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View all search resultsSecond best policy and the danger of doing too much
When the government tends to do something rather than do nothing, we must be more cautious about the dangers of doing too much.
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A buyer pays his bill using Quick Response Indonesia Standard (QRIS) code on Feb. 6, 2021 at a street food stall on Jl. Ampera Raya in South Jakarta. (Antara/Reno Esnir)
N
owadays, it is all too common in public discourse to hear that policymakers can never have the luxury of adopting the first-best policy but the second or even the third-best policy. In our political realm, the chosen government policy is driven by a political agenda that leaves no room for public debate over its effectiveness, let alone for alternative policies.
Before discussing policy, let me explain the ideal economic state that one economy needs to achieve: the general equilibrium in perfect markets. It is where there are no imperfections or distortions that create inefficiencies in the market. The first fundamental theory of welfare economics states that any, perfectly competitive equilibrium is efficient, which in laymen terms mean that goods and services match consumers’ preferences and are produced at the lowest possible cost. In this equilibrium, there is no need for government intervention.
Nevertheless, as we do not live in the first-best world, our market is not flawless. The market has imperfections and can fail to work. When the market fails, the government intervenes to correct it. In theory, this is called the first-best policy because it directly removes market distortions. One question arises though, what should the government do when market distortion cannot be removed? Is doing nothing an option?
In 1956, economists Richard Lipsey and Kelvin Lancaster argued for having the second-best policy. Their general theory of second-best states that it is preferable to introduce a new distortion, in other related markets, to counteract the existing ones, leading to a better overall outcome than doing nothing. Both the first- and second-best policies have a policy spectrum that encompasses all alternatives to be evaluated based on their effectiveness and efficiency.
Still, there has been a long-standing debate among economists over whether the second-best policy is necessary. They promote the government to do nothing, even in cases where market distortions are correctable. These economists argue that if markets can fail, so can governments. If the government fails to correct a market failure, the cost of government failure would exceed the cost of market failure. Why?
In principle, government failure can take two forms. In one, the first-best intervention is ineffective at removing market distortion or the second-best intervention fails to neutralize it. With the other form of government failure, the second-best intervention is excessive, leading to a heavily distorted market. The cost of both failures will exceed the initial cost of market distortion, as they incur intervention costs plus additional distortion costs for the second.
So, the issue is not the policy per se, but whether the government has the capacity to design a policy with the appropriate degree of intervention to neutralize market failures. When the government tends to do something rather than do nothing, we must be more cautious about the dangers of doing too much: the remedy is worse than the disease.
