Academic journal article Public Finance and Management

Why Should Governments Encourage Improvements in Infrastructure? Indirect Network Externality of Transaction Efficiency

Academic journal article Public Finance and Management

Why Should Governments Encourage Improvements in Infrastructure? Indirect Network Externality of Transaction Efficiency

Article excerpt

ABSTRACT

Governments have been very active in engaging in and in encouraging the improvements in transaction efficiency, including the provision of legal, social, and economic infrastructure. While this may partly be explained by the public goods nature, the presence of indirect network externalities due to the economies of specialization may also be important. The improvement in transaction (including communication and transportation) efficiency may generate benefits in excess of the direct private benefits through the promotion of division of labour that leads to more economies of specialization and the availability of more goods in the market. This is shown in the Yang-Ng framework of inframarginal analysis.

(ProQuest: ... denotes formulae omitted.)

1. WHY SHOULD GOVERNMENTS ENCOURAGE IMPROVEMENTS IN TRANSACTION EFFICIENCY?

Governments have been very active in engaging in and in encouraging the improvements in transaction efficiency, including the provision of legal, social, and economic infrastructure. (For the effects of infrastructure on productivity, see World Bank 1994 for a survey; see also Boserup 1981 and Chandler 1990 on the historical perspective and the importance of population size.) Even free-market economists including Adam Smith find 'the erection and maintenance of the public works which facilitate the commerce of any country, such as good roads, bridges, navigable canals, harbours, &c' desirable and indeed find this as 'evident without any proof' (Smith 1776/1976, II, p.245). Perhaps this apparently self-evident nature made economists pay little attention to the role of infrastructure in either theoretical or empirical studies until the late 1980's. (See Gramlich 1994 for a survey.) This interest is mainly concerned with the relationship of infrastructure investment and economic growth and development or the related issue of the productivity of public capital (e.g. Aschauer 2001, Batina 2001, Bougheas, Demetriades & Mamuneas 2000, Esfahani & Ramirez 2003, Evans & Karras 1994, Fernand 1999, Haughwout 2002, Holtz- Eakin 1994, Paul et al. 2004, Pereira 2001, Röller & Waverman 2001, Wang 2002).1 While these issues are also related to the theme of this paper, the latter is more concerned with the specific point as to the reasons why the involvement of the government is needed.

The need for government involvement may be explained by the public goods nature of infrastructure. This may well be the major part of the explanation for many cases. However, if this is the only reason, there is little reason for encouragement if the items involved are excludable and can be priced as applicable in many cases including communications. Moreover, according to the traditional analysis, even for non-excludable items, there should be no reason for providing them beyond the levels indicated by the equation of (aggregate) marginal benefits and marginal costs, evaluated at the existing structure of economic organizations or the degree of specialization of the whole economy (which is not taken as a variable in the traditional analysis). In this paper, it is argued that, if we take the degree of specialization as endogenous, the provision of infrastructure that decreases transaction costs may produce some indirect network externality by enhancing the network of social division of labour. This should be distinguished from the possible network externality of the infrastructure itself, which is well known. For example, the usefulness of a telephone, fax machines, email facility increases as more people are on the phone, etc. This is the direct network externality, which we shall abstract away. Rather, we refer to the following more indirect effects.2

The improvement in transaction (including communication and transportation) efficiency may generate benefits in excess of the direct private benefits through the promotion of higher degrees of specialization. If transaction efficiency is very low (i. …

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