C H A P T E R T W O Human Capital Externalities in Cities: Identification and Policy Issues INTRODUCTION The case for corrective economic policies as stated in Econ101 is relatively straightforward. In some instances, there is a wedge between the private costs (or benefits) resulting from some choice made by an economic | A Companion to Urban Economics Edited by Richard J. Arnott Daniel P. McMillen Copyright 2006 by Blackwell Publishing Ltd CHAPTER TWO Human Capital Externalities in Cities Identification and Policy Issues Gilles Duranton Introduction The case for corrective economic policies as stated in EconlOl is relatively straightforward. In some instances there is a wedge between the private costs or benefits resulting from some choice made by an economic agent and the social costs or benefits accruing to society. Such a wedge occurs when markets fail to mediate properly some economic interactions that is when there is an externality. In such a case the privately optimal decision made by the agent does not lead to a socially optimal outcome. For instance investors underinvest when they cannot appropriate all the positive returns from their investments. Firms overproduce goods whose production damages the environment at no cost to them and so on. Pigou s 1920 ingenious solution to this type of problem is to impose a tax or a subsidy so that the private and social costs are made equal. In other words whenever there is an externality an appropriately chosen Pigovian tax or subsidy can make agents internalize the external effects of their choices so that the privately optimal decision leads to a socially optimal outcome. After exposing the details of this argument the EconlOl textbook typically points out that such taxes and subsidies are difficult to implement empirically because of their informational requirements. Then the textbook usually ends the discussion on this topic and turns to something else. From a policy perspective Human Capital Externalities in Cities 25 however this is where the real work ought to start. In this chapter the objective is to show how in practice economists attempt to identify such externalities. With this in mind this chapter will analyze the case of one set of externalities those pertaining to the market for human capital and education. Human .
