The Role of Second-Best Theory in Public Economics
AbstractThis paper surveys the evolution of the use of the theory of second best in public economics. It argues that much of modern normative public economics can be interpreted as simply applied second-best analysis. The original theory of second best as expounded by Lipsey and Lancaster involved analyzing policy in a single-consumer economy with a fixed distortion, and was especially interested in whether marginal cost pricing, or piece-meal prescriptions, could still be maintained. That analysis was subsequently extended to multi-household economies, to multi-distortion cases and to dynamic settings, and became the basis for the optimal tax revolution in public economics. However, more significantly, in the wake of optimal tax analysis and duality theory, the second-best distortion has effectively been made endogenous; and the general government policy problem has been posed as a principal-agent one. The most common method is by assuming non-observability of some important household characteristic or behavioral outcome. As a consequence of these developments, most public policy problems can be viewed as special applications of second-best analysis. For example, the general problem of the efficiency-equity trade-off (the `optimal income tax' problem) and the limit to redistribution can be viewed as second-best problems. A couple of the interesting features of viewing policy problems as second-best problems are as follows. For one, simple policy prescriptions no longer become possible. For another, seemingly odd types of policies, such as quantity restrictions, in-kind transfers and public provision of social insurance become `efficient' policy instruments in certain circumstances. The literature also stresses that second-best policies are typically time-inconsistent. In the face of this, standard second-best optima cannot be attained. Optimal time-consistent policies can also include unusual policy instruments that would otherwise be ruled out in a second-best setting.
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Bibliographic InfoPaper provided by Queen's University, Department of Economics in its series Working Papers with number 910.
Length: 35 pages
Date of creation: Nov 1994
Date of revision:
Other versions of this item:
- Robin Boadway, . "The Role of Second-Best Theory in Public Economics," EPRU Working Paper Series 95-06, Economic Policy Research Unit (EPRU), University of Copenhagen. Department of Economics.
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- Misch, Florian & Gemmell, Norman & Kneller, Richard Anthony, 2011. "Fiscal policy and growth with complementarities and constraints on government," ZEW Discussion Papers 11-018, ZEW - Zentrum für Europäische Wirtschaftsforschung / Center for European Economic Research.
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- BOADWAY, Robin & LEITE-MONTEIR, Manuel & MARCHAND, Maurice & PESTIEAU, Pierre, . "Social insurance and redistribution," CORE Discussion Papers RP -1643, Université catholique de Louvain, Center for Operations Research and Econometrics (CORE).
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- Richard Lipsey, 2007. "Reflections on the general theory of second best at its golden jubilee," International Tax and Public Finance, Springer, vol. 14(4), pages 349-364, August.
- Teoría del Segundo Mejor in Wikipedia (Spanish)
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