22 August 2007

Second-best theory: reassessed

In March I wrote a post on the theory of the second-best — which Tim was kind enough to draw attention to. My main point was that the standard textbook interpretation of Richard Lipsey and Kelvin Lancaster's original observation* was at best biased towards interventionism, and at worst simply false. This interpretation is very common. Dani Rodrik, for example, uses it when he says that

the First Fundamental Theorem of Welfare Economics is proof, in view of its long list of prerequisites, that market outcome can be improved by well-designed interventions.
This is not exactly false, but does seem to exaggerate the case in favour of intervention. The best that could be said is:

The First Fundamental Theorem of Welfare Economics is proof, in view of its long list of prerequisites, that interventions may not necessarily make things worse.

Around the same time I made a similar point on the Talk page of the Wikipedia article, where the same misinterpretation was being used. ("FWadel" is me.)
This entry is incomplete as it stands, and in a way which generates a political bias i.e. in favour of state intervention.

Another way of looking at the Lipsey/Lancaster point is as follows. If you are not at a Pareto-optimal point for the economy, you don't know whether any change that doesn't actually take you onto an optimal point is going to improve efficiency (i.e. make everyone better off). Even when you move in what appears to be the direction of greater efficiency, e.g. by changing all controllable parameters to an average of where you are now and where a Pareto optimum is, you might be making things less efficient i.e. making everyone worse off.

So another moral (apart from the one given) is that, when you have a market that is already regulated or otherwise distorted, it is not necessarily a good idea to move in the direction of less distortion. You can be sure that if you can get to a Pareto optimum, that is a good thing (at least in terms of efficiency); apart from that, you can't be certain of the effects of different policy changes. This is a consequence of the severely restricted conclusions of Pareto theory.

In fact, the moral given in the entry is questionable as stated. It isn't really the case that intervention to move things in a direction different from the pro-market one is sometimes a good idea. It's just that such a move might be a good thing, only neither the government nor anyone else can ever know if it would or not.
Now, I am pleased to see, Professor Lipsey has himself come out in favour of my interpretation.
The upshot is that in practical situations, as opposed to theoretical models, we do not know the necessary and sufficient conditions for achieving an economy-wide, first-best allocation of resources. Achieving an economy-wide second best optimum allocation looks even more difficult than achieving the first best. Without a model of the economy’s general equilibrium that contains most let alone all of the above sources, we cannot specify the existing situation formally and so cannot calculate the second best optimum setting for any one source that is subject to policy change. This is an important point since much of the literature that is critical of second best theory assumes that economists know a distortion when they see one and know that the ideal policy is to remove the distortion directly, something that is necessarily welfare improving only in the imaginary one-distortion world.
h/t The Economist

* R. Lipsey and K. Lancaster (1956), 'The General Theory of Second Best',
Review of Economic Studies 24, 11-32.

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