Theory of Second Best: Concept & Explanation

This theory concentrates on the situation when one or more than one optimum situation cannot be satisfied. Richard Lipsey and Kelvin Lancaster showed interest in 1956 that if one optimum condition cannot be satisfied in the model, then the best possible solution involves changing the variables from the values that could be optimal.

Lipsey and Lancaster, in 1956, worked hard on this theory. They gave the following statement about this theory. The general theorem for the second best optimum states if there is introduced in the general equilibrium system, there is a constraint which prevents the attainment of one of the Pareto conditions. The other Pareto conditions still attainable are, in general, no longer desirable.

The primary focus of this theory is on what happens when the optimum conditions are not satisfied in an economic model. Lipsey and Lancaster’s results have important implications for the understanding of not only trade policies but many other government policies as well.

Lipsey and Lancaster said that the theorem of second best has important implications in applied welfare economics. Lipsey and Lancaster also gave the argument that the theory of second best shows the futility of piecemeal welfare economics to apply rules for a Pareto optimum to only one sector of an economy, which may move the economy away from the second-best situation.

For example, an economy consists of a private monopoly, which is a set of competitive firms and publicly owned firms which will be deciding how to price the goods in the public interest, and if the firm behaves in a competitive manner, then it will produce more output compared to monopolized goods then what is required by Pareto and various policymakers give their views that some conditions are worse and some conditions are better and no policy by public owned firms can achieve Pareto optimum situation because due to the presence of monopoly form of market in the economy.

The theory of second best also says that there are so many market failures in the economy, and only some market failures can be corrected, and some are uncorrectable, so actions are being taken to correct market failures of only related sectors with the motive of increasing economic efficiency in the market. If an attempt is being made to correct all the market failures, it will be impossible, and there will be a decline in overall economic efficiency in the market.

In this theory, it is better to let two market imperfections to cancel each other effects rather than putting an effort on one market. Thus, it is optimal from the government’s point of view also that only those markets should be corrected and studied in detail which is related with each other.

Indian economy is a mixed economy, and the problem related to the mixed economy also provides a way for applying the principles of the second-best theory. This can be explained with the help of the following example.

There are two sections in the economy. One section is rigidly controlled by the central authority, while the other section of the economy is virtually uncontrolled. If there is a high degree of control in one section and a complete absence of control from another section, then it would be very difficult to achieve a second-best optimum situation.

Thus, to increase efficiency in the market, it is better to increase the degree of control exercised over the uncontrolled sector or give some relaxation on the degree of control over the controlled sector. If this policy is being adopted in a mixed economy like India, then surely the economy will move in the direction of achieving the second-best optimum position.

Read More in: Theory of Public Finance

1. Public Finance: Meaning, Nature & Scope
2. Role of Government in Economy
3. Role of Government in Mixed Economy: Public & Private Sector
4. Role of Government under Cooperation and Competition
5. Role of Government in Economic Development and Planning
6. Concept of Public Goods, Private Goods, and Merit Goods
7. Concept of Market Failure and Functions of Government
8. Market Failure and Functions of Government: Decreasing Costs
9. Market Failure and Functions of Government: Externalities
10. Market Failure and Functions of Government: Public Goods
11. Future Market: Meaning, Role & Uncertainty
12. Concept of Information Asymmetry
13. Theory of Second Best: Concept & Explanation
14. Problem of Allocation of Resources: Public & Private Mechanisms
15. Preferences: Meaning, Types & Problems of Preference Revelation
16. Preference Aggregation & Its Mechanism
17. Voting Systems, Direct Democracy, Representative Democracy, Leviathan Hypothesis & Arrow’s Impossibility Theorem
18. Economic Theory of Democracy: Concept & Explanation
19. Politico Eco Bureaucracy: Concept & Explanation
20. Rent-Seeking and Directly Unproductive Profit-Seeking Activities
21. Rationale for Public Goods: Concept & Explanation
22. Benefit Theory or Voluntary Exchange Theory
23. Lindahl Model: Concept, Equilibrium & Limitations
24. Bowen Model: Concept, Advantages & Limitations
25. Samuelson’s Model of Public Expenditure
26. Musgrave’s Model of Public Expenditures
27. Demand Revealing Schemes for Public Goods
28. Vickery-Clarke-Groves Mechanism
29. Groves-Ledyard Mechanism
30. Tiebout Model: Concept, Assumptions Equilibrium & Simple Tiebout Model
31. Theory of Club Goods
32. Keynesian Principles of Stabilization Policy
33. Difference Between Keynesian Economic Thought and Others
34. Role of Expectations and Uncertainty in Formulating Stabilization Policy
35. Intertemporal Markets Efficiency & Failure
36. Liquidity Preference Theory
37. Diamond-Dybvig Banking Model
38. Preference Shocks, Adverse Selection & Central Bank
39. Equilibrium Deposit Contract
40. Social Goods and Its Effect on Stabilization Policy
41. Effect of Infrastructural Facilities on Stabilization Policy
42. Effect of Distributional Inequality on Stabilization Policy
43. Effect of Regional Imbalances on Stabilization Policy
44. Wagner’s Law of Increasing State Activities: Explanation, Graph & Criticism
45. Peacock-Wiseman Hypothesis: Explanation, Graph & Criticism
46. Public Expenditure: Concept, Objectives, & Public vs Private Expenditure
47. Pure Theory of Public Expenditure
48. Structure & Growth of Public Expenditure in India
49. Trends, Lessons & Priorities in Public Expenditure in India
50. Social Cost-Benefit Analysis: Project Evaluation, Estimation of Costs & Discount Rate
51. Performance Based Budgeting and Zero Based Budgeting
52. Theories of Tax Incidence: Concentration Theory, Diffusion Theory & Modern Theory
53. Tax System and Its Principles
54. Equity Principle and Efficiency Principle of Taxation: Meaning, Explanation & Examples
55. Ability to Pay and Benefits Received Principle of Taxation
56. Theory of Optimal Taxation: Excess Burden & Distortions of Taxation
57. Deadweight Loss of Taxation: Causes, Measurement & Example
58. Concept of Equity & Efficiency in Economics
59. Trade-Off Between Equity and Efficiency: Meaning & Example
60. Theory of Measurement of Dead Weight Loss
61. Double Taxation: Meaning, Desirability, Forms & Solution
62. Solution to Problem of Double Taxation: Intra-Country & International
63. Double Taxation Avoidance Agreement (DTAA) and Indian Policy
64. Classical View on Public Debt
65. Compensatory Aspect of Public Debt Policy
66. Public Debt or Borrowings: Concept, Need, Sources & Types
67. Concept of Public Debt or Public Borrowings
68. Need for Public Debt or Public Borrowing
69. Sources of Public Debt
70. Classification of Public Debt
71. Burden of Public Debt: Meaning, Types & Explanation
72. Debt Through Created Money or Deficit Financing
73. Public Debt (Public Borrowings) and Inflation (Price Level)
74. Crowding Out of Private Investment and Activity
75. Principle of Public Debt Management and Debt Repayment