Theory of the Second Best

Origins and the general theorem

Viner (1950) showed that a customs union, even though it removes tariffs among members, can reduce welfare through trade diversion, which replaces efficient imports from non-members with imports from members. Meade (1955) treated such cases in a broader framework. Lipsey and Lancaster (1956) generalized the insight, proving that if a constraint prevents one Pareto condition from being met, the best attainable state, the second best, will in general require the other conditions to depart from their optimal values as well. In other words, when a distortion remains in one market, piecemeal reform that removes distortions elsewhere one by one cannot be guaranteed to raise welfare.

Applications to taxation and pricing

Second-best reasoning connects to central results in public economics. Ramsey (1927) showed that when a given revenue must be raised, higher tax rates on goods with inelastic demand cause less efficiency loss than uniform rates, which is a second-best problem of finding the optimal pattern of distortions when some distortion is unavoidable. Boiteux (1956) applied the same logic to pricing by public enterprises subject to a budget-balance constraint. Diamond and Mirrlees (1971) proved an important exception: under suitable conditions, production efficiency should still be maintained even in a second-best setting. Bhagwati (1971) set out a general treatment of distortions and policy ranking in trade theory.

Critiques, extensions and modern implications

Davis and Whinston (1965) showed that piecemeal reform can still be meaningful when sectors of the economy are separable. Ng (1977) proposed a theory of third best, noting that information and administrative costs make even second-best policies hard to implement. Hammond (1990) addressed the issue in assessing theoretical progress in public economics, and Lipsey (2007) reflected on the theorem's significance at its fiftieth anniversary. Rodrik (2008) argued that in developing countries second-best institutions that take existing distortions into account may work better than transplanted institutions from advanced economies. Dixit (1985) systematized the principle for tax policy in open economies. Together with public choice theory, these ideas form a basic framework for policy evaluation.

FAQ

What is the theory of the second best in simple terms?

When the ideal outcome cannot be reached, meeting more of the ideal conditions one at a time does not necessarily lead to a better result.

What is a classic example?

Viner's analysis showing that a customs union can lower welfare through trade diversion even though it removes some tariffs.

Sources reviewed: 2026-10-26

References

1. Lipsey, R. G., & Lancaster, K. (1956). The general theory of second best. Review of Economic Studies, 24(1), 11–32.
2. Meade, J. E. (1955). Trade and Welfare. London: Oxford University Press.
3. Viner, J. (1950). The Customs Union Issue. New York: Carnegie Endowment for International Peace.
4. Ramsey, F. P. (1927). A contribution to the theory of taxation. Economic Journal, 37(145), 47–61.
5. Davis, O. A., & Whinston, A. B. (1965). Welfare economics and the theory of second best. Review of Economic Studies, 32(1), 1–14.
6. Diamond, P. A., & Mirrlees, J. A. (1971). Optimal taxation and public production I: Production efficiency. American Economic Review, 61(1), 8–27.
7. Boiteux, M. (1956). Sur la gestion des monopoles publics astreints à l'équilibre budgétaire. Econometrica, 24(1), 22–40.
8. Bhagwati, J. N. (1971). The generalized theory of distortions and welfare. In J. Bhagwati et al. (Eds.), Trade, Balance of Payments and Growth (pp. 69–90). Amsterdam: North-Holland.
9. Ng, Y.-K. (1977). Towards a theory of third-best. Public Finance, 32(1), 1–15.
10. Hammond, P. J. (1990). Theoretical progress in public economics: A provocative assessment. Oxford Economic Papers, 42(1), 6–33.
11. Lipsey, R. G. (2007). Reflections on the general theory of second best at its golden jubilee. International Tax and Public Finance, 14(4), 349–364.
12. Rodrik, D. (2008). Second-best institutions. American Economic Review, 98(2), 100–104.
13. Dixit, A. (1985). Tax policy in open economies. In A. Auerbach & M. Feldstein (Eds.), Handbook of Public Economics (Vol. 1, pp. 313–374). Amsterdam: North-Holland.