221
See also: Free market economics 54–61 ■ Economic equilibrium 118–23 ■
External costs 137
POST-WAR ECONOMICS
or remove it. There was no “first
best” solution. In such cases
government intervention elsewhere
in the economy might worsen the
effects of existing imperfections,
pulling the market still further
away from the ideal. Lancaster’s
and Lipsey’s insight was that
where an imperfection in one
market cannot be removed, all the
other markets will work around it.
They will achieve a relatively
efficient distribution of resources,
given the existing imperfection.
The least bad
Lancaster and Lipsey then went
further: the best available policy
option, when one distortion can be
corrected but others cannot, may
turn out to be the opposite of that
demanded by theory. For instance,
it might be better for government to
distort a market further, if it wants
to improve welfare overall. Ideal
policies, then, cannot be guided
by abstract principles alone. They
have to be based on a thorough
understanding of how markets
operate together.
One classic example is that of a
monopolist who pollutes a river
during production. The pollution
is both costly for society and an
inevitable result of production.
It cannot be removed from the
process and is a permanent market
imperfection. But the monopoly
can be removed.
Standard economic theory
would tell the government to break
up the monopoly and introduce
more competition to the markets.
This would drag the economy
closer to the efficient ideal.
But competing producers would
produce more than a single
producer, and also worsen the
pollution. The result for society’s
welfare as a whole is uncertain.
People might gain from increased
output and lower costs, but they
would lose out from more pollution.
The “second best” solution might
be to leave the monopoly in place.
The theory of the second best
remains critical to economic policy,
recommending that governments
act with caution rather than
attempting to achieve an ideal. ■Richard Lipsey
A Canadian economist born in
1928, Richard Lipsey is best
known for the theory of the
second best, formulated with
Kelvin Lancaster. He is
emeritus professor at Simon
Fraser University, Canada,
having taught in the US and
the UK. In 1968, his defense of
the Phillips Curve (p.203)
against the criticism of Milton
Friedman (p.199) formed one
of the great debates in
economics. Lipsey is the
author of a standard textbook
in economic theory, Positive
Economics, and recently has
helped develop evolutionary
economics, co-authoring an
influential book on the
processes of historical change.Key works1956 The General Theory of
the Second Best (with Kelvin
Lancaster)
2006 Economic
Transformations: General-
Purpose Technologies and
Long-Term Economic Growth
(with K. Carlaw, C. Bekar)12Choosing the least bad solution
(1) A monopolist is causing pollution. Both the
monopoly and the pollution are imperfections
in the market.
(2) A government could remove the monopoly
and replace it with competing firms. However,
as a result of more firms competing, the pollution
could get much worse.