Theory of the second best

Indian Economy glossary

Also called: Second-best theory · Topic: Market Structures, Market Failure and Competition · NCERT: Beyond NCERT

Meaning

The theory of the second best was set out by Lipsey and Lancaster in 1956. It says that if one condition for Pareto efficiency cannot be met, meeting the other conditions does not necessarily raise welfare. It can even make things worse.

The lesson is that piecemeal reform needs a map of all the distortions that remain. Removing one distortion while others stay may simply create new problems.

Example

Suppose diesel prices are freed while kerosene stays subsidised. The price gap then encourages people to mix cheap kerosene into diesel, which is adulteration. A reform that looks efficient on its own creates a new distortion. In the same way, cutting tariffs on only some goods can divert trade to less efficient sources.

Don't confuse with

  • Government failure: inefficiency caused by the state's own action, for example through rent seeking or regulatory capture. Second-best theory explains why even a well-meant partial reform can backfire when other distortions remain.

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