Suppose Russia can produce automobiles relatively cheaply, but they have poor gas mileage and create a great deal of air pollution. The U.S. government, concerned about the quality of air, would like to see fewer Russian automobiles and more cleaner-running American automobiles on the road.a. What is the nature of the market failure that would justify the U.S. government taking some action against the importation of Russian automobiles?b. Explain why imposing a tariff is a second-best policy to employ in this case and what policy choice would be more efficient.

Question

What will be an ideal response?

Answer 1

POSSIBLE RESPONSE:

a. The market failure in this case is a negative external effect that arises because of the air pollution from the Russian automobiles. There is misalignment between the private marginal cost facing the individual consumer who purchases a Russian car, and the social marginal cost, which also includes the damage arising from air pollution. In the presence of such external cost, U.S. government action is warranted.

b. Imposing a tariff can reduce the number of Russian cars on the streets, so the gap between the social marginal benefit and the social marginal cost narrows. The specificity rule says to try to use a government policy that acts as directly as possible on the source of the problem. In this particular example, the government should impose a tax on air pollution. That means car drivers should pay a tax commensurate to the damage they cause to society due to the air pollution. This is a first-best policy because it also provides an incentive for Russian automobile firms to look for cost-effective ways to produce cars that produce less pollution.