Compensation Principle of Kaldor, Hicks and Scitovsky

In this article we will discuss about compensation principle of Kaldor, Hicks and Scitovsky.

Kaldor, Hicks and Scitovsky have given their tests for judging an increasing in welfare. Like Pareto, they isolate the problem of production from that of distribution. They deal with policy change with ambiguous welfare effects saying that if the people benefiting from it can gainfully compensate the losers, then the policy change is desirable otherwise not. This extension is popularly called the compensation principle.

This compensation tests are based on several restrictive assumptions:

1. It is assumed that individual tastes do not change and there are no external effects.

2. It is assumed that inter-personal comparisons of welfare are inadmissible.

3. It is assumed that individuals are the best judges of their own welfare.

4. It is implied that although social welfare depends on the level of distribution and the level of production, it is possible to study only the changes in the level of production.

The compensation principle that underlies all the welfare criteria was proposed by Kaldor. His formulation is: Let there be a policy measure which takes the society from state A to state B, then state B of the society is preferable to state A, if the gainers from the policy measures can compensate the losers and still be in a better position.

Prof. Hicks proposed a test which is the reverse of Kaldor test. He pointed out that in any policy proposal there are two parties, one gainers and the other loses. In the event of a decision of the proposal the losers may try all the means to forestall this, to keep this eventually out and this criterion Hicks proposed the reverse test: state B of society is socially preferable to A if the losers from the policy change from A to B can’t profitably bribe the gainers into not making the change from A to B.

Scitovsky’s Paradox:

Scitovsky has pointed out that the Kaldor – Hicks compensation test has a contradiction. He pointed out that it is possible according to Kaldor-Hicks criteria that state B is better than state A, but once the society moves to the state B, the same criteria may reveal that the return move from B to A is also desirable on welfare grounds. This contradiction has been called the ‘Scitovsky Paradox’. Scitovsky pointed out that to get at the correct criterion of welfare we must remove this contradiction. He has therefore offered his own criterion called the “Scitovsky Double criterion”.

Scitovsky wanted an economic change to satisfy double test-the fulfillment of Kaldor-Hicks test plus the non-fulfillment of the reversal test. This means, that a movement from state A to state B must be desirable in terms of the Kaldor-Hicks criteria but a return from B to A should not be an improvement on these criteria.

The essence of Kaldor, Hicks and Scitovsky criteria can be expressed thus: The Kaldor-Hicks criteria are met if in an economic change, “gainers can over-compensate the losers, “The reversal test is satisfied” if losers are able to bribe the gainers to stay in the old position”. The Schtovsky double test is satisfied “By the fulfillment of the Kaldor-Hicks test plus the non-fulfillment of the reversal test”.

Dr. Little’s Criterion:

Dr. Little has developed a reaction against the compensation criteria proposed by Kaldor, Hicks and Scitovsky. In form, it is also a compensation criterion, but in spirit, it differs markedly from the earlier Kaldor-type criteria. Dr. Little asserts that neither the Kaldor-Hicks test nor the Scitovsky double test, either alone or together, can possibly be taken as a criterion of welfare.

Since little believes that value judgements are essential in welfare economics, he bases his criterion on two value premises. 1. The wellbeing of an individual is supposed to be greater in a chosen position that it is in any other position. 2. Any social alternation that makes everybody better off is a good thing.

Based on these value judgements, the criterion can be stated in this way: An economic change constitutes social improvement (a) if the resulting redistribution is no worse than the old and (b) if it is impossible to make the community as well off in the initial position as it would be after the change.

There are 3 main features of Little’s criterion, as pointed out of Prof. A.K. Sen:

(1) Little bases the overall economic welfare on the welfare of the individual members of the society.

(2) Like Pareto, Little assumes that if at-least one person is better off and none worse off than in an alternative state. Then this state is better.

(3) Little says nothing about the exact nature of welfare judgements.