What Is Second-Best Theory?

What is Second-best theory? Essentially, it’s a theory about the optimal price of goods, which can be applied to the design of tax systems and the pricing of goods produced by a regulated monopoly. The critics of the theory, though, argue that the theory is flawed because the economists implementing it fail to recognize that the prices of goods are inherently unattractive.

The Second-best theory is a concept in economics that holds that the optimum allocation of resources is not guaranteed unless all other conditions are met. In other words, the first-best allocation may not be the optimal solution for a given set of circumstances, and the second-best allocation may be even worse for the economy. This concept has been around since 1956 and was developed by Kelvin Lancaster and Richard Lipsey, two Australian mathematical economists.

The Second-best theory originated from economists Kelvin Lancaster and Richard Lipsey. Early studies on the theory explored whether optimal first-best policies were feasible in a sector controlled by government. However, later, the theory was adopted by Arnold Harberger and incorporated into public policy evaluation. Today, second-best theory has expanded its scope to include distorted economies and dynamic settings. It is also a useful tool for understanding public policy in uncertain situations, such as the optimal taxation of commodities and income.

The theory of the second-best is based on well-established generalizations and artful application of economic sense. Lipsey argues that it’s best to study the Second-best theory in terms of its application in policy. For example, an economic policy analysis of a specific market situation should consider the “third-best” equilibrium. While it’s still the best solution, the Third-Best approach still adheres to the principles of the First-best theory.

The Second-best theory is often associated with Lipsey and Lancaster, but it was present in the economics literature before them. Vilfredo Pareto discussed the issue of free trade and protection in the early twentieth century. Paul Samuelson and James Meade wrote about the Second-Best theory in 1947 and 1955, respectively. However, Lipsey and Lancaster provided a more formal analysis of the concept and discussed its implications for policy makers.

In conclusion, second-best theory is a useful tool for understanding how people make decisions. It can help us to better understand why people choose the options they do, and it can also be used to predict how people will behave in certain situations. Additionally, second-best theory can help us to identify ways to improve our decision-making process. Finally, it is important to note that second-best theory is not perfect, and there are some situations in which it may not be applicable.