Kaldor-Hicks efficiency

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Kaldor–Hicks efficiency, named for Nicholas Kaldor and John Hicks, also known as Kaldor–Hicks criterion, is a measure of economic efficiency that captures some of the intuitive appeal of Pareto efficiency, 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.



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 or not an outcome improves economic efficiency. 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 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.

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