Wednesday, May 2, 2012

Highways as Public Goods

And why are highways, unlike so many other forms of investment, deserving of public support for their construction and maintenance?

Let’s start with why highways are publicly supported. Transportation links are different from most other forms of private investment because transportation links generate large spillover benefits(the technical term economists use is “positive externalities”) for the general public. Spillover benefits are essentially third party benefits. When you get a vaccination against a contagious disease, for example, the doctor gets a benefit(what you paid for the vaccination), and you get a benefit as well (a higher probability of staying in good health). But the rest of the general public gets a benefit as well. They also are more likely to stay in good health because of your being vaccinated, since if you don’t get sick they can’t catch the disease from you. However, the private market, which communicates via prices paid, doesn’t see external benefits to third parties. It only sees the benefits to the people who are actually paying and receiving the money changing hands. This means that the private market sees all the costs of vaccination(the doctor will incorporate those costs into the price of the vaccine) but only part of the benefits(the patient will not pay for the good health of others, only his own good health). So the private market underestimates the benefits of vaccination and how much vaccination is socially efficient. Highways also generate substantial third party benefits. What this means is that if the private market was left to it’s own devices it would underfund the highway system, making less investment in it than it should.

The spillover benefit of a highway system, or any transportation system for that matter, actually has a lot of different names among economists. Two of my college professors call it “market expansion”, others call it “competition support”, etc. But it might be best to illustrate just with another example.
Say there are two cities, each with one car manufacturer plant in them. There are no highways to travel between these two cities(though there must be roads within the cities that they use, or else there wouldn’t be a car manufacturer right?) Because there are no inter-city roads, each car manufacturer has a monopoly on car sales in their city. Each car costs $10,000 to make, including fair return on capital, and each customer in the city derives a benefit of $15,000 from their car. This means that the car manufacturers in each city are deriving $5,000 in monopoly profits on each car. They sell each car for the full $15,000 that a customer is willing to pay, because there is no competition to force them to charge a fair price closer to the actual cost of production.

What, you say, does any of this have to do with highways? Let’s say there are 50,000 cars sold in each city each year. Also say that a highway costs $20 million to build between the two cities and will last for 20 years. And finally, say it costs $100 to drive a car from one city to the other.
With a highway now built and a cost of $100 to move a car from one city to the other, prices start to fall. TWO car manufacturers are now competing with one another. They begin to offer lower prices hoping to win away customers from the other manufacturer. As each cuts prices, customers benefit. Eventually prices will fall to $10,100. Why? Because that is the cost of going to get your car in the other city if the car manufacturer is not offering you a good deal. $10,000 to build the car, plus $100 to ship it to the other city.

But wait a minute. Each car manufacturer has one last insight. “If my competitor CANNOT charge less than $10,100 without losing money, than I have an advantage in my own city. I don’t have to pay the $100 to ship the car on the highway when I am selling to customers in my own city. So I can charge $10,099 to customers in my own city and they will never buy a car from the other city, since it will always be cheaper to buy it here.” So the price drops to $10,099.

BUT, that means NO ONE is shipping cars on the highway. Those car buying customers are not contributing one dollar towards the highway that is saving them $5 million a year total in car costs.
Highways have large, uncompensated positive externalities because they increase the size of markets. They bring many smaller markets together to form one larger market with more competition and lower prices for consumers. But because what actually travels on the highway is only a small fraction of the goods that have seen their prices drop, highway builders are never fully compensated for this market effect. This persistent underfunding of transportation links is what necessitates public investment in the nation’s transportation infrastructure.

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