Monetizing Positive Externalities to Mitigate the Infrastructure Underinvestment Problem

Many cities face challenges in financing their infrastructure. If a decision maker cannot capture all the benefits of its investment, there is a risk of underinvestment. Hong Kong’s transit operator designed a scheme in which it not only receives fare revenues, but also participates in a property management business, exploiting the positive externalities of public transport on nearby property prices. We develop a stochastic Stackelberg game of timing to explore the rationale of this scheme. The underlying problem is nontrivial because the operator faces a two-dimensional optimal stopping problem that cannot be reduced by a change of numéraire. We determine the operator’s optimal investment policy via the intermediation of a “penalized problem” and derive comparative statics. We determine the circumstances under which monetizing positive externalities effectively favors infrastructure investment. Other management problems have similar structures.