Increasing Returns and Transport costs - The fundamental Trade-off of a spatial economy

Seminar Paper 2004 21 Pages

Economics - Micro-economics



1. Introduction

2. Benefits and costs of transport
2.1 External benefits to transport
2.2 Cost in transport systems and marginal external cost pricing

3. The implementation of marginal external cost pricing in road transportation

4. Extension of the Krugman-model

5. Monopolistic competition, increasing returns, agglomeration,and transport costs
5.1 Spatial characteristics
5.2 Organisation of production and transport costs

6. Trade-off between scale economies and commuting costs in the context of city formation
6.1 The "City as a firm" –Approach
6.2 Specialization and Trade

7. Trade-off between increasing returns and transport costs in the context of spatial competition
7.1 Spatial organization and market equilibrium
7.2 Land capitalization

8. Conclusion

9. Literature

1. Introduction

In this study I want to provide an overview of different research areas according to the topic “Increasing Returns and Transport Costs: The Fundamental Trade-Off of a Spatial Economy”. Transport costs are a monetary measure of what the transport provider must pay to produce transportation services. They depend on a variety of conditions related to geography, infrastructure, administrative barriers, economies of scale, competition and regulation. First, I will figure out the benefits and cost of transport to show barriers, which confront the policy strategy in the following model of marginal external cost pricing. Further models investigate the impact of transport costs on production organization, city formation and spatial competition under different model-configurations and –perspectives.

2. Benefits and costs of transport

LAKSHMANAN, NIJKAMP, RIETVELD, VERHOEF1 provide a broad overview of the issues surrounding policy implications and the benefits and costs of transport. Transport demand is usually a derived demand, serving to satisfy spatial mismatches between demand and supply on various markets, like goods market for freight transport, housing and labour markets etc. Therefore, the benefits of infrastructure supply cannot be seen in isolation of its interaction with the entire economic system, nor in isolation of its spatial structure and nor in disregard of the dynamic behaviour of these two. Secondly, the authors underline, that the benefits and costs arise through the supply and existence of infrastructure and through its usage. The problem is the share of the costs of infrastructure, which are concentrated in time as the benefits are to be reaped over a much longer future period. Thirdly, transport activities themselves often give rise to a variety of costs, which can be

1) Internal (fuel, time)
2) external (intersectoral: pollution, noise, accidents) (intrasectoral : accidents, congestion)
3) Variable (fuel)
4) Fixed (purchase of cars, vehicle taxes)
5) Instantaneous (congestion)
6) Cumulative (CO2)
7) Local impact (noise)
8) Global impact (CO2)

and so forth. Therefore, the assessment of the costs and benefits of transport is difficult and complicates the design of transport policies.

To point out the benefits of transport, it is important to recognize the derived character of the demand. Often it is not the consumption of transport services itself that yields benefits, but rather the possibility to demand or supply certain goods or services at different locations. For a given infrastructure, the benefits of its usage often arise in other markets, and cannot be seen in isolation of the factors that determine the demand of transport. With the aid of a simple “Spatial price equilibrium model” (first presented by SAMUELSON2 ), LAKSHMANAN, NIJKAMP, RIETVELD, VERHOEF proof, that benefits of transport can often be thought of as the benefits of the increased local specialization it enables. Therefore, an estimation of the benefits of transport and infrastructure investment requires an estimation of its impact on other markets considered. Secondly, transport infrastructure improvements are likely to cause some agents to be better off (consumers in A and producers in B), but also some to be worse off (producers in A and consumers in B) and thus vary over space. LAKSHMANAN, NIJKAMP, RIETVELD, VERHOEF list up some aspects of spatial dynamic consequences of infrastructure supply:

1) Construction phase effects (e.g. tax increase/ increase in interest rates due to public infrastructure finance; spatial effects in construction materials industry and suppliers from other regions)
2) Trade (compare with Krugman model p.6)
3) Changes in distribution system (Organization of production, transport and distribution: e.g. Mc KINNON3: market expansion, spatial concentration (as a result of a trade-off between size dependent production costs and transport costs of inputs and outputs) and tighter scheduling (just-in-time- and quick-response principles) or KLAESSON p.8)
4) Productivity (Combining labour, private capital and infrastructure with substitive or complementary character) (described by HENDERSON and BECKER p.14)
5) Housing and labour markets (improved infrastructure leads to better functioning of labour markets/in the long run also towards a shift in settlement patters) (compare FUJITA p.12)
6) Monopolistic price settings (improved infrastructure leads to an increase in the number of suppliers (or demanders) in the market) (as partly described by FUJITA p.15)

2.1 External benefits to transport

Changes in transport may bring about a large number of changes in the economy, many of them having welfare improving effects. To what extent can these effects be taken into account in an appropriate way in a standard cost benefit analysis. LAKSHMANAN, NIJKAMP, RIETVELD, VERHOEF consider two important aspects. First, one should not focus on the average contribution of transport to welfare, but on the marginal. So what is the marginal change in social welfare given a marginal change in the number of kilometres driven? Secondly, it should be checked, whether in the procedure of estimating benefits of infrastructure improvements via consumer surpluses as shown above these is a neglect of certain benefits, which take place outside the transport sector (trips with a social purpose, emergency services, national security, image effects and so forth)

2.2 Cost in transport systems and marginal external cost pricing

A destinction can be made between costs of infrastructure supply and costs of its usage. Infrastructure supply costs are usually subdivided into costs made during the construction phase, and costs, which are subsequently incurred over the lifetime of the project. An important question concerning the cost of infrastructure supply is by whom these costs should be borne. Considering infrastructure as a public good, there is no direct link between those who pay for the infrastructure and those who use it. The question then becomes whether the pupose of pricing infrastructure should be cost recovery or regulation of externalities. Nevertheless, the external cost of road transport can be subdivided into intra-sectoral externalities, where road users pose upon one another (e.g. congestion) and inter-sectoral externalities, where road users pose upon society at large (e.g. noise annoyance). From the viewpoint of economic efficiency both are relevant for the regulation of road transport. From the viewpoint of equity especially inter-sectoral externalities are important, as these make up the "unpaid bill" that road usage poses upon society. Considering the right tax policy, the question is, whether "the polluter" should pay the total external cost through average external cost pricing or whether efficient tax rules based on marginal external cost should be used. Both pricing strategies lead to different outcomes in terms of allocative efficiency and equity.

