Economists like Kaldor, Hicks and Scitovsky have made efforts to evaluate the changes in social welfare resulting from any economic reorganisation which harms somebody and benefits the others. These economists have sought to remove indeterminacy in the analysis of Pareto optimality.
They have put forward a criterion known as the ‘compensation principle’ on the basis of which they claim to evaluate those changes in economic policy or organisation which makes some individual better off and others worse off. The ‘compensation principle’ is based on the following assumptions.
1. The satisfaction of an individual is independent of the others and he is the best judge of his welfare.
2. There exist no externalities of consumption and production.
3. The tastes of the individuals remain constant.
4. The problems of production and exchange can be separated from the problems of distribution. Compensation principle accepts the level of social welfare to be a function of the level of production. Thus it ignores the effects of a change in distribution on social welfare.
5. Utility can be measured ordinally and interpersonal comparisons of utilities are not possible.
Given the above assumptions, a criterion of compensation principle can be discussed. Kaldor, Hicks and Scitovsky have claimed to formulate a value-free objective criterion of measuring the changes in social welfare with the help of the concept of ‘compensating payments’.
Nicholas Kaldor was the first economist to give a welfare criterion based on compensating payments. Kaldor’s criterion helps us to measure the welfare implications of a movement in either direction on the contract curve in terms of Edgeworth box diagram.
According to Kaldor’s welfare criterion, if a certain change in economic organisation or policy makes some people better off and others worse off, then a change will increase social welfare if those who gain from the change could compensate the losers and still be better off than before. In the words of Prof. Baumol, “Kaldor’s criterion states that a change is an improvement if those who gain evaluate their gains at a higher figure than the value which the losers set upon their losses.”
Thus, if any policy change benefits any one section of the society (gainers) to such an extent that it is better off even after the payment of compensation to the other sections of the society (losers) out of the benefits received, then that change leads to increase in social welfare. In Kaldor’s own words, “In all cases…. where a certain policy leads to an increase in physical productivity and thus of aggregate real income… it is possible to make everybody better off without making anybody worse off. It is quite sufficient…. to show that even if all those who suffer as a result are fully compensated for their loss, the rest of the community will still be better off than before.”
Prof. J.R. Hicks supported Kaldor for employing compensation principle to evaluate the change in social welfare resulting from any economic reorganisation that benefits some people and harms the others. This criterion states that, “If A is made so much better by the change that he could compensate B for his loss and still have something left over, and then the reorganisation is unequivocal improvement.”
In other words, a change is an improvement if the losers in the changed situation cannot profitably bribe the gainers not to change from the original situation. Hicks have given his criterion from the losers’ point of view, while Kaldor had formulated his criterion from gainers’ point of view. Thus the two criteria are really the same though they are clothed in different words. That is why they are generally called by a single name ‘Kaldor-Hicks criterion’.
Kaldor-Hicks criterion can be explained with the help of the utility possibility curve. In Fig. ordinal utility of two individuals A and B is shown on X and Y axis respectively. DE is the utility possibility curve which represents the various combinations of utilities obtained by individuals A and B. As we move downward on the curve DE, utility of A increases while that of B falls. On the other hand, if we move up on the utility curve ED, utility of B increases while that of A falls.
Suppose the utilities obtained by A and B from the distribution of income or output between them is represented by point Q inside the utility possibility curve DE. Let us assume that as a result of some change in economic policy, the two individuals move from point Q to point T on the utility possibility curve DE.
As a result of this movement, utility of individual B has increased while the utility of A has declined, that is, B has been become better off and A has become worse off than before. Therefore, this movement from point Q to point T cannot be evaluated by means of Pareto criterion. Of course, points such as R, G, S or any other point on the segment RS of utility-possibility curve DE are socially preferable to point Q on the basis of Pareto criterion.
However, the compensation principle propounded by Kaldor-Hicks enables us to say whether or not social welfare has increased as a result of movement from Q to T. According to Kaldor-Hicks criterion, we have to see whether the individual A who gains with the movement from position Q to position T could compensate the individual A who is loser and still be better off than before.
Now, it will be seen from Figure that utility possibility curve DE passes through points R, G and S. This means that by mere redistribution of income between the two individuals, that is, if individual B gives some compensation to individual A for the loss suffered, they can move from position T to the position R.
It is evident from the figure that at position R individual A is as well off as at the position Q but individual B is still better off as compared to the position Q. It means due to a policy change and consequent movement from position Q to position T, the gainer (individual B) could compensate the loser (individual A) and is still better off than at Q.
Therefore, according to Kaldor-Hicks criterion, social welfare increases with the movement from position Q to position T, because from T they could move to the position R through mere redistribution of income (i.e. compensation).
It is noteworthy that, according to Kaldor-Hicks criterion, compensation may not be actually paid to judge whether or not social welfare has increased. It is enough to know whether the gainer could compensate the loser for the loss of welfare and still be better off.
Whether redistribution of income (that is, payment of compensation) should be actually made following the change in policy is left for the Government to decide. If it is possible for the gainer to compensate the loser and still be better off, the economists can say that social welfare has increased.
It may be noted that gainer can compensate the losers and still be better off only when the change in economic policy leads to the increase in output or real income. That is why Kaldor and Hicks claim that they have been able to distinguish between changes in output from change in distribution.
When their criterion is satisfied by a change in the situation, it means that the economy has moved to a potentially more efficient position and as a result social welfare can be said to have increased. Now, whether redistribution of income is actually made through payment of compensation by the gainers to the losers, according to them, is a different matter.
Now, the implications of Kaldor-Hicks criterion become more clear if through redistribution the position of the two individual changes from T to G . It is quite manifest that at position G both the individuals A and B are better off than at the position Q. Thus, the position T to which the two individuals moved as result of a certain change in economic policy is superior to the initial position Q from the viewpoint of social welfare, since from position T movement can be made merely through redistribution of income to position G where both are better off as compared to the position Q.
It may be noted that in the situation depicted in Figure, the change in economic policy brings about a movement from a position inside the utility possibility curve to a point on it. Now let us see what happens to social welfare if as a result of the adoption of a certain economic policy the utility possibility curve moves outward and the two individuals move from a point on a lower utility possibility curve to a point on a higher utility possibility curve.
It can be shown that, according to Kaldor-Hicks criterion, such a movement causes an improvement in social welfare. Consider Figure . UV is the original utility possibility curve and Q represents the position at which the two individuals are initially placed. Now, suppose utility possibility curve shifts outward to the new position, U’V, and the two individuals are placed at point R on it.
In movement from Q on the utility possibility curve UV to point R on the utility possibility curve U ‘V’ the utility of A has increased and that of B has declined. But position R denotes greater social welfare on the basis-of Kaldor’s criterion when compared to the position Q on the original utility possibility curve UV because with UV as the utility possibility curve it is possible to move through mere redistribution of income from position R to position S where the individual B has been fully compensated for his loss of utility, the individual A is still better off as compared to position Q. To conclude, any change in the economy that moves the individuals from a position on a lower utility possibility curve to a position on a higher utility possibility curve increases social welfare.