Policy Distortions and Derived Externalities

incentives for farmers to produce food (rather than export cash crops), and food production fell, actually making it more difficult to feed the poor. In another example, policies to encourage food production have sometimes included subsidies on fertilizer and chemicals, which in turn has led to overuse and worsened water pollution problems. Cheap coal in China and below-cost timber sales in the United States and many other countries are examples that show that one policy goal can be promoted at the expense of others. When these kinds of policies are recognized to be both inefficient and unjustified, abolishing them can create a "win-win" opportunity by eliminating two inefficiencies.

A somewhat related problem is one that economists call the theory of second best.2 This is a bit more subtle and not necessarily obvious. The basic idea is that in a world with two or more market failures (a "second-best" world), correcting one market failure could actually make society worse off. Free trade is an obvious example that was discussed in chapter 8. Opening an economy to trade should produce benefits owing to the gains from trade and market efficiency. But removing trade barriers may be welfare reducing if there are uncorrected externalities or insecure property rights in the domestic economy.

A fourth type of policy failure is rent seeking. Rent seeking refers to actions like lobbying to gain advantage through government action. A monopoly created or protected by government action is one example. Other examples include tariffs or import licenses that give certain individuals or groups benefits at the expense of others.

2Richard G. Lipsey and Kelvin Lancaster, "The General Theory of Second Best, " Review of Economic Studies 24 (1956): 11-32.

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  • ashleigh
    What are derived externalities?
    9 years ago

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