second-best

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second-best

adj. (of an economy) departing from an optimal pattern of resource allocation (see PARETO OPTIMALITY) because, for example, of MONOPOLY distortions and EXTERNALITIES.

If the production of a product such as a chemical leads to environmental POLLUTION, then the marginal SOCIAL COST of producing that output will exceed the marginal PRIVATE COST, and the economy will depart from an optimal pattern of resource allocation. In this ‘second-best’ situation, the government can improve matters by imposing a ‘pollution tax’ on offending chemical firms. This will, on the one hand, provide an incentive for the firms to adopt less polluting production processes and, on the other hand, to the extent that the tax is passed on to chemical buyers, will force buyers to pay the full social costs of the products they consume. See WELFARE ECONOMICS.

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