Theory of Third Best: How to Interpret and Apply

Abstract

AbstractSix decades after the formulation of his (Lipsey & Lancaster, ) celebrated general theory of the second best, Richard Lipsey has written on the important issue of second‐best and third‐best theories. In particular, he criticizes the theory of third best (see Section 3 below). This paper explains our agreements and differences and reaches the following conclusions. First, several arguments provided do not invalidate the theory of third best, at least if correctly interpreted and applied. We may have useful piecemeal welfare policies after all, if appropriately used. Second, I did not and do not attempt to refute the general result of second‐best theory; both the second‐best and third‐best theories remain valid, if properly interpreted. Third, the usefulness of some general results (properly interpreted and used) and the importance of additional information (if available) on specific context need not be an either–or choice (Section 1). Finally, the third‐best theory is not completely non‐context specific; the distinction between cases of Informational Poverty and Scarcity itself depends on the context. However, it also provides some general guides useful for making piecemeal policies in different contexts (Sections 3 and 4).