Second-Best Cost-Benefit Analysis with a Microfoundation of Urban Agglomeration

Many sources of urban agglomeration, such as the gains from variety, bette rmatching, and knowledge creation and diffusion, involve departures from the first-best world. Benefit evaluation of a transportation project must then take into account changes in excess burden along with any direct user benefits. A number of economists have addressed this issue, and policymakers in some countries, such as in the United Kingdom, have been attempting to include these considerations in their project assessments. By modeling the microstructure of agglomeration economies, we derive second-best benefit evaluation formulae for urban transportation improvements. Previous work has investigated the same problem, but without explicitly modeling the sources of agglomeration economies. Accordingly, our analysis examines whether earlier results remain valid when monopolistic competition with differentiated products provides the microfoundation of the agglomeration economies. By explicitly introducing the rural sector and multiple cities, we also show that the agglomeration benefits depend on where the new workers are from.