spatial general equilibrium model that accommodates both congestion and agglomeration externalities, while firms’ and households’ land-use decisions are endogenous across continuous space. Focusing on the interaction between externalities and land use patterns, we examine the efficiencies of first-best and second-best policy instruments using simulations. Pigouvian congestion tolling (PCT) alone can largely mitigate congestion but may erode agglomeration economies, while Pigouvian labor subsidies (PLS) alone correct labor market distortions, but raise congestion diseconomies. A first-best policy must combine both PCT and PLS instruments, or design an optimal toll (or subsidy) agglomeration externalities (or congestion externalities). The first-best and efficient second-best tolls or subsidies should lie below their Pigouvian levels. Urban growth boundaries (UGBs) can reduce congestion externalities and enhance agglomeration economies as first-best instruments do, while introducing land market distortions via rent-escalation and firm-centralization effects, even inducing a net welfare loss. These findings suggest that it is important to internalize firms’ land use decisions, and avoid monocentricity assumptions, in order to appreciate the interplay of both urban externalities, since spatial adaptations to policy interventions can distort system efficiencies.