14 March 2007

The problem of the second best

Further to "Markets and their limitations".


What does economics have to tell us about how to optimise efficiency, if we cannot achieve PC (perfect competition)? There are two ways of dealing with the "problem of the second best" for policy purposes. The first favours government intervention, the second doesn’t. No prizes for guessing which one is most often stressed in economics courses. *

1) If we had information about the preferences of every individual in the economy, we could calculate what the range of possible optimal states are, given the constraints we have to work with. (Call these states “second-best solutions".) In that case, it might turn out that, if the economy departs from PC in one specific area but is PC elsewhere, we will only be able to get to a second-best solution by departing from PC in other areas as well. In fact, it can be shown that for very simple scenarios, that is the case — i.e. it is better to deviate from perfect competition in all areas rather than just in some.

This is sometimes taken to prove that in certain cases government intervention is better than laissez-faire as a way of generating the best possible outcome, given the constraints. But note that this conclusion depends on knowing everybody’s preferences, which in practice is impossible. The great benefit of the strict-PC model — of being certain that the outcome will be efficient, without having to know anything about people’s preferences — doesn’t apply here.

* * * * *

2) The other way of treating the problem of the second best is to advocate agnosticism. If we don’t have perfect PC conditions and can’t get to them, and we don’t know everyone’s preferences, then we can’t know whether any particular policy change will move things in the direction of greater efficiency. Even if a policy change appears to be moving things in the direction of PC conditions, it might easily result in less overall efficiency.

Now there are two ways to interpret treatment (2), either of which might be appropriate depending on the circumstances.

(2a) One is to be conservative, in the sense of being cautious about doing anything, especially major changes. They might do harm on balance, rather than good. This generates the opposite conclusion to that of (1), in the sense that you should avoid tinkering further with an already imperfect system in case you make it worse.

(2b) The other way to react is to adopt a muddle-through approach, for which there isn’t any strict justification, but which might be the best one can do, on a sort of hopeful common-sense basis. This could be taken to mean, we should try to aim at the nearest thing to PC in all markets, being careful to ensure that we don’t miss out any major areas.


The one thing second-best theory can definitely tell you is the following: you should be wary of policy changes which involve partial marketisation of a given area. E.g. if the intergenerational market for private capital (= inheritance) is heavily distorted by estate duties, don’t rush to marketise (i.e. remove subsidies from) cultural institutions such as universities or opera houses.

Also — though you don’t really need second-best theory for this — don’t try to impose artificial marketisation, e.g. by making academics or medical professionals try to prove they are generating “value for money”. There is no support from economic theory for the idea that anything other than a genuine market (where the genuine end users are able to vote with their wallets) will generate any benefit whatsoever.

* For the avoidance of doubt: the first.


Gavin Ayling said...

Tim Worstall's right -- fascinating stuff. Thanks for sharing morsels that one could only otherwise pick up by wading through a book.

james higham said...

What about feasibility studies and questionnaires?

Fabian Tassano said...

You may be thinking of cost-benefit analysis. Opinions on CBA vary. Here is mine.

While I wouldn't go so far as to say CBA is meaningless, I think the numbers assigned to non-monetary costs and benefits have to be taken with a very large pinch of salt. Since the answer is usually highly sensitive to these numbers, the same is true for the answer.

The main point of a CBA exercise, in my opinion, is to identify the different pros and cons that should be taken into account, and to ensure that all the repercussions have been thought through.