The Theory of the Second Best

Why fixing one market distortion can sometimes make things worse when other distortions remain, a subtle but important idea for policymakers.

Imagine an economy with several distortions: taxes, monopolies and pollution. Removing one distortion seems like it should improve efficiency. Surprisingly, economic theory shows this is not always true.

The theory

In 1956, economists Richard Lipsey and Kelvin Lancaster published “The General Theory of Second Best”. They showed that when one condition for efficiency cannot be met, trying to satisfy the others may not bring the economy closer to efficiency. It could even make things worse. The best achievable outcome in the presence of an unavoidable distortion is called the second best.

An example: trade agreements

Suppose a country removes tariffs on imports from one neighbour but keeps tariffs on imports from others. This might seem like a move toward free trade. But it can lead the country to switch imports from a cheaper, more efficient producer that still faces tariffs to a more expensive producer in the neighbouring country that now enters duty-free. Economist Jacob Viner called this trade diversion, and it can reduce efficiency, a second-best problem.

Another example: monopoly and pollution

A monopoly polluting firm produces less than a competitive industry would, because monopolies restrict output. Its pollution means it produces more than would be best for society. The two distortions partly offset each other. Breaking up the monopoly to increase output might worsen pollution unless pollution is also addressed.

Lessons for policy

Consider interactions: reforms should account for other existing distortions.
Piecemeal reform can have unexpected effects.
Caution with simple rules: “remove every distortion” is good in principle but not always in practice when some distortions cannot be removed.

At the same time, economists warn that second-best arguments can be misused to justify keeping harmful policies. They require careful analysis, not general scepticism of reform.

The fuel subsidy and the congestion problem

A city has very cheap fuel due to subsidies and heavy traffic congestion. Removing the fuel subsidy would reduce both fiscal costs and congestion. But if the city also had an unrelated tax that discouraged public transport, reforms would need to consider how changes interact. Understanding the full set of distortions helps design better reforms.

Thinking every step toward the textbook ideal is always an improvement

When other distortions remain, partial moves toward the ideal can sometimes reduce efficiency. Good policy considers how distortions interact.

Key takeaways

Lipsey and Lancaster's 1956 theory of the second best says fixing one distortion may not improve efficiency if others remain.
Preferential trade deals can cause trade diversion, a second-best problem.
Distortions can partly offset each other, as with a polluting monopoly.
Reforms should consider interactions, but second-best arguments should not excuse harmful policies.