A Unification of the Theory of Second Best
Stanford King Center on Global Development Working Paper
The received wisdom from the theory of second best is that the presence of distortions in some sectors of the economy would in general require intervention in other sectors as well. This paper offers a simple set of propositions which help unify the results of numerous papers involving the theory of second best, many of which appear to contradict this theory. The propositions identify how, in optimization problems in economics, pre-imposed quantitative restrictions enter differently from price restrictions. The implications of this difference for the conduct of second best optimum policies are also analyzed. In particular, the paper identifies and discusses the conditions under which the presence of distortions in some sectors does not undermine the case for nonintervention in other markets.