Some Thoughts on Law and Economics and the Theory of Second Best

Abstract

This paper addresses the implications of the Theory of the Second Best for law and economics scholarship. The theory of the second best is at once fascinating and paralyzing. Fascinating because it so powerfully assaults much of modern economic theory; paralyzing in that it does not offer a clear replacement for what is purports to destroy. Dick Markovits, who has done so much to keep this important theory in the minds of law and economics scholars, gives an example that suggests the difficulty: a tort doctrine is implemented which compels manufacturers to pay the cost imposed by their discharge of pollutants into any body of water. At first blush, the policy change seems unambiguously good. Prior to the doctrinal change, manufacturers who dumped noxious chemicals and metals into bodies of water created "externalities", social costs that they imposed with impunity. As a result, a manufacturer would maximize profits by discharging pollutants whenever there was even the slightest benefit in so doing. In other words, instead of providing an incentive to promote the public good, the presence of large external costs in a market system encourages undeniably harmful activity. It would seem that eliminating this perverse incentive could only be beneficial, and, at least in the absence of the theory of the second best, this logic would be unassailable. But once the disruptive theory of the second best is introduced, all bets are off unless there happens to be no other distortion in the economy, a most unlikely event. The paper examines a variety of applications of the theory, including a paper by Fullerton and Metcalf that demonstrates that many scholars have been unduly optimistic in asserting that pollution taxes will yield the double dividend of a better environment and more tax revenues with less deadweight loss. In so doing, Fullerton and Metcalf have certainly diminished the prospect, advocated by some, that excess pollution taxes will be imposed to reduce the deadweight loss from distortionate labor taxes. Their paper also shows, however, that, as between the competing policies of the pollution tax or the pollution quota, the former is clearly preferable. Since Fullerton and Metcalf also demonstrate why business strongly prefers the quota to the tax, we may have our own ironic version of the second best in operation here. Three states of the world are plausible: 1) the overtaxation state that Fullerton and Metcalf attack; 2) the precise Pigovian tax rate that they presumably endorse; and 3) the command and control regulation (the undertaxation state) that business so strongly prefers. Since the pressures of special interests have clearly biased policy towards state (3), arguments in favor of position (1) might have corrected the political imbalance, thereby making position (2) more likely. Now that Fullerton and Metcalf have strongly denounced position (1), the counterbalance to the special interest bias towards state (3) is removed, making (3), the admittedly worst of the three outcomes, more likely than (2). This is clearly a frustrating aspect of the theory of the second best, because if the analysis of imperfections extends to political failures, then making truthful claims about the undesirability of certain policies may cause more harm than good. It is not hard to see why most academics shy away from this broad conception of the theory.