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Kaldor Hicks Compensation Criteria

 Compensation Criteria

            The compensation criteria also known as the New Welfare Economics have been formulated by Hicks, Kaldor and Scitovsky. Accepting Pareto’s ordinal measurement of utility and the impossibility of its interpersonal comparisons, they tried to show that social welfare could be increased without making value judgements.

The Kaldor – Hicks Criterion

Postulations

The compensation criterion of Kaldor – Hicks is based on the following:

  1. Each individual’s satisfactions are independent from the others so that he is the best judge of his welfare.
  1. There is the absence of external effects in production and consumption.
  1. The tastes of each individual are constant.
  1. It is possible to separate the problems of production and exchange from the problem of distribution.
  1. It is assumed that utility is measured ordinarily and interpersonal comparisons are impossible.

Explanation

            According to Kaldor, the test of increase in social welfare is that if some people are made better off and others worse off, the gainers from the change could more than compensate the losers and yet be better off themselves. The actual payment of compensation is regarded as a political or ethical decision.

            Kaldor does not require that the losers should actually be compensated. Rather he requires that the gainers should be able potentially to compensate the losers out of their gains. Hicks presents the same criterion in a little different way thus: “If A is made so much better off by the change that he could compensate B for his loss, and still have something left over, then the reorganisation is unequivocal improvement. “

            Thus the Kaldor Hicks criterion implies that if an economic change leads to the production of more goods and services they can be so distributed as to make some people better off and none worse off. Actual redistribution being a political or ethical issue, need not take place. It is enough that reorganisations create such conditions that redistribution can be effected.

            This criterion is illustrated with the help of utility possibility curves for two individuals. If A and B are two individuals, each utility possibility curve represents the locus of all combinations of their utility levels. Each curve is related to a given fixed bundle of goods and the various points on each curve are obtained by costless lump sum redistribution of a fixed commodity bundle.

            Let X and Y be the two bundles of goods represented by the utility possibility curves B1A1 and B2A2 respectively as utility possibility shown in the below diagram. Starting from a given bundle of goods represented by Q2 in terms of the Paretian criterion any change which leads to a movement to any one of the points C,D and E is a Pareto improvement on the B1A1 curve because it makes both individuals better off or atleast one better off without making the other worse off. But any movement outside C and E to Q1 cannot be evaluated by the Paretian criterion for the reason that it improves A’s welfare at the expense of B. Nevertheless, a move from Q2 to Q1 can be evaluated in terms of the Kaldor-Hicks criterion.

            This can be done by (i) asking B how much he would be willing to pay A to prevent this move and (ii) asking A how much he would be willing to pay to B to forgo it. If (ii) > (i), the change increases welfare for the reason that A would potentially compensate B for his loss and still be better off at Q1 than at Q2.

                                   

            A simple test for an improvement of welfare according to the Kaldor-Hicks criterion is that the initial bundle should lie below the utility possibility curve representing the new bundle. Thus a move from Q2 to Q1 satisfies the Kaldor – Hicks criterion for the reason that Q2 lies below the utility possibility curve B1 A1 of the final bundle Q1.

To present it differently, a move to Q1 can be contemplated to generate the point D on the same utility possibility curve B1A1 which is unambiguously better than Q2. After compensation one can move from D to Q1.

Criticisms

  1. Ignores Income Distribution – The Kaldor Hicks compensation principle, according to Dr. Little, is merely a definition and not a “test” of increase in welfare for the reason that it ignores income distribution. In fact, the problem of distribution cannot be ignored where the problem of productive efficiency is involved. To say that one ‘bundle of goods’ is greater than the order is meaningless without reference to income distribution. For any comparison between two bundles of goods involves their money values at their market prices.
  1. No universal Validity – Scitovsky has criticised Kaldor for the view that the state is fully responsible for maintaining an equitable distribution of income. If there is unequal income distribution in a community, it is corrected as a matter of course by the state through a system of compensations.
  1. According to Scitovsky, “This is likely to be the case in a socialist economy.” But in a free enterprise economy, the effects of a certain economic reorganisations on efficiency and equity cannot be separated for the reason that compensation payments are not feasible politically. Thus the Kaldor Hicks criterion has no universal validity, according to Scitovsky.

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