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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

• 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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