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Scitovsky pointed out an important limitation of Kaldor-Hicks criterion that it might lead to contradictory results. He showed that, if in some situation, position B is shown to be an improve­ment over position A on Kaldor-Hicks criterion, it may be possible that position A is also shown to be an improvement over B on the basis of the same criterion.

For getting consistent results when position B has been revealed to be preferred to position A on the basis of a welfare criterion, then position A must not be preferred to position B on the same criterion. According to Scitovsky, Kaldor- Hicks criterion involves such contradictory and inconsistent results. Since Scitovsky was the first to point out this paradoxical result in Kaldor-Hicks criterion, it is known as ‘Scitovsky Paradox’.

How Kaldor-Hicks criterion may lead to contradictory results in some situation is depicted in Figure 41.3. In this figure JK and GH are the two utility possibility curves which intersect each other. Now suppose that the initial position is at point C on JK.

Further suppose that due to a certain policy change, utility possibility curve changes and takes the position GH and the two individuals find themselves at position D. Position D is superior to position C on the basis of Kaldor-Hicks criterion because from position D movement can be made through mere redistribution to position F at which individual B has been fully compensated but individual A is still better off as compared to the original position C. Thus movement from position C to position D satisfies Kaldor-Hicks crite­rion.

But, as has been pointed out by Scitovsky, reverse movement from position D on the new utility possibil­ity curve GH to the position C on the old utility possibility curve JK also rep­resents an improvement on Kaldor- Hicks criterion, that is, C is socially better than D on the basis of Kaldor- Hicks criterion.

This is because from position C movement can be made by mere redistribution of income to posi­tion E on the utility possibility curve JK on which position C lies and which also passes through the position E. And, as will be observed from Fig. 41.3, that at position E while A is as well of as at position D, the individual B is still better off than at D.

We thus see that the movement from position C to the position D due to a policy change is passed by the Kaldor-Hicks criterion and also the movement back from position D to position C is also passed by the Kaldor-Hicks criterion. This implies that D is socially better than C on this criterion and C is also socially better than D on the same criterion. So Kaldor-Hicks criterion leads us to contradictory and inconsistent results.

It is mention worthy that these contradictory results are obtained by Kaldor-Hicks criterion when follow­ing a policy change new utility possibility curve intersects the former utility possibility curve. After bringing out the possibility of contradictory results in Kaldor-Hicks criterion Scitovsky formulated his own criterion which is generally known as Scitovsky’s Double Criterion.

Scitovsky’s Double Criterion of Welfare

To rule out the possibility of contradictory results in Kaldor-Hicks criterion Scitovsky formu­lated a double criterion which requires the fulfillment of Kaldor-Hicks criterion and also the fulfillment of the reversal test. It means that a change is an improvement if the gainers in the changed situa­tion are able to persuade the losers to accept the change and simultaneously losers are not able to persuade the gainers to remain in the original situ­ation.

Scitovsky’s double criterion can also be ex­plained with the help of utility possibility curve. In Figure 41.4, CD and EF are the two utility possi­bility curves which do not intersect each other at any point. Suppose there is a change from position Q on the utility possibility curve CD to the position G on the utility possibility curve EF as a result of the adoption of a new economic policy.

Such a movement is an improvement on Kaldor-Hicks cri­terion because G lies on the utility possibility curve EF passing through point R. From the position G, movement can be made to the position R simply by redistributing income between the two individu­als. And R is better than Q because the utility of both the individuals is greater at R as compared to the position Q. Thus the Kaldor-Hicks criterion is sat­isfied and therefore change from Q to G will increase social welfare.

Now, let us see, what happens to the reversal test. It must also be satisfied, if the Scitovsky double test is to be fulfilled. That is, a movement from the position G back to the original position Q must not be passed by Kaldor-Hicks criterion if Scitovsky’s reversal test is to be satisfied. It is evident from Figure 41.4 that from position R we cannot move to any position on the utility possibility curve CD merely through redis­tribution of income which is socially better than G (that is, which raises utility of either A or B, the utility of the other remaining constant or which raises the util­ity of both).

We thus see that while movement from position Q to G is passed by Kaldor-Hicks criterion, reverse movement from position G to position Q is not passed by Kaldor-Hicks criterion. Hence, in Figure 41.4 the movement from the position Q to G satisfies Scitovsky’s criterion.

Thus when the two utility possibility curves are non-intersecting and change involves movement from a position on a lower utility possibility curve to a position on a higher utility possibility curve, the change raises social welfare on the basis of Kaldor-Hicks-Scitovsky criterion. This happens only when a change brings about increase in aggregate output or real in­come.

A Critique of the Compensation Principle

The compensation principle as developed by Kaldor, Hicks and Scitovsky, has been a topic of much discussion in welfare economics since 1939. Prof. Kaldor was the first to give a criterion to judge the changes in social welfare when an economic change benefits some people and harms the others.

Later Hicks also supported this criterion in 1940, though he put it in different words. Scitovsky tried to improve the Kaldor-Hicks criterion by formulating his own double criterion. These welfare economists have claimed that they have succeeded in developing a welfare criterion based on ordi­nal concept of utility and also which is free from any value judgements. But compensation principle has been bitterly criticised by the various welfare economists.

First, little has pointed out that Kaldor did not formulate a new welfare criterion at all because he assumed welfare to be a function of increase in production or efficiency irrespective of the changes in distribution.

