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The General Theory of Second Best

February 28, 2010

One of the most powerful tools that has ever been handed to leftists as far as economics goes is Lipsey and Lancaster’s “General Theory of Second Best” (1956!). Unfortunately, this leverage remains unused by leftists, and they continue making poor compromises. Like one that Robert Reich points out in his article today (please dismiss all of the wrong-headed things about other aspects of the “Democratic base’s” desires, the rest of the article is mostly sloganeering):

The environment went from the base’s desire for a carbon tax to a cap-and-trade carbon auction then to a cap-and-trade with all sorts of exemptions and offsets for the biggest polluters, and now Senate Dems are talking about trying to do it industry-by-industry.

This is a case where Democrats (and the Pigou club — which I would consider myself a member, if I was important enough to be noticed by Greg Mankiw) have it right, specifically due to the reality of the “theory of second best”; which states that in the event of a market failure which afflicts some markets greater than others, the second best policy is not to leave all other markets undistorted, but distort them with taxes or subsidies (taxes preferably). The thought is that it is often welfare enhancing to let market imperfections cancel eachother out rather than attempt to address them individually.

However, addressing things individually is exactly what the Democrats are doing with this compromise. Not only does this exponentially increase the complexity of dealing with the problem — it increases the chances of unintended consequences arising which, in a rational world, would require undoing the damage done by the previous policy, and redoing the regulation in a more efficient way…however, that is not how our politics work. In the real world, we will just pile new regulations on top of the old regulations in a continuous effort to deal with every unintended consequence individually…which adds more complexity, will inevitably result in a more densely-connected network, and make our economic system much more inefficient than it would otherwise be.

That is the end result…and it is not a favorable one. Not only are Democrats not getting what they want in the compromise; by compromising, they are making the economy much less efficient overall. They need to stand up and say that economic theory is on their side here!

Thus, we should start with the broad base of an economy-wide tax on carbon, and allow the market to allocate resources as it sees fit. Moving forward from there, you can adjust the tax rate to make carbon energy generation more or less attractive, but doing this along a broad base is exactly what the “theory of second best” prescribes…and moreover, it does not make us poorer, as industry-specific taxes and subsidies do.

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