Stephen Monrad

Richard Lipsey and Kelvin Lancaster wrote the paper “The General Theory of the Second Best” (The Review of Economic Studies, Vol. 24, No. 1. (1956 – 1957), pp. 11–32.) in 1956. While I haven’t yet tracked down the paper and read the original, the idea presented in the paper is that getting incrementally closer to an ideal situation isn’t always an improvement. The paper is about welfare economics, but the idea is quite general.

Suppose your ideal vacation is to go to Bermuda but the plane you have access to can only get half way there. You are no better off if an extra tank can be added that will get you three quarters of the way there. Either way, you end up ditching in the ocean if you try to go.

In economics, it turns out that fixing some, but not all, problems doesn’t necessarily make the economy work better either. Suppose it is discovered that oil companies are colluding to increase prices. Normally, preventing collusion is a good idea. However, given the problems with global warming and dwindling supplies of oil, a higher price for oil might actually be a good thing. If the government were to crack down on oil companies to prevent collusion, we could all end up worse off.

The reason I find this interesting is because markets are only THE best way to organize an economy in very special circumstances. Economists have identified a number of assumptions that are required to prove that markets are the best way to organize an economy and are trying to make the real world conform to the assumptions. If we can’t get all the conditions right at the same time, however, we might be better off looking for other ways to organize economic production.