Thus, according to Little, Kaldor has given only a definition of ‘increase in wealth’ or ‘increase in efficiency’. Kaldor himself has interpreted the compensation principle in this sense as he says that, “when the production of wealth goes up, some income distribution could be found which makes some people better off, and no one worse off than before”. However, as desired income distribution via compensation is only hypothetical, therefore, according to little, it is not a welfare test but a definition of ‘economic efficiency’ in terms of over-compensation.

Second, compensation principle is not free value judgements as is claimed by its propounders. It involves implicit value judgements. Prof. Baumol and Little are of the opinion that the conten­tion of Prof. Kaldor that the changes which enable the gainers to compensate the losers and still be better off are good changes is itself a value judgement.

According to little, to say that a policy which meets the Kaldor-Hicks criterion increases the output or “efficiency” of society is, in effect, to recommend it. According to him, Kaldor and Hicks have coined a definition of “efficiency” whose implicit ethical implications or value judgements will hardly find favour with many people.

Compensation is after all only hypothetical; it is consistent with making the poor get poorer. Thus, according to Little, if the value judgements implicit in Kaldor-Hicks criterion are made explicit, then the claim of Kaldor and Hicks that they have discovered a criterion of detecting increases in wealth, production or efficiency free from value judgements is hardly acceptable.

Third, likewise, Baumol is also of the view that Kaldor-Hicks criterion is based upon unaccept­able implicit value judgements. “By using a criterion involving potential money compensations, they set up a concealed interpersonal comparison on a money basis”.

If an individual A evaluates his gain from a change worth Rs. 500 whereas another individual B evaluates his loss due to that economic change at Rs. 75, we cannot conclude that social welfare has increased; for if the loser is poor and the gainer a rich one, it may be possible that loss of satisfaction of the poor from Rs. 75 is far greater than the addition to the satisfaction of the rich by Rs. 500 because the marginal signifi­cance of one rupee to a poor is far greater than that of the rich.

Thus without actual compensation, the change would mean a major loss of welfare to the poor individual B and a trivial gain of welfare to the rich individual A even if it passes the Kaldor criterion with flying colours. To quote Baumol again, “The Kaldor and Scitovsky criteria have thus ducked the basic problem of the interpersonal comparison required to evaluate a policy change which harms X but aids Y. They duck it by saying implicitly that the recommendation should be based on X’s and Y’s relative willingness and ability to pay for what they want”?

Fourth, Kaldor-Hicks have claimed that through compensation principle they have been able to separate a production change from the distribution change by which it is accompanied. For in­stance, as a result of a policy change output of Coca-Cola increases and that of whisky decreases.

Now, if individual X prefers Cola Cola but Y prefers whisky, the question whether there has occurred any increase in. production is inseparably connected with the distribution of these beverages be­tween X and Y. In many cases it is, therefore, difficult to say whether or not production has increased without considering how the output or real income is being distributed.

Moreover, Kaldor and Hicks think that the level of production is the main determinant of social welfare and the distribution a secondary one. But this is quite untenable. A lower total output equitably distributed ensures greater social welfare than larger output, inequitably distributed. They essentially accept the existing distribution of income and wealth and ignore its impact on individual utilities and well-being.

Fifth, Prof. Baumol, Little and Arrow point out another major flaw in compensation principle that it does not envisage social welfare. This principle proves the social desirability of change in the social state on the basis of the criterion that gainers could compensate the losers and still be better off than before.

These critics are of the opinion that policy changes which would increase social welfare when accompanied by actual compensation need not lead to improvement in social welfare if compensation is not actually made.

Dr. Rothenberg has given a very good example to illustrate this. He supposes an initial social state in which a firm adopts a new invention and as a result the cost of production of the firm is reduced but it throws the competitors out of industry and the work­ers become unemployed.

Let us suppose that the gainer firm from the invention can compensate the losers out of its increased income and still be better off. If the compensation is not actually made in the changed situation, social welfare will decrease as the welfare loss suffered by the workers ren­dered unemployed will be very large indeed.

As a matter of fact, there is no guarantee that compen­sation will be actually made in such cases. Thus, so long as compensation is hypothetical a change might make the rich richer and the poor get poorer and therefore reduce social welfare.

It follows from above that a basic flaw in Kaldor-Hicks compensation principle is that it refers to potential welfare rather than actual welfare since it does not envisage that compensation should be actually made.

In the absence of actual compensation one cannot saw whether or not actual social welfare has increased as a result of a certain policy change unless one is prepared to make some value judgements. Therefore, making value judgements, especially that concerning distribution of income or welfare, is quite indispensable in welfare economics. And economists should not fight shy of making those value judgements which are widely accepted by the people.

It may also be noted that if compensation is actually made then Kaldor-Hicks criterion is quite unnecessary, for in that case only Pareto criterion will be sufficient to judge the effect of a policy change on social welfare.

Sixth, compensation principle does not take into account the external effects on consumption and production. The exponents of compensation principle are of the opinion that an individual’s welfare depends solely upon his own level of production and consumption and is not affected by the production and consumption activities of the others.

But this is not a realistic assumption because a person’s level of satisfaction (or dissatisfaction) depends to a large extent upon the consumption of goods and services by other persons. A person is more satisfied as his relative economic position in the society is improved.

Thus, if an economic change leaves a person where he was before but makes some other individuals better off, he will not feel as well off as in the original situation, that is, his level of welfare will fall. The gains by some individuals from a policy change have usually unfavourable external effects on the welfare position of those whose position is said to have remained unchanged.

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