Who is a first-best economist?

The gut instinct…is to apply a simple supply-demand framework to the question at hand. In this world, every tax has an economic deadweight loss, every restriction on individual behavior reduces the size of the economic pie, distribution and efficiency can be neatly separated, market failures are presumed non-existent unless proved otherwise (and to be addressed only by the appropriate Pigovian tax or subsidy), people are rational and forward-looking to the first order of approximation, demand curves always slope down (and supply curves up), and general-equilibrium interactions do not overturn partial-equilibrium logic.  The First Fundamental Theorem of Welfare Economics is proof that unfettered markets work best.  No matter how technical, complex, and full of surprises these economists’ own research might be, their take on the issues of the day are driven by a straightforward, almost knee-jerk logic.

The second group — "second best" economists — is Akerlof, Stiglitz, Shiller, Krugman, and Rodrik himself; I believe you know their approach.

I think of myself as a better-than-first-best economist.  On average market solutions have positive Pareto-relevant externalities, if only through supplying experimentation and strengthening social norms in favor of commerce.  That’s true even for the market in thumbtacks, if you consider it as feeding into a broader social stream.  Externalities are virtually everywhere and often I prefer to think in terms of Hayek’s theory of spontaneous order.  Where markets should be allowed to operate, markets are usually too weak in their reach and scope.  Yes there is a continuum of social returns but only rarely are we close to an optimum. 

But I don’t mean this as a plea for laissez-faire.  Governments must produce public goods, maintain social order, and of course support markets.  At the margin, those activities, such as imposing accountability under the law, are also largely underprovided.  For the appropriate selection of policies, government is also better-than-first-best, despite its apparent static inefficiencies.

An oversimplified version of my view is that anything good is underprovided at the margin.  This follows from a belief in strong network and peer effects, and a belief in the relevance of basic sociology.

I favor much less government than Akerlof or Stiglitz or Rodrik himself; yes I view them as "second best" when it comes to government just as they are second best when it comes to markets.  But I’m often 4th or 5th best when it comes to what government does.

Who’s really the utopian?  And how did government ever work itself up to that number two?


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