First-best in public, second-best in private

In a recent post, Dani Rodrik divides economists into first-best economists and second-best economists. Put simply, the former apply straightforward economic reasoning; the latter think more about market imperfections. To be precise:

You can tell what kind of an economist someone is by the nature of the response s/he offers when confronted with a policy issue. The gut instinct of the members of the first group is to apply a simple supply-demand framework to the question at hand. In this world, every tax has an economic deadweight loss, every restriction on individual behavior reduces the size of the economic pie, distribution and efficiency can be neatly separated, market failures are presumed non-existent unless proved otherwise (and to be addressed only by the appropriate Pigovian tax or subsidy), people are rational and forward-looking to the first order of approximation, demand curves always slope down (and supply curves up), and general-equilibrium interactions do not overturn partial-equilibrium logic.  The First Fundamental Theorem of Welfare Economics is proof that unfettered markets work best.  No matter how technical, complex, and full of surprises these economists’ own research might be, their take on the issues of the day are driven by a straightforward, almost knee-jerk logic.

Those in the second group are inclined to see all kinds of complications, which make the textbook answers inappropriate. In their world, the economy is full of market imperfections (going well beyond environmental spillovers), distribution and efficiency cannot be neatly separated, people do not always behave rationally and they over-discount the future, some otherwise undesirable policy interventions can generate positive outcomes, and general-equilibrium complications render partial-equilibrium reasoning suspect.

Reader Llewelyn Hughes emailed me, saying that he was pretty sure I’d be a second-best economist. Actually, I’m not so sure. In an academic seminar, that’s probably right. But in most Australian public policy debates, it seems to me that straightforward economic thinking often has a lot to offer. For example, thinking about water supply and skills shortages without considering prices has led our policymakers to some pretty silly places. There are certainly market imperfections here, but to get to them, you have to first pass through Econ 101. Or take the Baby Bonus. Simple economic theory suggests that unless you can identify credit constraints for parents or a positive externality of children, it’s hard to justify the policy.

In Australia, business economists are almost always in the ‘first best’ mould. In the ozeconblogosphere, I’d class Jason Soon, Joshua Gans and Harry Clarke as first-besters, and Nicholas Gruen, Fred Argy and Paul Frijters as examples of second-besters. IMHO, John Quiggin has played both roles. On economic reform in the 1990s, he was very much a second-best economist. On what to do about water policy today, he’s more of a first-best economist.

[See also Tyler Cowen’s views.]

Update: Joshua Gans puts himself in the second-best camp.

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7 Responses to First-best in public, second-best in private

  1. Pingback: CoreEcon » Blog Archive » One and three quarters best

  2. Damien Eldridge says:

    Are business economists really economists? If you mean the people from the financial institutions who always seem to get interviewed on televeision news programs, I’d say they are neither type. In fact, they are not really economists. As to my type, I am probably both. At different times and on different issues, I fall into different camps.

  3. Verdurous says:

    Andrew,

    Please tell me you’re not a first-bester !

    We need to talk.

  4. hc says:

    I would strongly claim to be a second-bester. That doesn’t sound flattering but it is true. In fact, I find the description ‘first-bester’ something I don’t like as it sounds to me naive.

    The first theorem is wrong because the economy has multiple distortions so Lipsey-Lancaster ‘second-best’ optimisations are essential – piecemeal reforms don’t work. I have recently looked at congestion pricing and waste disposal issues from this perspective. I also think first-best immigration reforms are ridiculous given the existence of public goods and unpriced externalities.

    Its the second theorem which suggests efficiency and equity can be separated. This is logically unsound since lump-sum transfers are required to do this. Another dimension of complications is therefore that the standard tax transfer mechanism will have adverse incentive effects that one needs to account for.

    Professor Yew Kwang Ng at Monash is one of the best ‘first-besters’ I know.

    For me first-best solutions are a starting point for analysis – not for the most part sensible policies.

  5. lh says:

    Andrew, I think the point is not that someone is a second-bester unless they are willing to use economic theory to analyze a problem. Rodrik I’m sure would not argue against the proposition that “straightforward economic thinking often has a lot to offer.”

    The point is whether one is willing to advocate policy based on “straightforward economic thinking” alone, or whether one recognizes that market imperfections and/or faulty assumptions can lead to unintended outcomes that must be taken into consideration when designing policy.

    As an aside, advocating the use of experiments to test policy outcomes seems to me to be a second-bester strategy. The work of Aberjit and Dupree on development does this; they do a lot or expensive testing of developmental policies in India and other places because it enables them to black box the messy institutional stuff that can make things go awry. (i.e. “We don’t know why World Bank programs fail, so why don’t we just find out what actually works for a change.”) Similarly with differentiated teacher pay: a first-bester would advocate policy change based on the assumption that individuals are wealth maximizers. A second-bester would say “yes, but hard-to-measure and unintended effects might nevertheless send things south, so let’s run an experiment and actually see what happens before we implement it.”

  6. Rajat Sood says:

    Isn’t it inherent in the second-best camp’s thinking that government can improve on market outcomes in these cases – ie a relative lack of concern about government failure? I am not an academic economist, but can I still imagine many instances where straightforward (first-best) demand and supply reasoning would fall short of providing a clear understanding of a problem. (For example, why do people maintain debts at credit card interest rates?) But I would nevertheless tend to put forward policy responses based on first-best thinking because, in my experience, governments are not very good at ‘correcting’ for market failures even where there is the theoretical potential for them to do so. Would that view possibly also explain your mixed status, Andrew?

  7. E.D. says:

    “For example, thinking about water supply and skills shortages without considering prices has led our policymakers to some pretty silly places.”

    I’d be interested in an elaboration on the above point with particular reference to skills shortages.

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