This theory says that when a PureMarket? economy does not exist (as it never can), further impurities in the market must be introduced to make the resultant system nearly optimal. For instance, the EconomyOfScale? that allows monopolies to form, plus the "Old Boys Club," and other impurities will imbalance competition. This is normally termed AntiTrust?.
Most people assume that by making the economy as nearly pure as it can, one will achieve nearly the benefits of a pure market. But the Theory totally refutes this. After all, as the economy is a chaotic system, small inefficiencies can easily stockpile into great imbalances.
This theory opposes the FirstFundamentalTheoremOfWelfareEconomics? by denying the fundamental assumptions that
Deny has bad connotations, but it deals with the more realistic case when all of those assumptions are true to varying degrees. For instance, FreeSoftware refutes the first bullet, monopolies refute the second, your boss refutes the third, and banks refute the fourth (although as InformationWantsToBeFree, it is more true online than anywhere else). The PureMarket? is only an approximation to reality, just like physicists use a frictionless plane or a spherical mass as an approximation to reality to simplify their calculations.
According to Lipsey in "What economists don't want you to know", ThisMagazine? (March-April 2001), there were "about 200 articles published trying to refute it. But in the end, they couldn't refute it, so they just decided to ignore it." Professor Gordon Anderson, who teaches economics at the University of Toronto, goes on to confirm this attitude. He says the theory is depressing as it is "essentially a theorem about how useless economics is." Then again, he points out that in France they still teach the theory.
Nonetheless, the theory is not a license to whinge about what is wrong with the economy. All it shows is that small imperfections quickly lead to imbalances. However, countermeasures not chosen well are also imperfections. The theory only goes so far as to say that it's impossible to generalize in any simple way from economic models.
For a detailed exposition with examples, see http://internationalecon.com/v1.0/ch100/100c030.html
See also SocialCapitalism.
The chief application of the TheoryOfSecondBest to OnlineCommunity is recognizing that small changes to the system can lead to dramatic changes in the community. Consider the KarmaCap. It's not a good idea to willy nilly whinge around with the code of a live site. -- SunirShah