Proposed by Canadian economist RICHARD LIPSEY (1928-1980) and Australian economist KELVIN LANCASTER (1924-1999), theory of second best assumes that if one of the conditions necessary to achieve Pareto-optimality is missing then the ‘second best’ position can only be reached by departing from all the other Paretian conditions.
Also see: pareto efficiency
R G Lipsey and K Lancaster, ‘The General Theory of Second Best’, Review of Economic Studies, vol. XXIV (October, 1956) 11-32
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.
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 is 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 without also reducing production. 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 monopolists restrict production). Because pollution is highly associated with production, pollution will most likely increase. Thus, it is not clear that eliminating the monopoly increases overall welfare. Gains from trade in the mined mineral will increase, but externalities from pollution will increase as well, possibly outweighing the gains from trade.