Updated: Aug 20, 2021

A situation in which a policy-maker is subject to one or more constraints in addition to those relating to technology and endowments. When a policy-maker is constrained only by technology and endowments a first-best outcome can be achieved which satisfies the full set of efficiency conditions for the economy. If there are additional constraints, such as asymmetric information or unavoidable monopoly power, the situation is one of second-best. The Lipsey-Lancaster theory of second-best shows how to choose policies optimally in these circumstances. The key result of the theory is that if there is even only one efficiency condition that cannot be satisfied it may be optimal to choose an allocation that satisfies none of the efficiency conditions. In other words, if there is a distortion away from efficiency in one market it may be optimal to counter this by offsetting distortions in all other markets. The policy implication is that piecemeal satisfaction of efficiency conditions is not generally an optimal policy.

Reference: Oxford Press Dictonary of Economics, 5th edt.

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James Knight
Editor of Education
James is the Editor of Education for Invezz, where he covers topics from across the financial world, from the stock market, to cryptocurrency, to macroeconomic markets.... read more.