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Second best, theory of

An area of economics concerned with the analysis of situations in which perfect competition does not prevail throughout the economy or in which, for same reason, the state of the economy which would result from a perfectly competitive equilibrium cannot be achieved by the market system. The most important proposition of the theory is that if same part of the economy does not attain the perfectly competitive equilibrium position, e.g. because of monopoly, it need not be optimal for any other sector of the economy to attain that position. Rather, optimality may require that the other sectors of the economy adopt positions which diverge from the perfectly competitive one. This apparently rather abstract pro­position, first advanced by R. G. Lipsey and K. Lancaster, has in fact very important implications for such subjects as the pricing of nationalized industry outputs and optimum tariff policies in international trade. For example, it may imply that nationalized industries should not adopt marginal cost pricing or that free trade is not an optimum policy.

Reference: The Penguin Dictionary of Economics, 3rd edt.