The Theory of Second Best
This chapter focuses on several sources of market failure, including monopoly markets, externalities and public goods. These failures cause the market outcome to deviate from the efficient or surplus-maximizing outcome, reducing total surplus. The chapter shows that government intervention can address these market failures and increase welfare in the market. In some cases, markets may be affected by more than one source of market failure – for example, a market may be affected by more than one externality. The chapter discusses why, in the presence of multiple market failures, it may be preferable not to address a single market failure on its own. In some instances, markets may be affected by more than one market failure. The Theory of Second Best posits that if there is a market failure that not or cannot be corrected, actions to correct other market failures may have the effect of decreasing total surplus overall.