I’m teaching urban economics now for the first time. There is still a lot I don’t know, but it seems clear to me that there is one big overall market failure in urban economics, one that the textbooks don’t seem to make clear.
Land in populated areas is valuable mostly because other people live nearby; people with whom one can have social, job, and shopping relationships. While our neighbors often hurt us, their net (and marginal) effect is on average positive, and huge.
This externality, however, mainly comes from the people on nearby land, and not from their gardens. So when we consider how much land to use for our homes or offices, we do not consider the gains to others from our using less land, and so allowing more people to be nearby. We also neglect the benefits we provide others when choosing to live at the edge of the populated area, versus living in an unpopulated area.
These neglects suggest a big market failure, wherein housing and office density, and the size of the populated areas, are too small. It might perhaps be countered by a status externality, wherein people gained status by living closer to an urban center. But I doubt status effects fully compensate.
Local governments are in a position to reduce this externality, but they seem to mostly make matters worse. Minimum lot sizes, maximum building heights, maximum densities, and barriers to development at the populated edge are far more common than their opposites.
Now why don’t the urban economics textbooks make this point clear?