Kaldor–Hicks efficiency facts for kids

A Kaldor–Hicks improvement, named after economists Nicholas Kaldor and John Hicks, is a way to decide if a change in how resources are used is good for society. It's a bit like a Pareto improvement, but it's easier to achieve.

A change is a Kaldor–Hicks improvement if the people who gain from it could pay back the people who lose out, and still be better off themselves. This payment doesn't actually have to happen. Because of this, a Kaldor–Hicks improvement can sometimes leave some people worse off, even if society as a whole benefits.

A situation is called Kaldor–Hicks efficient if there are no more Kaldor–Hicks improvements possible from that point. If an outcome is the best it can possibly be using this idea, it's called a Hicks-optimal outcome. A Hicks-optimal outcome is always Pareto efficient, meaning no one can be made better off without making someone else worse off.

What is a Kaldor–Hicks Improvement?

A Pareto improvement happens when at least one person is made better off and no one is made worse off. This sounds great, but in real life, it's very hard to make any big change, like a new law or economic policy, without someone being negatively affected. Even simple trades might affect others.

The Kaldor–Hicks idea is more flexible. It says a change is an improvement if those who gain could, in theory, pay back those who lose. This way, everyone could end up better off or at least no worse off, even if the payment doesn't actually happen.

For example, imagine a new factory is built. It creates jobs and products, which benefits many people. But it also causes some pollution, which harms people living nearby. A Kaldor–Hicks improvement would mean that the factory owners and customers make enough money from the factory that they could pay for the pollution cleanup and still have money left over. The pollution victims don't actually get paid, but the possibility of compensation makes it a Kaldor–Hicks improvement.

Every Pareto improvement is also a Kaldor–Hicks improvement. But most Kaldor–Hicks improvements are not Pareto improvements. This means the Kaldor–Hicks idea can be used in more situations because it's not as strict.

Using Kaldor–Hicks in Policy Making

The Kaldor–Hicks idea is often used to test if a new policy or project could make the economy better. It helps decide if an activity moves society closer to a more efficient state. Since almost every change helps some people and harms others, these tests look at what would happen if the winners were to pay the losers.

There are two main parts:

• The Kaldor criterion asks: Are the people who gain willing to pay more to the losers than the losers are willing to accept to agree to the change?
• The Hicks criterion asks: Are the people who lose willing to pay less to the gainers to stop the change than the gainers would accept to give up their benefits?

These two ideas were later combined into the "Kaldor–Hicks criterion" to fix some technical problems.

The Kaldor–Hicks criterion is often used in cost–benefit analysis. This is where the total benefits of a project are compared to its total costs. For example, when deciding whether to build a new airport, planners would compare the benefits (like more flights and jobs) with the costs (like building expenses and noise for nearby homes).

If the total benefits are greater than the total costs, the project would usually go ahead. This is like using the Kaldor–Hicks idea. It means the benefits are large enough that those who gain could theoretically pay back those who lose. This criterion is used because it suggests that it's fair for society as a whole to make some people slightly worse off if it means a much greater gain for many others.

Criticisms of Kaldor–Hicks

One common criticism of the Kaldor–Hicks idea is about the compensation. If the winners could pay the losers but don't actually do it, why should that count as a good decision? Some argue that if people are left worse off, it's not truly an improvement for everyone.

Also, there are some technical issues. For example, economist Tibor Scitovsky showed that the Kaldor criterion by itself can be tricky. It's possible for outcome A to be an improvement over B, but also for B to be an improvement over A. The combined Kaldor–Hicks criterion avoids this specific problem. However, it can still be non-transitive. This means if A is an improvement over B, and B is an improvement over C, A might not necessarily be an improvement over C.

See also

In Spanish: Eficiencia de Kaldor e Hicks para niños

• Compensation principle
• Pareto efficiency
• Scitovsky paradox