220
POLICIES TO CORRECT
MARKETS CAN MAKE
THINGS WORSE
THE THEORY OF THE SECOND BEST
S
tandard economic theory
holds that where markets
are available for all goods
and services, and everybody using
those markets is well-informed, the
economy will be efficient. It is not
possible to change the distribution
of resources to make one person
better off without making another
person worse off, so society’s
welfare is as good as it can be in
a free market. The best available
policy, according to the free-
marketeers, is for government to
remove imperfections in markets,
bringing them as close as possible
to the ideal.Working with imperfection
There are, however, strict
conditions before efficient policies
can be achieved. In 1956,
Australian economist Kelvin
Lancaster and his Canadian
colleague Richard Lipsey
demonstrated that in some
circumstances, policies aimed at
improving market efficiency may
make it worse overall. In a paper
entitled The General Theory of
Second Best, they looked at cases
where a market imperfection was
permanent—and where there was
no way for a government to correctIN CONTEXT
FOCUS
Economic policyKEY THINKERS
Kelvin Lancaster (1924 –99)
Richard Lipsey (1928– )BEFORE
1776 Adam Smith claims the
“invisible hand” of the self-
regulating market is superior
to government intervention.1932 British economist Arthur
Pigou advocates the use of
taxes to correct market failures.1954 In Existence of an
Equilibrium for a Competitive
Economy, Gérard Debreu and
Kenneth Arrow demonstrate
that an entirely free market
economy can maximize the
welfare of its participants.AFTER
From 1970s Welfare
economics is developed
through the work of
economists Joseph Stiglitz,
Amartya Sen, and others.In theory, a free market
is the most efficient
economy possible.But real economies
contain many distortions
that are inefficient and may
cause harm.Distortions may be
linked, and it may not
be possible for a government
to remove some of them.Attempts at removal
may worsen the effects
of other distortions, so
governments should act
with caution.Policies to correct
markets can make
things worse.