Towards a Theory of Third‐Best

Abstract

AbstractThe theory of second best (Lipsey & Lancaster ) shows that the presence of irremovable distortions renders the second‐best conditions exceedingly complicated; by satisfying some optimality conditions, an improvement is not ensured. However, the complicated second‐best rules are neither optimal nor feasible if informational and administrative costs are taken into account. The simple first‐best rules are the optimal feasible in an important class of situations (Informational Poverty), implying that analyses based on first‐best assumptions are still relevant for practical policy‐making. This is so because, with a reasonable concavity assumption, staying with the first‐best rules maximises expected benefit. With more (but not perfect) information, third‐best policies are appropriate. Some informal illustrative applications of this third‐best theory are provided. In particular, average‐cost pricing for public utilities may not be far from the third‐best optimum and the necessity to raise government revenue through non‐lump‐sum taxes need not impose any real distortion.