3. The implementation of marginal external cost pricing in road transportation

The article deals with the long and short run efficiency of marginal external cost pricing as a policy strategy in transport in reality.4 The concept of Pigouvian taxation has remained the leading principle in transport economic theory on road traffic externalities regulation.

When there is high demand resulting in congestion, charges should be high to deter excessive road use during peak hours. When transport noise affects residential areas more strongly, higher charges should give a stronger incentive to reduce mobility levels, to drive at different times, on different routes, or to use more quiet cars, and so forth. Even if one ignores more general implementation problems, such as the limited social and political acceptability and the technical feasibility of marginal external cost pricing, it can be expected that in reality, most of the implicit assumptions underlying the standard economic analysis, leading to the basic Pigouvian tax rule, will not be met. Although a marginal external cost pricing is a first best solution as it simultaneously provides optimal incentives in the short and in the long run aspects, second best situations are likely to be the rule rather than the exception in setting regulatory transport taxes. VERHOEF discusses some of the short and long-run issues that will become important when designing transport pricing policies in practice. He differs “long-run-factors” that determine the relevant curve position in his model:

1) Factors affecting the shape and position of the demand curve for transport (locational choices of firms and households)
2) Factors affecting the shape and position of the marginal inter-sectoral external cost curve (e.g. emissions of pollutants)
3) Factors determining the shape and position of the marginal intra-sectoral external cost curve (capacity and quality of the infrastructure)
4) Factors determining the shape and position of the marginal private cost curve (fuel efficiency, vehicle technology)

VERHOEF considers three models to demonstrate the long-run optimality of marginal external cost pricing: One dealing with factors behind the demand curve, one with factors behind the marginal environmental cost curve, and finally, one involving optimal investments in road infrastructure under conditions of congestion.

Given the short run and long run optimality of marginal external cost pricing, VERHOEF questions, why such evidently attractive instruments have not, or only sparsely, been used in the practice of policy making. Limited social feasibility of pricing instruments, as well as a variety of technological, political, social, psychological and institutional barriers is hard to implement in reality for such policies. VERHOEF also lists up the most important implicit assumptions underlying and simplifying his model:

1) There is complete certainty and perfect information on all benefits and costs of road usage
2) Road users are completely homogenous, and only (possibly) differ in terms of their marginal willingness to pay to use the road
3) The demand curve is stable over time, so that a static approach is valid
4) The road system is a one-link network
5) The (spatial-) economic system within which this transport network operates is otherwise in a first best optimum, without any uncorrected market failures like external effects, market power, distortionary taxes, and so forth.

Transport externalities cause a large variety of effects, so that individual charges should vary at least according to the following dimensions:

The vehicle technology used, the actual state of this vehicle, the kilometres driven, the time of driving, the place of driving, the actual route chosen, the driving style.

Only then can the feature of road charging provide optimal incentives to change behaviour in both the short run and the long run that possibly carry over to real life situations. Furthermore, the informational needs increase for the regulator, and wrong interpretations of this information can lead to government failures and unavoidable welfare losses. Things become quite different, however, when second best policies are used, and the regulator feels that some of the implied imperfect or perhaps lacking long run incentives should be compensated for using policies directly aiming at the relevant long run issues. VERHOEF concludes, that economic efficiency requires instruments to be applied according to different rules than that applies for the first best bench-mark policy, when applying second-best regulatory tools. VERHOEF presents four models, reflecting for major types of second-best distortions that may occur in reality. The first model deals with the distortions on other routes within the same mode, the second one with distortions in other transport modes, the third one with distortions elsewhere in the economy, and the forth one with distortions due to government budget constraints. Second best tax rules can become rather complicated as models become more realistic. Nevertheless, second-best alternatives will normally only cover parts of the first-best incentives, and will therefore often have to be combined in packages, such that the complete range of incentives is eventually covered. This normally involves instruments covering short-run behaviour, long-run demand factors, and long-run supply-side related factors.


1 LAKSHMANAN, T.R., NIJKAMP, P., RIETVELD, P., VERHOEF, E.T. (2001): "Benefits and costs of transport. Classification, methodologies and policies." Papers in Regional Science 80, 139-164 (2001)

2 SAMUELSON, (1952): “Spatial Price equilibrium and linear programming”. American Economic Review 42: 283-303

3 Mc KINNON, A. (1996): “The contribution of road construction to economic development. In: Roads and economy. European Federation for Transport and Environment, Brussels

4 VERHOEF, E.T. (2000): "The implementation of marginal external cost pricing in road transport. Long run vs. short run and first-best vs. second-best." Papers in Regional Science 79, 307-332 (2000)


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University of Paderborn
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Increasing Returns Transport Trade-off Research Independent Studies




Title: Increasing Returns and Transport costs - The fundamental Trade-off of a spatial economy