The Compensation Criteria: Kaldor-Hicks | Economics Optional Notes for UPSC PDF Download

Introduction

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 Assumptions:

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

• Each individual’s satisfactions are independent from the others so that he is the best judge of his welfare.
• 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.

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 them. 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 В for his loss, and still have something left over, then the reorganization 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 reorganization creates such conditions that a redistribution can be effected.
• This criterion can be illustrated with the help of utility possibility curves for two individuals. If A and В 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 shown in Figure 2 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 or E is a Pareto improvement on the B1 A1, curve because it makes both individuals better off or at least one better off without making the other worse off.

• But any movement outside С and E to Q1 cannot be evaluated by the Paretian criterion because it improves A’s welfare at the expense of B. However, a move from Q2, to Q1 can he evaluated in terms of the Kaldor-Hicks criterion. This can be done by
  • Asking В how much he would be willing to pay to A to prevent this move, and
  • Asking A how much he would be willing to pay to В to forgo it.
  • If (ii) > (i), the change increases welfare because A would potentially compensate В 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 He below the utility possibility curve representing the new bundle. Thus a move from O2, to Q1 satisfies the Kaldor-Hicks criterion, because Q2 lies below the utility possibility curve Вt A: 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.

Its Criticism:

This compensation criterion has been criticised by Scitovsky, Baumol, Samuelson, Little and others.

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 because 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 other is meaningless without reference to income distribution. For any comparison between two bundles of goods involves their money values at their market prices.

2. Measures only potential welfare:

• In trying to separate production from distribution, this criterion confuses potential welfare with actual welfare. It simply measures potential welfare changes associated with changes in any particular bundle of goods.
• The actual welfare depends not only on the production of goods and services but also on their distribution. The compensation principle errs in neglecting the distributional aspect. It measures only the potential welfare which does not serve any practical purpose.

3. No common standard of value:

• Prof. Baumol opines that when more than two commodities are involved, optimum production is not possible unless there is a common standard of value for measuring different commodities. But such a standard depends on income distribution which the compensation principle neglects. In such a situation, says Prof. Baumol, one has to use a standard that ‘bends and stretches and falls to pieces in our hands.’

4. Not free form Interpersonal Comparisons:

• Kaldor, Hicks and their followers failed in their efforts to find out a value-free criterion. The Kaldor-Hicks criterion is based on the assumption that the ‘social value of money’ is the same in the hands of both the rich and the poor. Moreover, money is not actually transferred but remains with the better off.
• Thus this criterion has a utilitarian scheme of ethics and involves interpersonal comparisons of utility. In fact, as pointed out by Dr. Nath, the attempts of Kaldor and others who followed him were foredoomed as “no prescriptions can be derived without starting from some ethical premises.”

5. Based on Long-Run Welfare Adjustments:

• Little and Scitovsky have criticised Hicks for suggesting long-run welfare adjustments which would have insignificant real income distribution effects. Moreover, the effects would be random so that they cancel out in the long-run.
• Scitovsky agrees with Little that some of the changes which might pass the Kaldor-Hicks criterion will have quite sufficient real income distribution effects, so that it would be, at best, wishful thinking to suppose that they would cancel out with the effects of other changes. If, however, the time period is long enough, even the people who are better off would be dead and this criterion then becomes meaningless.

6. Does not Involve Actual Compensation:

• This criterion does not take into consideration the payment of actual compensation. It recognises only potential compensation with which actual increase in welfare cannot be measured. There- fore, actual compensation is necessary so that no individual remains a loser. But the payment of actual compensation involves many administrative problems which render this criterion impracticable.

7. 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.
• 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 reorganization on efficiency and equity cannot be separated because compensation payments are not feasible politically. Thus the Kaldor-Hicks criterion has no universal validity, according to Scitovsky.

[Question: 957381