Two Distortion-Analysis Approaches to Economic-Efficiency Analysis: A Third-Best-Economically-Efficient Response to the General Theory of Second Best

Abstract:     
The General Theory of Second Best argues that, since in general a Pareto imperfection that can be eliminated will be as likely to counteract as to compound the net effects of the other Pareto imperfections in the relevant economy, (1) there is no general reason to believe that policies that decrease the Pareto-imperfectness of an economy without making it Pareto perfect will even tend on that account to increase economic efficiency and (2) to predict the economic efficiency of a policy one will have to (put crudely) (A) identify the various categories of economic inefficiency the policy will affect, (B) determine the respective ways in which the economy's various types of Pareto imperfections interact to cause each of these types of economic inefficiency, (C) estimate the incidence of the various types of Pareto imperfections in the economy pre-policy, and (D) predict the impact of the policy on these Pareto imperfections.

Economists and Law & Economics scholars pay almost no attention to The General Theory of Second Best - i.e., almost always assume that any tendency a policy has to decrease the Pareto-imperfectness of an economy will cause it to increase economic efficiency. Many economists who admit to being aware of The General of Second Best try to justify ignoring it by claiming that it implies the impossibility or economic inefficiency of providing reliable estimates of the economic efficiency of any policy.

This Article attacks the premise of this (invalid) justification for ignoring Second-Best Theory by delineating two "distortion-analysis" protocols for predicting or post-dicting the effect of a policy on economic efficiency that (it maintains) are third-best allocatively efficient - i.e., would be economically efficient to use if policy decisions were based on the conclusions the protocols generated even given that the policies to be scrutinized will leave the economy highly-Pareto-imperfect, many types of economic inefficiency must be distinguished, analysis is costly, and data is inevitably costly and imperfect. The protocols in question are called distortion-analysis protocols because they derive their economic-efficiency conclusions from the predicted impact of the policy in question on the "distortion" in the profits yielded by the marginal exemplars of each category of resource allocation the policy will affect that is analytically useful to distinguish - i.e., on the difference between those profits and the economic efficiency of the resource allocations in question.

Working Paper Series