December 9, 2014

Welfare Economics and Second-Best Theory: Filling Imaginary Economic Boxes

  • Richard Wagner

    Distinguished Senior Fellow, F. A. Hayek Program for Advanced Study in Philosophy, Politics and Economics
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The economic theory of the second best has been an analytical staple of welfare economics and policy analysis since Lipsey and Lancaster (1956) set forth the idea. That theory challenged the then standard claim that removing violations of the necessary conditions for a competitive equilibrium would be Pareto efficient. According to second best theory, if two or more violations of those conditions exist, there can be no assurance that removing one violation will be Pareto efficient. Indeed, adding further violations could be Pareto superior. Second best theory is now widely ensconced throughout policy analysis; however, that theory amounts to filling imaginary economic boxes, to recur to a theme J. H. Clapham (1922) once advanced about the use of increasing and decreasing returns in policy analysis. Second best theory is a feature of a particular theoretical model that might be useful for blackboard demonstrations but which is incapable of advancing the analysis of public issues which require plausible and not demonstrative reasoning.