Kaldor-Hicks efficiency - AbsoluteAstronomy.com

Kaldor–Hicks efficiency, named for Nicholas Kaldor

Nicholas Kaldor

Nicholas Kaldor, Baron Kaldor was one of the foremost Cambridge economists in the post-war period...

John Hicks

Sir John Richard Hicks was a British economist and one of the most important and influential economists of the twentieth century. The most familiar of his many contributions in the field of economics were his statement of consumer demand theory in microeconomics, and the IS/LM model , which...

, also known as Kaldor–Hicks criterion, is a measure of economic efficiency that captures some of the intuitive appeal of Pareto efficiency

Pareto efficiency

Pareto efficiency, or Pareto optimality, is a concept in economics with applications in engineering and social sciences. The term is named after Vilfredo Pareto, an Italian economist who used the concept in his studies of economic efficiency and income distribution.Given an initial allocation of...

, but has less stringent criteria and is hence applicable to more circumstances. Under Kaldor–Hicks efficiency, an outcome is considered more efficient if a Pareto optimal outcome can be reached by arranging sufficient compensation from those that are made better off to those that are made worse off so that all would end up no worse off than before.

Explanation

Under Pareto efficiency, an outcome is more efficient if at least one person is made better off and nobody is made worse off. However, some believe that 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. Under ideal conditions, voluntary exchanges are Pareto improving since individuals would not enter into them unless they were mutually beneficial. However, a voluntary exchange would not be Pareto superior if external costs (such as pollution that hurt a third party) exist, as they often do.

Using Kaldor–Hicks efficiency, an outcome is more efficient if those that are made better off could in theory compensate those that are made worse off, so that a Pareto improving outcome results. 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.

The key difference is the question of compensation. Kaldor–Hicks does not require compensation actually be paid, merely that the possibility for compensation exists, and thus does not necessarily make each party better off (or neutral). Thus, under Kaldor–Hicks efficiency, a more efficient outcome can in fact leave some people worse off. Pareto efficiency requires making every party involved better off (or at least no worse off).

While every Pareto improvement is a Kaldor–Hicks improvement, most Kaldor–Hicks improvements are not Pareto improvements. This is because, as the graph above illustrates, the set of Pareto improvements is a proper subset of Kaldor–Hicks improvement, which also reflects the greater flexibility and applicability of the Kaldor–Hicks criteria relative to the Pareto criteria. For example, in a society with two people, suppose initially Person A has 10 sheep and Person B has 100 sheep. If some policy change or other shock results with Person A ending up with 20 sheep and Person B with 99 sheep, this change would not be Pareto improving, since Person B is now worse off. However, it would be a Kaldor–Hicks improvement, as Person A could theoretically give Person B anywhere between 1 and 10 sheep to accept this alternative situation.

Use in policy-making

The Kaldor–Hicks methods are typically used as tests of Pareto efficiency 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 or vice versa.

The Kaldor criterion is that an activity contributes 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 contributes to 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 welfare economics

Welfare economics

Welfare economics is a branch of economics that uses microeconomic techniques to evaluate economic well-being, especially relative to competitive general equilibrium within an economy as to economic efficiency and the resulting income distribution associated with it...

and managerial economics. For example, it forms an underlying rationale for cost-benefit analysis

Cost-benefit analysis

Cost–benefit analysis , sometimes called benefit–cost analysis , is a systematic process for calculating and comparing benefits and costs of a project for two purposes: to determine if it is a sound investment , to see how it compares with alternate projects...

. 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 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

The most common criticism of the Kaldor–Hicks criterion is the taking into account of only the absolute level of income, not its distribution.

A related problem is that any social welfare function

Social welfare function

In economics, a social welfare function is a real-valued function that ranks conceivable social states from lowest to highest. Inputs of the function include any variables considered to affect the economic welfare of a society...

s based on Kaldor–Hicks criteria are cardinal in nature, and therefore suffer from the aggregation problem

Aggregation problem

An aggregate in economics is a summary measure describing a market or economy. The aggregation problem refers to the difficulty of treating an empirical or theoretical aggregate as if it reacted like a less-aggregated measure, say, about behavior of an individual agent as described in general...

s associated with discrepancies between the marginal value of money of rich and poor people.

This has mainly to do with the assumption of diminishing marginal utility for income: taking one dollar from a poor person causes a greater loss in utility than taking a dollar from a rich one. By weighting utility variations by the marginal utilities, the social welfare function implicit to the Kaldor–Hicks compensation principle is represented by anti-egalitarian, concave indifference curves.

At a more technical level, various versions of the Kaldor–Hicks criteria lack desirable formal properties. For instance, Tibor Scitovsky

Tibor Scitovsky

Tibor de Scitovsky, also known as Tibor Scitovsky, , was a Hungarian born, American economist who was best known for his writing on the nature of people's happiness in relation to consumption...

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 (A may be an improvement over B, and B over C, but A may not be an improvement over C).

Explanation

Use in policy-making

Criticisms

See also