A Kaldor–Hicks improvement, named for
Nicholas Kaldor
Nicholas Kaldor, Baron Kaldor (12 May 1908 – 30 September 1986), born Káldor Miklós, was a Hungarian-born British economist. He developed the "compensation" criteria called Kaldor–Hicks efficiency for welfare spending, welfare comparisons ...
and
John Hicks
Sir John Richard Hicks (8 April 1904 – 20 May 1989) was a British economist. He is considered one of the most important and influential economists of the twentieth century. The most familiar of his many contributions in the field of economics ...
, is an economic re-allocation of resources among people that captures some of the intuitive appeal of a
Pareto improvement, but has less stringent criteria and is hence applicable to more circumstances. A re-allocation is a Kaldor–Hicks improvement if those that are made better off could
hypothetically compensate those that are made worse off and lead to a Pareto-improving outcome. The compensation does not actually have to occur (there is no presumption in favor of status-quo) and thus, a Kaldor–Hicks improvement can in fact leave some people worse off.
A situation is said to be Kaldor–Hicks efficient, or equivalently is said to satisfy the Kaldor–Hicks criterion, if no potential Kaldor–Hicks improvement from that situation exists. If an outcome is the highest it could possibly be, it is called a Hicks-optimal outcome. A Hicks optimal outcome is always Pareto efficient.
Explanation
A reallocation is said to be a
Pareto improvement if at least one person is made better off and nobody is made worse off. However, in practice, it is almost impossible to take any social action, such as a change in economic policy, without making at least one person worse off. Even voluntary exchanges may not be Pareto improving if they make third parties worse off.
Using the criterion for Kaldor–Hicks improvement, an outcome is an improvement if those that are made better off could in principle compensate those that are made worse off, so that a Pareto improving outcome ''could'' (though does not have to) be achieved. For example, a voluntary exchange that creates pollution would be a ''Kaldor–Hicks improvement'' if the buyers and sellers are still willing to carry out the transaction even if they have to fully compensate the victims of the pollution. Kaldor–Hicks does not require compensation actually be paid, merely that the possibility for compensation exists, and thus need not leave each at least as well off. Under Kaldor–Hicks efficiency, an improvement can in fact leave some people worse off. Pareto-improvements require making every party involved better off (or at least none worse off).
While every Pareto improvement is a Kaldor–Hicks improvement, most Kaldor–Hicks improvements are not Pareto improvements. In other words, the set of Pareto improvements is a proper subset of Kaldor–Hicks improvements. This reflects the greater flexibility and applicability of the Kaldor–Hicks criterion relative to the Pareto criterion.
Use in policy-making
The Kaldor–Hicks methods are typically used as tests of potential improvements rather than as efficiency goals themselves. They are used to determine whether an activity moves the economy toward Pareto efficiency. Any change usually makes some people better off and others worse off, so these tests consider what would happen if gainers were to compensate losers.
The Kaldor criterion is that an activity moves the economy closer to Pareto optimality if the maximum amount the gainers are
prepared to pay to the losers to agree to the change is greater than the minimum amount losers are prepared to accept; the Hicks criterion is that an activity moves the economy toward Pareto optimality if the maximum amount the losers would pay the gainers to forgo the change is less than the minimum amount the gainers would accept to so agree. Thus, the Kaldor test supposes that losers could prevent the arrangement and asks whether gainers value their gain so much they would and could pay losers to accept the arrangement, whereas the Hicks test supposes that gainers are able to proceed with the change and asks whether losers consider their loss to be worth less than what it would cost them to pay gainers to agree ''not'' to proceed with the change. After several technical problems with each separate criterion were discovered, they were combined into the
Scitovsky criterion, more commonly known as the "Kaldor–Hicks criterion", which does not share the same flaws.
The Kaldor–Hicks criterion is widely applied in
game theory
Game theory is the study of mathematical models of strategic interactions. It has applications in many fields of social science, and is used extensively in economics, logic, systems science and computer science. Initially, game theory addressed ...
's non-zero sum games, such as
DOTMLPF
DOTMLPF (pronounced "Dot-MiL-P-F") stands for doctrine, organization, training, materiel, leadership and education, personnel, and facilities. It is used by the US Department of Defense and was defined in the Joint Capabilities Integration D ...
,
welfare economics
Welfare economics is a field of economics that applies microeconomic techniques to evaluate the overall well-being (welfare) of a society.
The principles of welfare economics are often used to inform public economics, which focuses on the ...
, and
managerial economics
Managerial economics is a branch of economics involving the application of economic methods in the organizational decision-making process.*
*
* Economics is the study of the production, distribution, and consumption of goods and services. Manag ...
. For example, it forms an underlying rationale for
cost–benefit analysis
Cost–benefit analysis (CBA), sometimes also called benefit–cost analysis, is a systematic approach to estimating the strengths and weaknesses of alternatives. It is used to determine options which provide the best approach to achieving benefits ...
. In cost–benefit analysis, a project (for example, a new airport) is evaluated by comparing the total costs, such as building costs and environmental costs, with the total benefits, such as airline profits and convenience for travelers. (However, as cost–benefit analysis may also assign different social welfare weights to different individuals, e.g. more to the poor, the compensation criterion is not always invoked by cost–benefit analysis.)
The project would typically be given the go-ahead if the benefits exceed the costs. This is effectively an application of the Kaldor–Hicks criterion because it is equivalent to requiring that the benefits be enough that those that benefit could in theory compensate those that have lost out. The criterion is used because it is argued that it is justifiable for society as a whole to make some worse off if this means a greater gain for others.
Criticisms
Perhaps the most common criticism of the Kaldor-Hicks criteria is that it is unclear why the ''capacity'' of the winners to compensate the losers should matter, or have moral or political significance as a decision criteria, if the compensation is not actually paid.
At a more technical level, various versions of the Kaldor–Hicks criteria lack desirable formal properties. For instance,
Tibor Scitovsky demonstrated that the Kaldor criterion alone is not
antisymmetric: it's possible to have a situation where an outcome A is an improvement (according to the Kaldor criterion) over outcome B, but B is also an improvement over A. The combined Kaldor–Hicks criterion does not have this problem, but it can be
non-transitive (though A may be an improvement over B, and B over C, A is not thereby an improvement over C).
See also
*
Compensation principle
In welfare economics, the compensation principle refers to a decision rule used to select between pairs of alternative feasible social states. One of these states is the hypothetical point of departure ("the original state"). According to the comp ...
*
Pareto efficiency
In welfare economics, a Pareto improvement formalizes the idea of an outcome being "better in every possible way". A change is called a Pareto improvement if it leaves at least one person in society better off without leaving anyone else worse ...
*
Scitovsky paradox
References
Further reading
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External links
{{DEFAULTSORT:Kaldor-Hicks efficiency
Law and economics
Welfare economics
Pareto efficiency
1939 introductions