International Journal of Management and Commerce Innovations ISSN 2348-7585 (Online)Vol. 6, Issue 2, pp: (623-628), Month: October 2018 - March 2019, Available at: www.researchpublish.comKALDOR-HICKS COMPENSATIONCRITERION: A MEASURE OF SOCIALWELFARE1P.O Idisi, 2I. J Ogwu, 3M. N. ZortoDepartment of Agricultural Economics, University of Abuja,PMB 117, Abuja, FCT, Nigeria.Corresponding Author: Maigari Nduayoma [email protected]: Welfare economics is concerned with the evaluation of alternative economic situations from the point ofview of the society’s well-being (welfare). However, ability to measure the welfare of the society remains a greaterchallenge to economists. Therefore, amongst several attempts made by economists to construct tool for measuringsocial welfare is Kaldor-Hicks criterion. A Kaldor–Hicks criterion, named after the originators, Nicholas Kaldorand John Hicks, is a tool of measurement of economic re-allocation of resources among people that captures someof the intuitive appeal of a Pareto effeciency, but has less stringent criteria and is hence applicable to morecircumstances. It claims that in certain circumstances, it is possible to change available rules for obtaining moreeconomic benefit and efficiency, while this change may create loss to some specific groups. Kaldor-Hicks criterionis used as a tool for decision making. In this regard, Kaldor-Hicks criterion is observed as basis for making somesocial-economic decisions. However, applying this criterion has other consequences as well that attracts criticalattention. Therefore, this article attempts to evaluate these critiques with respect to its assumptions andconvenience of its application to social-economic issues by the decision makers.Keywords: Kaldor-Hicks compensation criterion, social welfare, possibility curve.1. INTRODUCTIONThe concept of efficiency has great importance in the economics. After all, economics is efficient allocation of resourcesto “satisfy the insatiable human wants”. Amongst different efficiency criteria, Kaldor-Hicks Efficiency Criterion hasreceived several criticisms. A fundamental issue in economic analysis of government policy is to change such policy togive room for more efficient one. Kaldor-Hicks criterion claims that in certain circumstances, it is possible to changeavailable rules for obtaining more economic benefits and efficiency, while this change may create loss to some specificgroups. This action has specific practical importance; since, social economics decisions should be made according toadvantages and disadvantages and their impact on different classes of society. In fact, those suggesting this criterion haveoffered a rule for making collective decisions that are not applied by Pareto criterion. In this regard, Kaldor- Hickscriterion is observed as basis for making social economic decisions.The compensation criteria also known as the New Welfare Economics was formulated by Nicholas Kaldor and JohnHicks. Accepting Pareto‟s ordinal measurement of utility and the impossibility of its interpersonal comparisons, they triedto show that social welfare could be increased without making value judgment. Kaldor–Hicks postulated that eachindividual‟s satisfactions are independent from the others so that he is the best judge of his welfare. There is the absenceof external effects in production and consumption. The tastes of each individual are constant. It is possible to separate theproblems of production and exchange from the problem of distribution. It is assumed that utility is measured ordinarilyand interpersonal comparisons are impossible. A Kaldor–Hicks improvement is an economic re-allocation of resourcesamong people that captures some of the intuitive appeal of a Pareto improvement, but has less stringent criteria and ishence applicable to more circumstances. A reallocation is a Kaldor–Hicks improvement if those that are made better offPage 623Research Publish Journals
International Journal of Management and Commerce Innovations ISSN 2348-7585 (Online)Vol. 6, Issue 2, pp: (623-628), Month: October 2018 - March 2019, Available at: www.researchpublish.comcould hypothetically compensate those that are made worse off and lead to a Pareto improving outcome. Thecompensation does not actually have to occur (there is no presumption in favor of status-quo) and thus, a Kaldor–Hicksimprovement can in fact leave some people worse off. A situation is said to be Kaldor–Hicks efficient, or equivalently issaid to satisfy the Kaldor–Hicks criterion, if no potential Kaldor–Hicks improvement from that situation exists.2. KALDOR – HICKS CRITERIONA reallocation is said to be a Pareto efficient, 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, withoutmaking at least one person worse off. Even voluntary exchanges may not be Pareto efficient if they make third partiesworse off.Pareto efficiency occurs where at least one party benefits and nobody is made worse off. Kaldor- Hicks states that adecision can be more efficient as long as there is a net gain to society. The criterion enables any potential losers to becompensated from the net gain.Kaldor–Hicks criterion is an improvement