Kaldor–Hicks efficiency
Kaldor-Hicks efficiency (named for Nicholas Kaldor and John Hicks) is a type of economic efficiency that captures some of the intuitive appeal of Pareto efficiency, while having less stringent criteria and therefore being applicable in more circumstances.
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 an outcome is efficient or not. However, in practice it is almost impossible to make any change without making at least one person worse off. Using Kaldor-Hicks efficiency, a more efficient outcome can leave some people worse off. Thus, an outcome is more efficient if those that are made better off could in theory compensate those that are made worse off and lead to a Pareto optimal outcome.
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). Pareto efficiency does require making each party better off (or at least no worse off).
Since any Kaldor-Hicks efficient allocation maximizes social welfare, it must necessarily be the case that any Kaldor-Hicks efficient allocation is also Pareto efficient. This is because, at any give point along the PPF, no one person can be made better off without making at least one person worse off. However, while all Kaldor-Hicks efficient allocations are Pareto efficient, the reverse is not true. On the other hand, while every Pareto improvement is a Kaldor-Hicks improvement, most Kaldor-Hicks improvements are not Pareto improvements.
The Kaldor and Hicks methods are typically used as tests of Pareto efficiency rather than 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.
Under the Hicks criterion, an activity will contribute to Pareto optimality if the maximum amount the losers are prepared to offer to the gainers in order to prevent the change is less than the minimum amount the gainers are prepared to accept as a bribe to forgo the change. The Hicks compensation test is from the losers point of view, while the Kaldor compensation test is from the gainers point of view. After several technical problems with each seperate criterion were discovered, they were combined into the Scitovsky criterion, more commonly known as the ""Kaldor-Hicks criterion"", which does not share the same flaws.
The Kaldor-Hicks criterion is widely applied in welfare economics and managerial economics. For example, it forms an underlying rationale for cost-benefit analysis. In cost benefit analysis, a project (for example a new airport) is evaluated by comparing the total costs, such as building costs and environmental costs, with the total benefits, such as airline profits and convenience for travellers.
The project would typically be given the go-ahead if the benefits exceed the costs. This is effectively an application of the Kaldor-Hicks criterion, because it is equivalent to requiring that the benefits should be enough that those that benefit could in theory compensate those that have lost out. The criterion is used because it is argued that it is justifiable for society as a whole to make some worse off if this means a greater gain for others.
Criticisms
The most common criticism against the Kaldor-Hicks criterion is that it only takes into account the absolute level of income, but disregards its distribution.
A related problem is that any social welfare functions based on K-H criteria are cardinal in nature, and therefore suffer from the aggregation problems associated with discrepancies between the marginal value of money of rich and poor people.
Another criticism of the combined Kaldor-Hicks criteria is that the potential existence of non-transitivity (For any given allocations of resources A, B, and C, A may be an improvement over B, and B over C, but A may not be an improvement over C). [1]