Second-Best Theory: Ageing well at Sixty

We summarize the evolution of the theory of second best since the original contribution of Richard Lipsey and Kelvin Lancaster. Early studies investigated the optimality of piecemeal first-best policy in controlled sectors when distortions exist elsewhere. The applied welfare economics approach of Arnold Harberger and its embodiment in cost-benefit analysis incorporated second-best analysis into the evaluation of public programs. Modern second-best analysis emphasizes policy-making in a distorted economy where distortions reflect either constraints on government policy instruments or features of the economic environment such as limited government information. This is illustrated using optimal commodity and income taxation and its refinements to intertemporal and uncertain settings. Second-best analysis is a defining feature of modern normative public economics.