The Theory of the 2nd-Best

by Steven Suranovic ©1997-2004

Trade 120-5b  





One of the more compelling counter-arguments to potentially welfare-improving trade policies relies on the theory of the 2nd-best. This theory shows that when private markets have market imperfections or distortions present, it is possible to add another (carefully designed) distortion, such as a trade policy, and improve economic efficiency both domestically and worldwide. The reason for this outcome is that the second distortion can correct the inefficiencies of the first distortion by more than the inefficiencies caused by the imposed policy. In economist's jargon, the original distorted economy is at a 2nd-best equilibrium. In this case, the optimal trade policy derived for an undistorted economy (most likely free trade) no longer remains optimal. In other words, policies that would reduce national welfare in the absence of distortions can now improve welfare when there are other distortions present.

This argument, then, begins by accepting that trade policies (protection) can be welfare improving. The problem with using trade policies, however, is that in most instances they are a 2nd-best policy choice. In other words there will likely be another policy - a domestic policy - that could improve national welfare at a lower cost than any trade policy. The domestic policy that dominates would be called a 1st-best policy. The general rule used to identify 1st-best policies is to use that policy which "most directly" attacks the market imperfection or distortion. It turns out that these are generally domestic production, consumption or factor taxes or subsidies rather than trade policies. The only exceptions occur when a country is large in international markets or when trade goods affect the provision of a public good such as national security.

Thus the counter-argument to selected protection based on the theory of the 2nd-best is that 1st-best rather than 2nd-best policies should be chosen to correct market imperfections or distortions.

Since trade policies are generally 2nd-best while purely domestic policies are generally 1st-best, governments should not use trade policies to correct market imperfections or distortions. Note that this argument does not contend that distortions or imperfections do not exist, nor does it assume that trade policies could not improve economic efficiency in their presence. Instead the argument contends that governments should use the most efficient (least costly) method to reduce inefficiencies caused by the distortions or imperfections, and this is unlikely to be a trade policy.

Note that this counter-argument to protection is also effective when the issue is income distribution. Recall that one reason countries may use trade policies is to achieve a more satisfying income distribution (or to avoid an unsatisfactory distribution). However, it is unlikely that trade policies would be the most effective method to eliminate the problem of an unsatisfactory income distribution. Instead there will likely be a purely domestic policy that could improve income distribution more efficiently.

In the cases where trade policy is 1st-best, as when a country is large in international markets, this argument does not act as a counter-argument to protection. However, retaliation remains a valid counter-argument in many of these instances.

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International Trade Theory and Policy Lecture Notes: ©1997-2004 Steven M. Suranovic
Last Updated on 7/19/97