The Theory of the Second-Best

We got a bit philosophical in the last post. Now, let’s get back to reality, to economics. Below, we will discuss a very interesting economic theory that helps partly explain what are usually factored into the decision making process of economic policy makers.

“The theory of the second-best”,

In Economics, one of the ultimate objectives we pursue is efficiency, meaning we like optimization. Expanding to its best possible form whatever is favourable to us, and eliminating or shrinking what adversely affects our well-being. This is one of the basic principles of economics, universally agreed. However, in maximization/minimization problem, the so-called necessary and sufficient conditions (sometimes known as ‘optimization constraints’) always present, and to achieve the best possible outcome, they must be met. In practice, though, utopia is rather infeasible, and there are, on many instances, more than a few unsatisfiable conditions. The implication is that the best possible outcome is unlikely. Thus, we mostly have to settle for something of second-grade, or what “the theory of the second-best” calls the second-best outcome. So, assuming point A is unobtainable, what shall we do to at least get to point B?

If, say, the greatest optimal result requires 5 conditions to be met, but one of the 5 can never be achieved, should we then not give it our best effort to at least get the other 4 right? No, not necessarily. Actually, it would be a very bad idea to act based on such supposition. The presence of the other 4 necessary conditions does not ensure our arrival at the second-best result we want.

Take making fried-rice as an example. We normally need oil, garlic, eggs, salt, sugar, pepper, and rice of course. If salt and pepper are not available, it probably does not pay off very well trying our hardest to make fried-rice with the remaining ingredients. Probably, a better dish is simply fried-egg on steamy rice with some soy sauce on top. You see, you do not simply use, to your very utmost capacity, the remaining ingredients to make a second-rate of the same dish, but maybe only a few components of the former dish in addition to something new – in this case, soy sauce – to create a completely different dish that can satisfy you better than the fried-rice without salt and pepper.

In practice, economics is no different. Assuming that, a perfect free market requires perfect information, absence of barrier entrance and exit, many buyers and sellers, and no externality (ex: no pollution, etc). However, say, polluting is an inevitable by-product of the free market economy, and it is nowhere possible to eradicate pollution. Then, is our second best option to satisfy as much as possible the other conditions of a perfect free market?

To answer this question, suppose there is a monopoly (a sole firm that dominates the market of a certain product) producing cars, and that its operation damages environment. If pollution is unavoidable, then should the government at least break down the monopoly in order to achieve the “many buyers and sellers” element of the free market?

No. A rash decision can be very harmful to the social well-being in this case. Consider the following:

Getting rid of the monopoly will introduce new producers into the industry. The competition among these new producers would only make pollution worse, stripping away even more of the social return.

If the government however decides to heavily tax the monopoly to reduce pollution, it might drastically change the market due to the inter-links between products (complementarity). Taxing the monopoly, even with the good intention to reduce pollution, can lead to fewer cars produced and thus higher car price. It might end up lowering the demand for intra-country travel, and the green tourism sector might suffer as a consequence. Having fewer cars will also translate to smaller range of access to the available jobs within one country. Not being able to afford a car, a potential financial consultant living 20 kilometres away from the financial centre might instead of working at the centre and making full use of her capacity, instead work for a small local bank. The job market can face a shortage due to the distance barrier. Of course, I am exaggerating the effect to make it more visible to you, but note that, the true ramification, small effects combined, can actually make a bigger problem than one could have thought.

The argument against this idea is though, that in the real world, economists really do not have full knowledge of what all the necessary and sufficient conditions are for our economy to perform at its fullest. Thus, any attempt to break down or tax the monopoly as mentioned might not be as bad as we make it sound theoretically. Of course, for economists, this is a mental exercise, and we do not normally think only of what we draw on the blackboard. There are many other factors, theories, and empirical findings to look at, and carefully studying them is a must when it comes to policy making.

I hope you enjoy reading and learning from Economind. Until our next post.