Theory of the second best

Statement

The theory of the second best states that if one or more of the optimality conditions necessary for an economic model is not satisfied, the optimal values of the other variables may be different from their optimal values assuming that all optimal conditions are satisfied.

Typical application to correcting market failures

Applied to the context of market failure, it says that in the presence of one uncorrectable market failure, it may well be the case that it is better to not correct the other (correctable) market failures. In particular:

• In an optimal world where there are no uncorrectable market failures, it makes sense to fix all market failures and achieve the optimal outcome.
• If, however, market failure $A$ is uncorrectable while market failure $B$ is correctable, it may make sense to not fix market failure $B$, because the uncorrectability of $A$ creates a "failure of optimality" that alters the optimal value. In particular, it may so happen that correcting failure $B$ exacerbates the problems associated with failure $A$ in a manner that offsets the direct gains from correcting $B$.

Note that the theory only says that it may be the case that market failure $B$ should not be corrected. It does not mean that it is always the case. Rather, each situation needs to be looked at individually to determine whether correcting market failures is optimal in the presence of other uncorrectable market failures.