Optimal Policies in Cities with Congestion and Agglomeration Externalities: Congestion Tolls, Labor Subsidies, and Place-Based Strategies

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 policies and second-best pricing and placebased strategies using simulations. A first-best policy must combine both Pigouvian congestion tolling (PCT) and Pigouvian labor subsidies (PLS) instruments, or design an optimal toll (or subsidy) internalizing agglomeration externalities (or congestion externalities). We also examine second-best pricing policies if only one instrument is adopted. Congestion pricing alone policies (e.g., a partial PCT or a flat-rate toll) can improve social welfare only in heavy-congestion cities while their welfare gains could be trivial (e.g., below 10% of the welfare improvement achieved by first-best policies). In contrast, second-best labor subsidy alone policies are a more effective alternative to first-best policies. As to place-based policies, the firm cluster zoning (FCZ) regulation is more efficient than the urban growth boundary (UGB) policy. UGBs only have small effects on the agglomeration economy but could worsen land market distortion via the residential rent-escalation effects. These findings suggest that it is important to internalize firms’ land use decisions and relax monocentricity assumptions, in order to appreciate the interplay of both urban externalities, since spatial adaptations to policy interventions can distort system efficiencies.