Externalities and Urban Congestion: Analyzing the Economic Costs and Policy Responses in Major Global Cities

In basic free market economics, the quantity supplied and quantity demanded of a good or service are found at the price where the supply curve and demand curve “meet”.  The real world, however, is more complex.  Supply and demand curves are impacted by externalities, or costs or benefits received by third parties.  Negative externalities are harmful costs of economic production and/or transactions that affect third parties not part of the transaction.  One of the most common examples of negative externalities, as explained by the International Monetary Fund (IMF), involve pollution.  Positive externalities, by contrast, help third parties, with vaccines and other health care being common examples.

Traffic Congestion as Negative Externality

Related to pollution is traffic, with society bearing costs from automobile transportation that are not fully captured by motorists when they pay for fuel, tolls, vehicle registration, et cetera.  Gasoline taxes and vehicle inspection and registration taxes in some places help raise revenue to offset pollution and road degradation costs, but not close to the full amount.  In addition to raising revenue that governments can use toward pollution-fighting practices like building greenbelts in urban areas, taxes on driving reduce (to some extent) the amount of driving, and thus pollution, that occurs.  Whenever a tax is applied to something, the supply curve shifts to the left, reducing the quantity supplied at any given prices.  

Traffic congestion adds to the harmful effects of vehicle pollution by placing additional stress on public infrastructure and reducing the amount of time for workers’ outputs.  When more vehicles travel on a section of roadway, that roadway wears out faster, creating depreciation costs.  More frequently, the roadway will have to be repaired, usually at taxpayer expense.  The traffic congestion creates a negative externality because all taxpayers will pay for increased road repair through various taxes - even if they never use that road!  If a road bond is paid for through sales taxes, this may affect all consumers, even those not old enough to be drivers.

Worker productivity can be reduced by traffic congestion due to tardiness and/or stress.  Congestion can lengthen commute times, leading to more workers showing up late.  For salaried workers who do not clock in upon arrival, this can lead to hours of productive work time missed each month.  If workers begin sneaking out of the office early to manage the congestion-lengthened commute time home, the loss of productivity is doubled.  Workers who feel stressed from traffic congestion may also be less productive, for at least part of the day, while working.  Fears about congested roadways may cause workers to be more distracted than otherwise, especially if they have friends and family who are also afflicted.

Over time, these costs will be imposed on society and become substantial.  Pollution and stress from traffic congestion can cause both physical and mental health conditions, ranging from asthma to depression.  These health conditions cause negative externalities because their costs are not solely borne by the sufferer.  Workers who suffer from health conditions due to pollution and stress from traffic congestion impose costs on taxpayers if their health care is provided with public funds.  These explicit costs are in addition to those from infrastructure repair.  In terms of the private sector, a negative externality caused by traffic congestion is higher insurance costs faced by all local drivers.  Traffic congestion causes more vehicle accidents, which makes insurance companies raise their premiums for motorists in that area.

Options to Mitigate Negative Externalities of Traffic Congestion

Governments often try to reduce negative externalities by taxing or regulating related behaviors.  Sin taxes are commonly imposed on goods and services that cause society to spend more money on health care and/or law enforcement, such as alcohol, tobacco, and gamblin.  Fossil fuel production is taxed because it creates pollution, which can lead to environmental degradation (and natural resource degradation) and health issues.  A simple excise tax may not be the best option, however, because it does not incentivize efficiency or innovation - the producer pays the unit tax on each unit produced, with no reward for reducing the incidence of negative externality.

A more flexible solution is allowing some sort of cap-and-trade regulation, with producers of the negative externality being allowed a certain amount of externality production (i.e., pollution) at a low tax rate.  If the producers consistently stay below this “cap”, they can “trade” their remaining allowed units of negative externality by selling that allotment to other producers.  This incentivizes producers to become more efficient and thus be able to sell more externality units to less-efficient rivals.  If producers exceed the “cap”, they will pay higher taxes, making it financially advantageous to buy externality allotments from other producers and extend their cap.  

Cities could use this model to reduce traffic congestion by giving each resident a certain number of cost-free passes to visit congested areas, such as downtown.  Many residents rarely drive and park downtown, and so could sell their unused visits to those who wish to drive and park downtown frequently.  This would be hard to regulate, however, and would require a high amount of surveillance and monitoring that many citizens may fear.  Also, what would the penalties be for being caught parking downtown after having used up one’s free passes?

1. Congestion Pricing

A more realistic option is congestion pricing, also known as value pricing.  In consumer economics, it is more recently known as surge pricing.  Essentially, people pay more during times of peak demand.  Government-owned parking spaces or toll roads can easily be programmed to charge higher rates based on times of higher demand.  This would incentivize drivers to reschedule their trips to congested areas, if at all possible.  Thus, the congestion would “spread out” and become less severe during peak periods.  

Private sector firms could assist with this, especially if given government tax credits or subsidies to do so.  Insurance companies could reward drivers who more frequently run errands during off-peak hours and allow their driving to be tracked with an app on their smartphones.  Businesses that hold events in congested areas may receive government incentives to schedule more events during off-peak hours.  Tax credits or subsidies could be provided to venues that offer lower prices during off-peak hours and/or increase their prices during peak hours.

2. Public-Private Partnerships

Public-private partnerships can create congestion-busting innovations when the government incentivizes private contractors, such as toll road operating companies, to fix the problem without causing reductions to services.  Aside from roads and parking spaces, public-private partnerships could reduce traffic congestion by delivering more remote services through video conferencing.  One example would be telehealth services, with medical providers receiving incentives to offer more services via video call.  Doctors receiving government funds could be rewarded for processing more patients efficiently, either through video conferencing, more paperwork handled digitally, or online appointment scheduling options.  

Allowing more patients to have medications delivered by mail, as opposed to driving into congested areas to pick them up at pharmacies, would also help.  A positive externality of making healthcare more remote-friendly is a reduced likelihood of transmitting communicable diseases, such as the flu, while sitting in waiting rooms or standing in lines.  This reduction of communicable illness would be another reason to incentivize telehealth service and automated pharmacy deliveries.  Doctors’ offices improving their online information gathering would also create a positive externality of improved data-sharing during a health crisis.

3. Behavioral Economics

A third option to reduce traffic congestion would be using behavioral economics to incentivize consumers to make more congestion-reducing transportation choices.  Government-funded rewards could be provided to people who use public transportation instead of personal automobiles.  An example would be a lottery with riders of public transportation being entered into periodic drawings each time they utilized the service.  The lottery winnings could be drawn from increased public transportation revenue, with more city residents likely to purchase tickets or passes due to the chance of winning the monetary reward.

Although the chance of winning such a lottery is very slim, many people may be drawn to switch from their personal automobiles to public transportation due to the irrational belief that they could win the grand prize.  Thus, the increased revenue from the lottery program would outweigh its costs, creating a net benefit for the city in terms of funding its public transportation.  Rewarding users of public transportation with unpredictable rewards, be they gift cards or other financial tokens, could significantly reduce traffic congestion due to consumers’ built-in biases of overconfidence in winning - they will take the bus, subway, or train because someday they will win the prize!