Economic policy
Kelvin Lancaster (1924–99)
Richard Lipsey (1928–)
1776 Adam Smith claims the “invisible hand” of the self-regulating market is superior to government intervention.
1932 British economist Arthur Pigou advocates the use of taxes to correct market failures.
1954 In Existence of an Equilibrium for a Competitive Economy, Gérard Debreu and Kenneth Arrow demonstrate that an entirely free market economy can maximize the welfare of its participants.
From 1970s Welfare economics is developed through the work of economists Joseph Stiglitz, Amartya Sen, and others.
Standard economic theory holds that where markets are available for all goods and services, and everybody using those markets is well-informed, the economy will be efficient. It is not possible to change the distribution of resources to make one person better off without making another person worse off, so society’s welfare is as good as it can be in a free market. The best available policy, according to the free-marketeers, is for government to remove imperfections in markets, bringing them as close as possible to the ideal.
There are, however, strict conditions before efficient policies can be achieved. In 1956, Australian economist Kelvin Lancaster and his Canadian colleague Richard Lipsey demonstrated that in some circumstances, policies aimed at improving market efficiency may make it worse overall. In a paper entitled The General Theory of Second Best, they looked at cases where a market imperfection was permanent—and where there was no way for a government to correct or remove it. There was no “first best” solution. In such cases government intervention elsewhere in the economy might worsen the effects of existing imperfections, pulling the market still further away from the ideal. Lancaster’s and Lipsey’s insight was that where an imperfection in one market cannot be removed, all the other markets will work around it. They will achieve a relatively efficient distribution of resources, given the existing imperfection.
Lancaster and Lipsey then went further: the best available policy option, when one distortion can be corrected but others cannot, may turn out to be the opposite of that demanded by theory. For instance, it might be better for government to distort a market further, if it wants to improve welfare overall. Ideal policies, then, cannot be guided by abstract principles alone. They have to be based on a thorough understanding of how markets operate together.
One classic example is that of a monopolist who pollutes a river during production. The pollution is both costly for society and an inevitable result of production. It cannot be removed from the process and is a permanent market imperfection. But the monopoly can be removed.
Standard economic theory would tell the government to break up the monopoly and introduce more competition to the markets. This would drag the economy closer to the efficient ideal. But competing producers would produce more than a single producer, and also worsen the pollution. The result for society’s welfare as a whole is uncertain. People might gain from increased output and lower costs, but they would lose out from more pollution. The “second best” solution might be to leave the monopoly in place.
The theory of the second best remains critical to economic policy, recommending that governments act with caution rather than attempting to achieve an ideal.
A Canadian economist born in 1928, Richard Lipsey is best known for the theory of the second best, formulated with Kelvin Lancaster. He is emeritus professor at Simon Fraser University, Canada, having taught in the US and the UK. In 1968, his defense of the Phillips Curve against the criticism of Milton Friedman formed one of the great debates in economics. Lipsey is the author of a standard textbook in economic theory, Positive Economics, and recently has helped develop evolutionary economics, co-authoring an influential book on the processes of historical change.
1956 The General Theory of the Second Best (with Kelvin Lancaster)
2006 Economic Transformations: General-Purpose Technologies and Long-Term Economic Growth (with K. Carlaw, C. Bekar)
See also: Free market economics • Economic equilibrium • External costs