Equilibrium and Optimum City Size with the Presence of Pollution

This paper attempts to find the equilibrium and the optimum size of a monocentric open city that produces a constant return to scale good and a group of differentiated goods and services (increasing return to scale goods and services), where the production of goods and services causes negative externalities (pollution). The model in this paper also assumes the presence of positive externalities of agglomeration (agglomeration economies). As it is an open city, there will be too much agglomeration in the absence of any penalty on the polluters. The results of this paper show that if the city dwellers value environmental quality the market outcomes are sub-optimal. Therefore, a tax scheme is necessary for the correct level of agglomeration or the optimum size of the city. The optimal tax rate in the differentiated goods and services sector depends on the emission intensity of output, consumer preference for product diversity, demand for labour (or level of output), and the wage rate; and that in the constant return to scale good sector depends on the emission intensity of output, average labour productivity, and the wage rate.