on Pareto efficiency. A resources allocation is considered efficient and animprovement if those that are made better off could in principle compensate those that are made worse off so that a Paretoimproving outcome could (though does not have to) be achieved. For example, a voluntary exchange that creates pollutionwould be a Kaldor–Hicks improvement if the buyers and sellers are still willing to carry out the transaction even if theyhave to fully compensate the victims of the pollution. Kaldor–Hicks does not require compensation actually be paid. Itmeans mere existence of possibility for compensation. Under Kaldor–Hicks efficiency, an improvement can in fact leavesome people worse off while Pareto efficiency require making every party involved better off (or at least none worse off).While every Pareto efficiency is a Kaldor–Hicks criterion most Kaldor–Hicks criterion are not Pareto efficient. This isbecause the set of Pareto efficient is a proper subset of Kaldor–Hicks criterion. This reflects the greater flexibility andapplicability of the Kaldor–Hicks criterion relative to the Pareto criterion.Hypothetical ExampleITEMEPassengersBENEFITSN200mAirline companyLocal residentsEnvironmentTotal benefitTotal costNet gain to societyN220mCOSTSN40mN60mN420mN100mN320mThe total benefit is N420m. But, two groups lose out – local residents and the environment.To build the airport would not be Pareto efficient because although there is a net gain of N320m, two groups lose out andare worse off.However, according to the Kaldor-Hicks criterion, it would be efficient to go ahead because of the net-gain and the factthat, in theory, the groups losing out could be compensated.Under Kaldor Hicks, the key principle is the idea that, in theory, people could be compensated. This compensationdoesn‟t actually have to occur. Under Pareto efficiency, this compensation would have to occur through voluntaryagreements between two parties. Kaldor-Hicks criteria may be used to judge the effectiveness of a Cost-Benefit Analysisscheme.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 paymentof compensation is regarded as a political or ethical decision.AssumptionsThe compensation criterion of Kaldor – Hicks is based on the following: Each individual‟s satisfactions are independent from the others so that he is the best judge of his welfare.Page 624Research Publish Journals
International Journal of Management and Commerce Innovations ISSN 2348-7585 (Online)Vol. 6, Issue 2, pp: (623-628), Month: October 2018 - March 2019, Available at: www.researchpublish.com There is the absence of external effects in production and consumption. The tastes of each individual are constant. It is possible to separate the problems of production and exchange from the problem of distribution. It is assumed that utility is measured ordinarily and interpersonal comparisons are impossible.3. MATTER ARISING FOR KALDOR HICKS Just because, in theory, compensation may be given to those who lose out, in practice it may not. Local residentswould feel unfairly treated if the airport went ahead. Kaldor-Hicks criteria can lead to an increase in inequality and be perceived as unfair. For example, those under flightpath may feel it is unfair they have been singled out to have to put up with an airport nearby. It places economic welfare and total economic utility above other moral considerations. Utilitarianism verses notionsof fairnessKaldor does not require that the losers should actually be compensated. Rather he requires that the gainers should be ableto compensate the losers out of their gains. Hicks presents the same criterion in a little different way thus: “If A is madeso much better off by the change that he could compensate B for his loss, and still have something left over, then thereorganisation is unequivocal improvement. “Thus the Kaldor Hicks criterion implies that if an economic change leads to the production of more goods and servicesthey can be so distributed as to make some people better off and none worse off. Actual redistribution being a political orethical issue, need not take place. It is enough that reorganizations create such conditions that redistribution can beeffected.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 givenfixed bundle of goods and the various points on each curve are obtained by costless lump sum redistribution of a fixedcommodity bundle.Let X and Y be the two bundles of goods represented by the utility possibility curves B1A1 and B2A2 respectively asutility possibility shown in the below diagram. Starting from a given bundle of goods represented by Q2 in terms of theParetian criterion any change which leads to a movement to any one of the points C,D and E is a Pareto improvement onthe B1A1 curve because it makes both individuals better off or at least 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‟swelfare at the expense of B. Nevertheless, a move from Q2 to Q1 can be evaluated in terms of the Kaldor-Hicks criterionThis can be done by (i) asking B how much he would be willing to pay A to prevent this move and (ii) asking A howmuch he would be willing to pay to B to forgo it. If (ii) (i), the change increases welfare for the reason that A wouldpotentially 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 liebelow the utility possibility curve representing the new bundle. Thus a move from Q2 to Q1 satisfies the Kaldor – Hickscriterion 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 curveB1A1 which is unambiguously better than Q2. After compensation one can move from D to Q1.4. USES OF KALDOR-HICKS CRITERION IN POLICY-MAKINGThe Kaldor–Hicks methods are typically used as tests of potential improvements rather than as efficiency goalsthemselves. They are used to determine whether an activity moves the economy toward Pareto efficiency. Any changeusually makes some people better off and others worse off, so these tests consider what would happen if gainers were tocompensate losers.An economic activity meets Kaldor-Hicks criterion and moves the economy closer to Pareto optimality if the maximumamount the gainers are prepared to pay to the losers to agree to the change is greater than the minimum amount losers areprepared to accept; the Hicks criterion is that an activity moves the economy toward Pareto optimality if the maximumamount the losers would pay the gainers to forgo the change is less than the minimum amount the gainers would accept toPage 625Research Publish Journals
International Journal of Management and Commerce Innovations ISSN 2348-7585 (Online)Vol. 6, Issue 2, pp: (623-628), Month: October 2018 - March 2019, Available at: www.researchpublish.comagree not to proceed with the change. Thus, the Kaldor test supposes that losers could prevent the arrangement and askswhether gainers value their gain so much they would and could pay losers to accept the arrangement, whereas the Hickstest supposes that gainers are able to proceed with the change and asks whether losers consider their loss to be worth lessthan what it would cost them to pay gainers to agree not to proceed with the change.The Kaldor–Hicks criterion is widely applied in welfare economics and managerial economics. For example, it forms anunderlying rationale for cost–benefit analysis. In cost–benefit analysis, a project (for example, a new airport) is evaluatedby comparing the total costs, such as building costs and environmental costs, with the total benefits, such as airline profitsand convenience for travelers. (However, as cost–benefit analysis may also assign different social welfare weights todifferent 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 theKaldor–Hicks criterion because it is equivalent to requiring that the benefits be enough that those that benefit could intheory compensate those that have lost out. The criterion is used because it is argued that it is justifiable for society as awhole to make some worse off if this means a greater gain for others.5. CRITICISMSIgnores Income Distribution: The Kaldor Hicks compensation principle, according to Dr. Little, is merely a definitionand not a “test” of increase in welfare for the reason that it ignores income distribution. In fact, the problem of distributioncannot be ignored where the problem of productive efficiency is involved. To say that one „bundle of goods‟ is greaterthan the order is meaningless without reference to income distribution. For any comparison between two bundles of goodsinvolves their money values at their market prices.No universal ValidityScitovsky has criticised Kaldor for the view that the state is fully responsible for maintaining an equitable distribution ofincome. If there is unequal income distribution in a community, it is corrected as a matter of course by the state through asystem of compensations. According to Scitovsky, “This is likely to be the case in a socialist economy.” But in a freeenterprise economy, the effects of a certain economic re-organisations on efficiency and equity cannot be separated forthe reason that compensation payments are not feasible politically. Thus the Kaldor Hicks criterion has no universalvalidity, according to Scitovsky.6. WELFARE ECONOMICSGeneral Welfare economics refers to all economic and non-economic goods and services that provide utilities orsatisfaction to individuals living in a community. In this sense, general welfare becomes a very wide, complicated andimpracticable notion. Pigou therefore defines economic welfare as that part of general welfare which can be broughtdirectly or indirectly into relation with the measuring rod of money.” In the Pigovian sense economic goods and servicesof those that can be exchanged for money.But Dr. Graaf does not agree with Pigou‟s concept of economic welfare for two reasons. First, money as a measure ofwelfare is neither accurate nor satisfactory for the reason that value of money changes with variations in the price level.Second, economic welfare does not depend upon exchangeable goods and services for the reason that it is not possible toseparate economic factors from non-economic factors, so far as an individual‟s state of mind is concerned.In fact, an individual‟s welfare depends upon both economic and non-economic factors. Since non-economic factors arenot capable of assessment, Graaf opines that in welfare theory only in economic factors are considered, assuming noneconomic factors to be constant.Robertson while accepting Pigou‟s distinction between general and economic welfare prefers to use the world welfare foreconomic welfare, Boulding on the other hand, defines economic welfare in terms of the opportunity cost of exchangeablegoods and services.According to Prof. Pigou, an individual‟s welfare resides in his state of mind or consciousness which is made up on hissatisfactions or utilities. But modern economists explain it in terms of a given scale of preferences. An individual‟swelfare is said to have increased when he is better off, when he himself believes that his welfare has increased or not.Page 626Research Publish Journals
