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Compensation Tests Vs Social Welfare Functions Notes

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Microeconomics Compensation Tests vs. Social Welfare Functions Introduction for Compensation Tests

* There are limitations of the Pareto principle, as it cannot rank all states. Also, most policies make some better off whilst others worse off. In real life there are always losers and gainers, and the pareto criterion cannot handle such circumstances.

* One approach of moving beyond the Pareto principle involves the use of "potential pareto improvements" via compensation tests.

* This expands the range of states that can be ranked to include those where some are made worse off, but without recourse to distributional judgements. Compensation Tests Explained

* Kaldor and Hicks suggested the compensation principle in 1939. According to the Kaldor criterion, if the gainers from a project can fully compensate the losers, and still be better off themselves, then the change is a potential Pareto improvement in welfare and is therefore socially desirable.

* The Hicks Criterion suggests that a project should go ahead if losers cannot bribe the gainers to refrain from undertaking the considered project.

* The power of the compensation test lies with it being hypothetical, and that it is not actually paid. If the compensation was paid, then we would not have advanced beyond the Pareto principle. In practical applications it would also be impossible to compensate everyone anyway. By focusing on the potential compensation one focuses on the efficiency aspects of the policy change. For instance, through knowing that the winners could compensate the losers, we understand that the benefits outweigh the costs - this is the basis for social cost benefit analysis. Graphical Illustration

The UPC draws the utility implications of the contract curve. Say some project can now be implemented that reaches a higher UPC curve. B is preferred to A because there is a potential Pareto improvement, even though it is not an improvement according to the Pareto criterion. But according to the Kaldor criterion, redistribution could move to point C, where there is an improvement in welfare for both individuals the winners could compensate the losers and still be better off.

If we expand the range of states for further investment projects, we can note social ordering. That is, each change results in a potential Pareto improvement. Continued

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