Kaldor–Hicks efficiency

A Kaldor–Hicks improvement, named for Nicholas Kaldor and John Hicks, also known as the Kaldor–Hicks criterion, is a way of judging economic re-allocations of resources among people that captures some of the intuitive appeal of Pareto efficiencies, but has less stringent criteria and is hence applicable to more circumstances. A re-allocation is a Kaldor–Hicks improvement if those that are made better off could hypothetically compensate those that are made worse off and lead to a Pareto-improving outcome. The compensation does not actually have to occur (there is no presumption in favor of status-quo) and thus, a Kaldor–Hicks improvement can in fact leave some people worse off.

A situation is said to be Kaldor–Hicks efficient if no potential Kaldor–Hicks improvement from that situation exists.

A reallocation is said to be a Pareto improvement if at least one person is made better off and nobody is made worse off. However 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 if they make third parties worse off.

Using the criterion for Kaldor–Hicks improvement, an outcome is an improvement if those that are made better off could in principle compensate those that are made worse off, so that a Pareto improving outcome could (though does not have to) be achieved. 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. Kaldor–Hicks does not require compensation actually be paid, merely that the possibility for compensation exists, and thus need not leave each at least as well off. Under Kaldor–Hicks efficiency, an improvement can in fact leave some people worse off. Pareto-improvements require 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, 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 criterion relative to the Pareto criterion.

The Kaldor–Hicks methods are typically used as tests of potential improvements 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.

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