International Journal of Management and Commerce Innovations ISSN 2348-7585 (Online)Vol. 6, Issue 2, pp: (623-628), Month: October 2018 - March 2019, Available at: www.researchpublish.comMeasuring WelfareThere are mainly two concepts for measuring welfare. The first relates to a Pareto improvement whereby social welfareincreases when society as a whole is better off without making any individual worse off. The proposition also includes thecase that when one or more persons are better off, some persons may be neither better off nor worse off. It is thus freefrom making interpersonal comparisons. Hicks, Kaldor and Scitovsky have explained social welfare in the Paretian sensein terms of the „Compensation Principle‟.In the second place, social welfare is increased, when the distribution of welfare is better in some sense. It makes somepersons in society better off than others so that the distribution of welfare is more equitable. This is known asdistributional improvement and relates to the Bergson social welfare function.Value JudgmentsAll ethical judgments and statements which perform recommendatory, influential and persuasive functions are valuejudgments. According to Dr. Brandt a judgment is it entails or contradicts some judgment which could be formulated soas to involve any one of the following terms in an ordinary sense; „is a good thing that‟ or „is a better thing that‟; isnormally obligatory‟; is reprehensible; and „is normally praiseworthy‟.Value judgments describe facts in an emotive way tend to influence people by altering their beliefs or attitudes. Suchstatements as „this change will increase economic welfare‟, „rapid economic development is desirable‟, „inequalities ofincomes need be reduced‟, are all value judgments.Welfare is an ethical term. So all welfare propositions are also ethical and involve value judgments. Such terms as„satisfaction‟, „utility‟ are also ethical in nature since they are emotive. Similarly, the use of a highly emotive word as„social‟, „community‟ or „national‟ in place of „economic‟ is ethical.Since welfare economics is concerned with policy measures, it involves ethical terminology, such as increase of „socialwelfare‟ or „social advantage‟ or „social benefit‟.Thus welfare economics and ethics cannot be separated. They are inseparable, according to Prof. Little, “because thewelfare terminology.” Since welfare propositions involve value judgements, the question arises whether economistsshould make value judgements in economics.Positive Economics and Welfare EconomicsPositive Economics is concerned with „what is‟. It has generalisations, principles, theories or laws which trace out acausal relationship between cause and effect. As a pure or positive science, economics seeks to explain what actuallyhappens and not what ought to happen. Welfare economics on the other hand is a normative study. It also deals withcausal relationship between cause and effect. But in addition to deriving conclusions from this relationship, it seeks toevaluate various results and to distinguish between them from a normative point of view.In other words, of Scitovsky, “welfare economics is that part of the general body of economic theory which is concernedprimarily with policy. Whenever the economist advocates a policy, for instance, when he favours full employment oropposes government interference in economic affairs, he makes a welfare proposition.” Thus positive economics is toexplain and welfare economics is to prescribe.7. CONCLUSIONHaving realized the cumbersomeness in ensuring efficient reallocation of resource, the policy makers should continue tostrive hard to ensure that no one is worse off. They should ensure adequate compensation is made for new policy. It isalso note-worthy that welfare economics and ethics are inseparable and interpersonal comparisons or value judgementsare inseparable from welfare economics.REFERENCESA Koutsoyiannis.(1979), Modern Microeconomics, Macmillan Press Ltd, London.Buchanan, James.  1999. Cost and Choice: An Inquiry in Economic Theory. Volume 6. The Collected Worksof James M Buchanan. Indianapolis, Ind.: Liberty Fund.Page 627Research Publish Journals
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Kaldor-Hicks criteria can lead to an increase in inequality and be perceived as unfair. For example, those under flight . 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 .