The Compensation Principle (New Welfare Economics)

The Compensation Principle:

Vilfredo Pareto provided us with a value-free criterion to test whether a particular policy change increased social welfare or not. It stated that an economic change that harmed none but made some people better off must be considered an improvement. Pareto’s criterion did not apply to those policy changes which benefited some and harmed others. It applied only to unambiguous changes. By confining his criterion to unambiguous changes, Pareto skilfully avoided the problem of interpersonal comparisons of utility.

During the period from 1935 to 1951, efforts were made to forge criteria to evaluate ‘ambiguous’ changes in welfare (i.e., those changes which benefited some and harmed others). As said above, there were two main lines along which attempts were made to rehabilitate welfare economics. The first approach known as the Compensation Principle was suggested by economists like Kaldor, Hicks, and Scitovosky. The Compensation Principle is often known as the New Welfare Economics. The second approach to reconstruct welfare economics was suggested by economists like Bergson, Samuelson, Tintner, and others. They developed an alternative criterion known as the Social Welfare Function.

The Compensation Principle extends Pareto’s criterion for an increase in social welfare to ambiguous changes or those changes which benefit some and harm others. This principle is based on certain important assumptions. Firstly, it assumes that the tastes of the individuals are constant and that there are no external effects in production and consumption. Secondly, there is no cardinal measurement of utility and that interpersoanl comparisons of well-being are not possible. Thirdly, individuals are the best judge of their own welfare. Fourthly, it assumes that the problem of production can be separated from the problem of distribution. As such, it considers the effect of changes in the level of production alone on group welfare.

Both Kaldor and Hicks held the firm view that it was possible to draw social welfare conclusions without recourse to interpersonal comparisons. They further claimed that Pareto’s criterion for an increase in social welfare could be extended to cases where some people are made better off and some worse off if the gainers were able to compensate the losers and still remain gainers. The Compensation Principle is best expressed in Kaldor’s own words, “In all cases, where, a certain policy leads to an increase in physical productivity and thus, of aggregate real income, the economist’s case for the policy is quite unaffected by the question of the comparability of individuals satisfaction; since in all such cases, it is possible to make everybody better off than before or at any rate to make some people better off without making anybody worse off. There is no need for the economist to prove- as indeed he never could prove- that as a result of the adoption of certain measures nobody in the community is going to suffer. In order to establish his case, it is quite sufficient for him to show that even if all those who suffer as a result are fully compensated for their loss, the rest of the community will still be better off than before.

Kaldor’s criterion can thus be put in this way: State X is socially preferable to State Y if the gainers in State X can compensate the losers in State X and still be in a better position than in State Y. In such a case, society can increase its real income by moving from State Y to State X. And this increase in real income, in Kaldor’s view, is synonymous with an increase in social welfare.

Hicks expressed the Compensation Principle thus: “If A is made so much better off by the change that he could compensate B for his loss and still have something left over, then the reorganization is an unequivocal improvement.”

The Kaldor-Hicks criterion, then, boiled down to this: Any reorganization will increase social welfare if it is possible for the State to give full compensation to the losers for their losses out of the fund raised by taxing the gainers and still retain a surplus. If, on the contrary, the fund raised by taxing the gainers is not sufficient to compensate the losers fully, the reorganization in question will diminish social welfare.

The Compensation Principle as formulated by Kaldor and Hicks has been subjected to the following criticism:

Firstly, it is pointed out that this criterion makes an uncalled-for distinction between production and distribution and attempts to define the concept of real income without reference to its distribution. The critics have said that the problem of production cannot be isolated from the problem of distribution, particularly when the problem of productive efficiency is under consideration.

Secondly, it is pointed out that the interpersonal utility comparisons which Kaldor and Hicks wanted to avoid or eliminate are found to be implicit in their criterion. The money measure of an individual’s losses and gains, according to this criterion, is based on the tacit assumption that the marginal utility of money to the rich and the poor is the same.

Thirdly, it is pointed out that the criterion may give rise to practical difficulties on the issue of payment of actual compensation. In order to estimate the loss or gain of an individual (consequent upon certain economic reorganization), it is necessary to know about his utility-scale. But placed as we are, we are not in a position to know about everyone’s utility-scale. Consequently, it is not possible to say how much an individual has gained or lost as a result of any economic reorganization. Further, there are several administrative difficulties involved in the payment of compensation to those who lose consequent upon any economic reorganization.

Fourthly, the critics have pointed out that Kaldor’s argument implies that the State is, in the ultimate analysis, responsible for securing and maintaining an equitable distribution of national income. If the distribution of national income is not just or equitable, it is the duty and responsibility of the State to take steps to make it just and equitable among the various sections of the community. Prof. Scitovosky points out that, while it may be true of a socialist economy, there is no such obligation on the government of a capitalist economy to secure equity in the distribution of national income. The guide thus provided by the new welfare economics has, in the words of Scitovosky, “no universal validity”.

Fifthly, the critics have drawn attention to the paradox which is likely to arise if compensation is not paid to those who lose consequent upon reorganization. Scitovosky stated that if any reorganization takes place and no compensation is paid to the losers, then it may lead to such a redistribution of national income that a change back to the position prior to reorganization may also be desirable on the basis of the Kaldor-Hicks criterion. It would then be difficult to say which of the two changes is more desirable. In order to do away with this paradox, Scitovosky suggested his own criterion which comprises two conditions. According to Scitocosky, a change in the economic organization would increase social welfare if-

• The gainers are able to compensate the losers.
• The losers are unable to bribe the gainers into not accepting the proposed change.

It is evident from the above criticism that the attempts so valiantly made by Nicholas Kaldor and J. R. Hicks to rehabilitate Welfare Economics and to place it on a secure basis have not borne much fruit and may be considered as having failed in their objective.