Kaldor-Hicks efficiency

Kaldor-Hicks efficiency (named for Nicholas Kaldor and John Hicks) is a type of economic efficiency that captures some of the intuitive appeal of Pareto efficiency, while having less stringent criteria and therefore being applicable in more circumstances.

Under Pareto efficiency, an outcome is more efficient if at least one person is made better off and nobody is made worse off. This seems a reasonable way to determine whether an outcome is efficient or not but in practice, it is almost impossible to make any change without making at least one person worse off. Using Kaldor-Hicks efficiency, a more efficient outcome can leave some people worse off. Here, an outcome is more efficient if those that are made better off could in theory compensate those that are made worse off and lead to a Pareto optimal outcome.

The key difference is the question of compensation. Kaldor-Hicks does not require compensation to be paid, merely the possibility for compensation to take place, and thus does not necessarily make each party better off. Pareto efficiency does require making each party better off (or at least no worse off).

While all Kaldor-Hicks efficient situations are Pareto efficient, the reverse is not true. Conversely, though every Pareto improvement is a Kaldor-Hicks improvement, most Kaldor-Hicks improvements are not Pareto improvements.

The Kaldor and Hicks methods are typically used as tests of Pareto efficiency rather than efficiency goals themselves. They are used to determine whether an activity is moving the economy towards Pareto efficiency. Any change usually makes some people better off while making others worse off, so these tests ask what would happen if the winners were to compensate the losers. Using the Kaldor criterion an activity will contribute to Pareto optimality if the maximum amount the gainers are prepared to pay is greater than the minimum amount that the losers are prepared to accept. Under the Hicks criterion, an activity will contribute to Pareto optimality if the maximum amount the losers are prepared to offer to the gainers in order to prevent the change is less than the minimum amount the gainers are prepared to accept as a bribe to forgo the change. The Hicks compensation test is from the losers point of view, while the Kaldor compensation test is from the gainers point of view. If both conditions are satisfied, both gainers and losers will agree that the proposed activity will move the economy toward Pareto optimality (referred to as the Scitovsky criteria).

The Kaldor-Hicks criterion is widely applied in welfare economics and managerial economics. For example, it forms an underlying rationale for cost-benefit analysis. 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 travellers.

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 should 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

One problem with the K-H criteria is that it will conclude that any change that results in an increase in income will lead to Pareto optimality. Further, this Pareto optimality will result, no matter what the income distribution consequences of the change are.

A related problem is that any social welfare functions based on K-H criteria are cardinal in nature, and therefore suffer from the aggregation problems associated with discrepancies between the marginal value of money of rich and poor people.

At a more technical level, various versions of the K-H criteria lack desirable formal properties. For instance, Tibor Scitovsky demonstrated that the Kaldor criterion alone is not symmetric: 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 (A may be an improvement over B, and B over C, but A may not be an improvement over C).

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