Theory of the second best

{{Short description|Branch of economics studying next-best alternatives}} {{Redirect|Second best|the films|Second Best (1994 film)|and|Second Best (2004 film)}}

In welfare economics, the '''theory of the second best''' concerns the situation when one or more optimality conditions cannot be satisfied.<ref>{{Cite book|last=Heath|first=Joseph|title=Filthy lucre : economics for people who hate capitalism|date=2009|publisher=HarperCollins|isbn=978-1-55468-769-5|location=Toronto|oclc=615371821}}</ref> The economists Richard Lipsey and Kelvin Lancaster showed in 1956 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 values that would otherwise be optimal.<ref name="Lipsey" /> Politically, the theory implies that if it is infeasible to remove a particular market distortion, introducing one or more ''additional'' market distortions in an interdependent market may partially counteract the first, and lead to a more efficient outcome.<ref>{{cite web|url=https://www.nytimes.com/2014/06/23/opinion/paul-krugman-conservatives-and-climate-change.html|title=The Big Green Test - Conservatives and Climate Change|date=June 22, 2014|website=The New York Times|last1=Krugman|first1=Paul|author-link1=Paul Krugman|accessdate=27 June 2014}}</ref>

==Implications==

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 economic efficiency may actually decrease overall economic efficiency. 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.<ref>{{cite news|title=Making the second best of it|url=https://www.economist.com/blogs/freeexchange/2007/08/making_the_second_best_of_it|accessdate=27 June 2014|work=Free Exchange|publisher=Economist|date=August 21, 2007}}</ref>

==Application== Even though the theory of the second best was developed for the Walrasian general equilibrium system, it also applies to partial equilibrium cases.{{examples needed|date=March 2025}}

==Common misinterpretation==

A common misinterpretation of the theory, sometimes termed the '''fallacy of exhaustive effort''', is the assumption that when one optimality condition cannot be satisfied, satisfying as many of the remaining conditions as possible must yield the second-best outcome. The theory of the second best demonstrates the opposite: because optimality conditions are typically derived from an interdependent system, perturbing one condition alters the marginal trade-offs throughout the entire system, so the second-best optimum generally requires violating ''all'' remaining conditions as well.

This misinterpretation is related to piecemeal social engineering and contrasts with the holistic policy design that the theory prescribes. In practice, the error arises when policymakers treat the individual conditions for a first-best outcome as separately desirable goals—for example, liberalising trade while ignoring an environmental externality because "free trade is good," or deregulating markets while assuming away imperfect information because "competition is good." Each such prescription satisfies one condition from the first-best list, but without the others in place, it can reduce welfare relative to doing nothing at all.<ref>{{cite journal |last=Ng |first=Yew-Kwang |date=1977 |title=Towards a Theory of Third Best |journal=Public Finance |volume=32 |issue=1 |pages=1–17 |jstor=40690487}}</ref>

==References== {{Reflist|refs= <ref name="Lipsey">{{Cite journal | last1 = Lipsey | first1 = R. G. | last2 = Lancaster | first2 = Kelvin | year = 1956 | title = The General Theory of Second Best | journal = Review of Economic Studies | volume = 24 | issue = 1 | pages = 11–32 | jstor = 2296233 | doi = 10.2307/2296233 }}</ref>  }}

==External links== * [https://legaltheorylexicon.blogspot.com/2003/11/legal-theory-lexicon-011-second.html Introduction to Second Best in legal theory] * [https://marginallabs.github.io/blog/The-Fallacy-of-Exhaustive-Effort/ "The Fallacy of Exhaustive Effort: Why Leaving No Stone Unturned Can Bury You"] — Marginal Lab

{{DEFAULTSORT:Second best}} Category:Microeconomic theories Category:Market failure Category:Welfare economics