Question

In each of the following situations, explain how government intervention could improve society's welfare by changing people's incentives. In what sense is the market going wrong? a. Pollution from auto emissions has reached unhealthy levels. b. Everyone in Woodville would be better off if streetlights were installed in the town. But no individual resident is willing to pay for installation of a streetlight in front of his or her house because it is impossible to recoup the cost by charging other residents for the benefit they receive from it.

Short answer

Short Answer: In situation a, pollution from auto emissions is an example of a negative externality, causing a market failure. A possible government intervention is to impose a Pigouvian tax on auto emissions, leading to a reduction in pollution levels and improving society's welfare. In situation b, streetlights in Woodville represent a public good, and the market fails to provide them efficiently because of the free-rider problem. A possible government intervention is to fund the installation and maintenance of streetlights through tax revenues, ensuring community-wide benefits and improved welfare.

Step-by-step solution

Situation a: Pollution from auto emissions

The main problem here is that pollution from auto emissions has reached unhealthy levels, affecting society's welfare. This is an example of a negative externality, which occurs when the actions of one party impose costs on others that are not accounted for in the price of a product or service. In this case, the social cost of driving (including pollution) is higher than the private cost, leading to a market failure.

Government intervention for situation a

One possible government intervention to address this market failure is implementing a Pigouvian tax, which is a tax equal to the marginal external cost of pollution. By imposing a tax on auto emissions, the government can force drivers to internalize the social cost of pollution, leading to a reduction in the number of cars on the road or encouraging the use of cleaner transportation alternatives. This would ultimately improve society's welfare by reducing pollution levels and associated health problems.

Situation b: Streetlights in Woodville

In this situation, the main problem is that no individual resident is willing to pay for the installation of a streetlight in front of their house, even though the entire community would benefit from it. This is an example of a public good, which is a good that is both non-excludable (people cannot be excluded from benefiting from it) and non-rival (one person's consumption does not reduce its availability to others). The provision of public goods often leads to a market failure because the market cannot allocate resources efficiently in such situations.

Government intervention for situation b

One possible government intervention to address this market failure is to provide the public good (streetlights) through tax revenues. By funding the installation and maintenance of streetlights using taxes, the government can overcome the free-rider problem (where no one is willing to pay for the public good) and ensure that the entire community benefits from the streetlights. This would improve society's welfare by providing better lighting and safety in Woodville without relying on individual residents to voluntarily pay for the streetlights.

Key concepts

Understanding Negative Externality

Negative externality occurs when the actions of an individual or firm result in adverse effects on others that aren't reflected in the costs involved. Imagine driving a car that releases emissions into the air.
This act affects not just the driver but also people who suffer from polluted air. This negative impact on society is not considered in how much the driver pays for fuel or the car.
Thus, pollution becomes a cost that is ignored by the market.
If left unchecked, it leads to excessive pollution because individuals aren't factoring in the impact on others.

• Social Cost > Private Cost
• Example: Auto emissions causing health issues

This scenario highlights a significant efficiency problem—the market fails to account for the external costs, leading to overuse or overproduction of pollution-generating vehicles.

Pigouvian Tax as a Solution

A Pigouvian tax is designed to correct negative externalities. It's a tax imposed on activities that generate harmful side effects on society. The idea is to make the party causing the externality—like vehicle emissions—pay for the societal cost.
This tax should be equal to the marginal external cost of the damage caused.
With a tax in place, motorists will become more conscious of their choices, potentially leading to less polluting vehicles or alternative transport methods. The shift aims to align private incentives with societal welfare.

• Goal: Internalizes external costs
• Example: Taxing carbon emissions from cars
• Outcome: Encourages pollution reduction and cleaner alternatives

By adjusting prices to reflect true social costs, a Pigouvian tax leads to an improved allocation of resources, bringing about a healthier environment.

Public Good and Its Challenges

A public good is characterized by its non-excludability and non-rivalry. This means no one can be excluded from using the good, and one person's use of the good doesn't diminish its availability to others. An example is street lighting.
Everyone in a community benefits from the presence of streetlights.
However, these positive attributes create challenges in the context of market supply.

• Non-excludable: All residents benefit
• Non-rival: One resident's benefit doesn't reduce availability

The market struggles to provide public goods since it's hard to charge individuals who benefit or to exclude those who don't pay.

Market Failure Explained

Market failure occurs when resources are not allocated efficiently by the free market. This inefficiency usually arises due to externalities, public goods, and monopolies.
In our examples, market failure is evident in pollution levels and public goods like streetlights.
When markets fail, society incurs a loss of economic and social welfare.

• Market doesn't provide optimal quantity of goods
• Example: Underprovision of streetlights and over-pollution

It's the task of government interventions to address these inefficiencies, ensuring that resources are used in a way that benefits everyone.

The Free-Rider Problem

The free-rider problem arises when people benefit from resources, goods, or services that they do not pay for. This is common in the case of public goods like street lighting. Residents enjoy improved safety without directly contributing financially to the provision of those services.
The presence of free riders can discourage individuals or businesses from providing such goods.
Thus, despite broad communal benefits, public goods might be underproduced or not produced at all by the market.

• Challenge: Non-contributors still benefit
• Example: Streetlight benefits to all residents

Government intervention often resolves this by funding public goods through taxation, which spreads the cost across all beneficiaries.