Second-Best

Background

The concept of “second-best” arises within the field of economics to describe scenarios where achieving a fully efficient outcome, known as the “first-best” outcome, is unattainable due to existing constraints such as asymmetric information or monopoly power. Instead, policymakers aim for a “second-best” solution, where the presence of one or more constraints requires a more nuanced approach to optimization.

Historical Context

The theory of second-best was formally introduced in a seminal paper by Richard G. Lipsey and Kelvin Lancaster in 1956. While previous economic thought fixated on achieving perfect efficiency, Lipsey and Lancaster highlighted the practical complexities that often impede this ideal, offering a framework to optimize policies even under suboptimal conditions.

Definitions and Concepts

The term “second-best” denotes a situation where constraints prevent the attainment of an entirely efficient allocation of resources. The crucial insight from second-best theory is that if one of the efficiency conditions cannot be met due to a distortion, other efficiency conditions might also need to be deliberately unmet to achieve an overall optimal outcome.

Major Analytical Frameworks

Classical Economics

Classical economics typically assumes conditions that allow for first-best outcomes, relying heavily on simplifications like perfect information and absence of market power.

Neoclassical Economics

Neoclassical economics engages with second-best scenarios more critically, often dealing with markets where institutions and policy can mitigate but not remove inefficiencies, thereby relying on second-best optimization strategies.

Keynesian Economics

Keynesian economics addresses market failures and constraints related to aggregate demand and suggests that in circumstances where full employment (a first-best scenario) is unattainable, various forms of government intervention may improve economic outcomes even if they introduce new distortions.

Marxian Economics

Marxian economics attributes these inefficiencies and constraints primarily to capitalist structures and often sees the second-best outcomes as emblematic of deeper systemic issues rather than scenarios to be optimized through policy tweaks.

Institutional Economics

Institutional economics incorporates the second-best notion by emphasizing how legal, cultural, and historical contexts create layers of constraints that policymakers must navigate.

Behavioral Economics

Behavioral economics acknowledges second-best realities by considering how psychological factors distort market outcomes and how policies can be designed considering these human behaviors even if they further diverge from Classical efficiency ideals.

Post-Keynesian Economics

Post-Keynesianists typically focus on macroeconomic idiosyncrasies such as financial instability and see second-best policies like financial regulation and fiscal policies as necessary counteractions.

Austrian Economics

Austrian economics often criticizes second-best interventions, arguing that interventions add layers of complexity and inefficiency than less government involvement would avoid.

Development Economics

In development economics, second-best solutions are often crucial given the multitude of constraints faced by developing economies, where ideal policy prescriptions often confront real-world institutional and resource limitations.

Monetarism

Monetarists, like classical and neoclassical economists, generally aim for first-best outcomes through policy rules but will acknowledge second-best solutions in an empirical context where ideal monetary control is impeded by practical realities.

Comparative Analysis

While mainstream economics often searches for first-best solutions, applying a second-best approach introduces practical adaptability to policymaking in reality where various constraints impede ideal conditions. Each economic school has developed its approach to these practicalities, showcasing the broad spectrum of answers to the challenges posed by second-best scenarios.

Case Studies

Antitrust Policies: Real-world monopolies create unavoidable conditions where solutions seeking perfect competition (first-best) aren’t achievable. Policies counterbalance these by sometimes accepting overall less-than-optimal outcomes.
Public Health Interventions: Constraints in information and differing levels of epidemiological complexities lead to second-best dosing strategies and lockdown methods.
Trade Tariffs: Given geopolitical and economic constraints, tariffs sometimes reflect second-best outcomes in balancing trade objectives against practical realities.

Suggested Books for Further Studies

“The Theory of Second Best” by Lipsey and Lancaster
“Microeconomic Theory” by Andreu Mas-Colell, Michael D. Whinston, Jerry R. Green
“Policy Analysis: Concepts and Practice” by David L. Weimer and Aidan R. Vining

First-Best: Optimal outcomes achieved when only constraints are technology and endowments, meeting all efficiency conditions.
Asymmetric Information: Situations where one party in a transaction has more or better information than the other.
Monopoly Power: The ability of a firm to influence the price of a good or service in the market by virtue of its dominant position.