Modelling Transport in an Interregional General Equilibrium Model with Externalities

industry becomes the LRAC curve rather than the marginal cost curve, as when price equals
marginal cost, firms will make a loss. A further consequence is that an increase in demand
(from D to D¹ ) for this type of industry will result in both lower prices and increased output,
as shown in figure 1. This is a prime reason for policymakers’ interest in external scale
economies. The theory of economies of agglomeration builds upon the assumption that spatial
proximity magnifies these effects and in many cases is a condition for their operation.

Figure 1

Industry supply curves for a constant cost industry (S¹) and a declining cost industry
(S²)

(industry)

Marshall’s (1890) writings represent a first attempt to examine the concept of economies of
agglomeration, identifying four types of advantage. His original formulation includes the
advantages of a thick market for specialised skills in the labour force, the development of
specialized firms with backward and forward linkages associated with large markets (Fujita,
Krugman & Venables, 1999) and the existence of ancillary trades. The fourth factor,
‘mysteries of the trade... in the air’ , relates to what now can be termed spillover effects,
which are dynamic external economies.

The labour market advantage arises mainly because of efficiency gains from a pooled
labour market (Krugman 1991). The linkage gains are straightforward, resting partly on
assumptions of scale economies in supplying firms (which are pecuniary external economies),
as well as transport cost savings.

A distinction can be made between pecuniary and technological externalities Scitovsky
(1952). A pecuniary externality (which can be either positive or negative) affects the price of
inputs as the size of an industry grows. If supplying firms enjoy scale economies as the
industry grows, unit costs of the production of inputs will fall. Economic theory tends not to
regard this as a market distorting externality, as the benefit is generally available to
competitive firms. However, pecuniary externalities may be distortionary as they frequently

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