73 Chi.-Kent L. Rev. 3 (1997-1998)
Second-Best Theory and Law & (and) Economics: An Introduction

handle is hein.journals/chknt73 and id is 21 raw text is: SECOND-BEST THEORY AND LAW & ECONOMICS:
According to The General Theory of Second Best,' if one or
more members of a set of optimal conditions cannot be fulfilled, there
is no general reason to believe that fulfilling (or more closely approxi-
mating) more of the remaining conditions will bring you closer to the
optimum than fulfilling fewer of the remaining conditions. Second-
Best Theory has startling implications for law-and-economics analysis.
Most importantly, it undermines the standard law-and-economics as-
sumption that any policy or choice that reduces the number or magni-
tude of the Pareto imperfections2 in the economy will on that account
increase allocative efficiency:3 because two Pareto imperfections
can counteract each other, one cannot assume without further argu-
* Lloyd M. Bentsen, Jr. Centennial Professor of Law, University of Texas Law School.
B.A., Cornell University (1963); Ph.D., London School of Economics (1966); LL.B., Yale Uni-
versity, (1968); M.A., Oxford University (1981).
1. For the first formal statement of The General Theory of Second Best (and the first use
of this name), see R.G. Lipsey & Kelvin Lancaster, The General Theory of Second Best, 24 REV.
ECON. STUD. 11 (1956).
2. Welfare economics delineates seven (arguably eight) conditions whose fulfillment guar-
antees Pareto optimality. The statement that an economy is Pareto optimal in the pure sense
indicates that, even if no transaction costs would have to be incurred to reallocate resources, it
would be impossible to reallocate resources in a way that would make somebody better off with-
out making anyone else worse off. The statement that the economy is Pareto optimal in the
impure and somewhat inaccurate sense in which I am using (and virtually all economists in prac-
tice use) this expression indicates that, even if no transaction costs would have to be incurred to
reallocate resources, it would be impossible to effectuate a reallocation that would give its bene-
ficiaries the equivalent of more dollars than it would take away from its victims. The Pareto-
optimal conditions are (1) no monopoly, (2) no monopsony, (3) no externalities, (4) no taxes on
the margin of income, (5) individual sovereignty, (6) no failures to maximize, and (7) no
problems caused by consumer surplus or its analogues (usually misdescribed as no public
goods). The eighth arguable condition is that no transaction costs need be incurred to fulfill the
other seven conditions. This Article uses the expression Pareto imperfection to refer to any
departure from one of the basic seven Pareto-optimal conditions.
3. I substitute allocative-efficiency analysis for the standard term economic-efficiency
analysis to remind readers that the concept is a technical term and that one cannot assume that
choices that increase allocative efficiency are either desirable from any legitimate personal-ulti-
mate-value perspective or consistent with our rights-commitments. In any event, in my terminol-
ogy, a choice is said to increase or decrease allocative efficiency if the equivalent-dollar gains it
confers on its beneficiaries exceed the equivalent-dollar losses it imposes on its victims. For a
critique of the standard economic definition and use of the concept of the effect of a choice on
allocative efficiency, see Richard S. Markovits, A Constructive Critique of the Traditional Defini-
tion and Use of the Concept of the Effect of a Choice on Allocative (Economic) Efficiency: Why
the Kaldor-Hicks Test, the Coase Theorem, and Virtually All Law-and-Economics Welfare Argu-
ments Are Wrong, 1993 U. ILL. L. REV. 485 [hereinafter Markovits, Constructive Critique].

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