Theory of the Second Best
Encyclopedia
In welfare economics
, the theory of the second best concerns what happens when one or more optimality conditions
cannot be satisfied. Canadian economist Richard Lipsey
and Australian economist Kelvin Lancaster
showed in a 1956 paper that if one optimality condition in an economic model cannot be satisfied, it is possible that the next-best solution involves changing other variables away from the ones that are usually assumed to be optimal.
This means that in an economy
with some uncorrectable market failure
in one sector, actions to correct market failures in another related sector with the intent of increasing overall economic efficiency may actually decrease it. In theory, at least, it may be better to let two market imperfections cancel each other out rather than making an effort to fix either one. Thus, it may be optimal for the government to intervene in a way that is contrary to usual policy. This suggests that economists need to study the details of the situation before jumping to the theory-based conclusion that an improvement in market perfection in one area implies a global improvement in efficiency.
Even though the theory of the second best was developed for the Walrasian
general equilibrium
system, it also applies to partial equilibrium
cases. For example, consider a mining monopoly
that's also a polluter: mining leads to tailings being dumped in the river and deadly dust in the workers’ lungs. Suppose in addition that there is nothing at all that can be done about the pollution. However, the government is able to break up the monopoly.
The problem here is that increasing competition in this market is likely to increase production (since competitors have such a hard time restricting production compared to a monopoly). Because pollution is highly associated with production, pollution will most likely increase. This may actually make the world worse off than before.
Gradual International economic integration may be considered as a second best solution, since it provides degree of trade advanced according to stages of economic integration (gradual abolishment of customs tariffs, non-tariff barriers such as registration rights etc. due to coherence policy of economic unions). It seems that the first-best option (free trade) is achieved as to gains from trade
when economic integration reaches a stage of political union (EU in 2009).
Welfare economics
Welfare economics is a branch of economics that uses microeconomic techniques to evaluate economic well-being, especially relative to competitive general equilibrium within an economy as to economic efficiency and the resulting income distribution associated with it...
, the theory of the second best concerns what happens when one or more optimality conditions
Pareto efficiency
Pareto efficiency, or Pareto optimality, is a concept in economics with applications in engineering and social sciences. The term is named after Vilfredo Pareto, an Italian economist who used the concept in his studies of economic efficiency and income distribution.Given an initial allocation of...
cannot be satisfied. Canadian economist Richard Lipsey
Richard Lipsey
Richard George Lipsey, OC, FRSC is a Canadian academic and economist. He is best known for his work on the economics of the second-best, a theory of constrained optimization by government of the tax system, which he co-authored with Kelvin Lancaster, a mathematical economist of high...
and Australian economist Kelvin Lancaster
Kelvin Lancaster
Kelvin John Lancaster was a mathematical economist and John Bates Clark professor of economics at Columbia University. He is best known for the development of the Theory of the Second Best with Richard Lipsey...
showed in a 1956 paper that if one optimality condition in an economic model cannot be satisfied, it is possible that the next-best solution involves changing other variables away from the ones that are usually assumed to be optimal.
This means that in an economy
Economy
An economy consists of the economic system of a country or other area; the labor, capital and land resources; and the manufacturing, trade, distribution, and consumption of goods and services of that area...
with some uncorrectable market failure
Market failure
Market failure is a concept within economic theory wherein the allocation of goods and services by a free market is not efficient. That is, there exists another conceivable outcome where a market participant may be made better-off without making someone else worse-off...
in one sector, actions to correct market failures in another related sector with the intent of increasing overall economic efficiency may actually decrease it. In theory, at least, it may be better to let two market imperfections cancel each other out rather than making an effort to fix either one. Thus, it may be optimal for the government to intervene in a way that is contrary to usual policy. This suggests that economists need to study the details of the situation before jumping to the theory-based conclusion that an improvement in market perfection in one area implies a global improvement in efficiency.
Even though the theory of the second best was developed for the Walrasian
Léon Walras
Marie-Esprit-Léon Walras was a French mathematical economist associated with the creation of the general equilibrium theory.-Life and career:...
general equilibrium
General equilibrium
General equilibrium theory is a branch of theoretical economics. It seeks to explain the behavior of supply, demand and prices in a whole economy with several or many interacting markets, by seeking to prove that a set of prices exists that will result in an overall equilibrium, hence general...
system, it also applies to partial equilibrium
Partial equilibrium
Partial equilibrium is a condition of economic equilibrium which takes into consideration only a part of the market, ceteris paribus, to attain equilibrium....
cases. For example, consider a mining monopoly
Monopoly
A monopoly exists when a specific person or enterprise is the only supplier of a particular commodity...
that's also a polluter: mining leads to tailings being dumped in the river and deadly dust in the workers’ lungs. Suppose in addition that there is nothing at all that can be done about the pollution. However, the government is able to break up the monopoly.
The problem here is that increasing competition in this market is likely to increase production (since competitors have such a hard time restricting production compared to a monopoly). Because pollution is highly associated with production, pollution will most likely increase. This may actually make the world worse off than before.
Gradual International economic integration may be considered as a second best solution, since it provides degree of trade advanced according to stages of economic integration (gradual abolishment of customs tariffs, non-tariff barriers such as registration rights etc. due to coherence policy of economic unions). It seems that the first-best option (free trade) is achieved as to gains from trade
Gains from trade
Gains from trade in economics refers to net benefits to agents from allowing an increase in voluntary trading with each other. In technical terms, it is the increase of consumer surplus plus producer surplus from lower tariffs or otherwise liberalizing trade...
when economic integration reaches a stage of political union (EU in 2009).