First, Second or Third Best?

In Chapter 2 we discussed the necessary conditions for Pareto optimality and how these conditions could be fulfilled. A factor that makes fulfilment of the necessary conditions difficult in a market economy is monopolistic power, which is quite impossible to eliminate in the presence of the increasing returns to scale and product differentiation that are characteristic of many sectors of the economy. The presence of external effects (Chapter 7) makes things even more complicated. In principle there may exist a tax/ subsidy system that enables all the necessary conditions to be fulfilled and a first-best Pareto optimum achieved. But this may not be politically or institutionally feasible. (In the presence of ‘non-amenable’ externalities, the first best is inherently impossible to achieve, even abstracting from the problems of political feasibility, costs and information. Non-amenable externalities include those external effects, such as social interaction, which change their character once tax/subsidy, regulation, bargaining and so on are introduced to internalise the effects. See Ng, 1975d.) If the necessary conditions cannot be satisfied for some sectors of the economy for one reason or another, what is the best we can do for the rest of the economy? This is the problem of second best.