Give an example of a free market failure in the context of what we have learned in the course, and a policy that proposes to fix the market failure.
The correct answer and explanation is:
An example of a free market failure is pollution caused by factories. In this case, factories produce goods and release pollutants into the environment as a byproduct. The pollution negatively affects the health of nearby residents and damages natural ecosystems. This is a market failure because the factory does not bear the full cost of the pollution it creates. These costs, known as externalities, are imposed on society and are not reflected in the price of the factory’s products. As a result, factories may produce more pollution than is socially optimal.
A common policy to fix this market failure is the implementation of a pollution tax, also known as a Pigovian tax. This tax charges polluters a fee based on the amount of pollution they emit. By doing so, the policy forces factories to internalize the external cost of pollution. The tax increases the cost of production for polluting factories, providing an economic incentive to reduce emissions. Factories might invest in cleaner technology or change production processes to lower the tax burden.
The pollution tax aligns private costs with social costs, leading to a more efficient market outcome. It encourages producers to consider the environmental impact of their activities and reduces overall pollution levels. Additionally, the revenue collected from the tax can be used to fund environmental cleanup, public health programs, or further pollution control measures.
This policy approach is preferred over outright bans because it allows firms flexibility in how they reduce pollution. They can decide whether to pay the tax or invest in cleaner alternatives based on cost-benefit considerations. Thus, the pollution tax effectively corrects the market failure by reducing harmful externalities while maintaining productive economic activity.