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Kaldor-Hicks Criterion Analysis

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Published: Tue, 17 Oct 2017

Kaldor-Hicks criterion is named by Nicholas Kaldor and John Hicks. Kaldor-Hicks criterion is also known as Kaldor-Hicks efficiency. Kaldor-Hicks criterion is a measure of economic efficiency that captures a number of the intuitive attractiveness of Pareto efficiency, however have less stringent criteria and is thus applicable to a lot of cases. According to Kaldor-Hicks criterion, a more efficient outcome will leave some individuals worse off. Using Kaldor-Hicks criterion, an outcome is more efficient if those that are made better off can in theory compensate those that are made worse off. Additionally, the Kaldor-Hicks don’t require compensation, and therefore does not have to make every individual better off.

Although all Kaldor-Hicks criterion situations are Pareto criterion, on the contrary isn’t true. In contrast, through each Pareto improvement could be Kaldor-Hicks improvement, but most of the Kaldor-Hicks improvements don’t seem to be Pareto improvements. This is because, the Pareto improvements are a small part of Kaldor-Hicks improvements; it also reflects the most flexibility and applicability of the Kaldor-Hicks criterion relative to the Pareto criterion.

The Kaldor-Hicks methods are usually used as tests of Pareto criterion instead of as efficiency goals themselves. They’re used to verify whether or not an activity is moving the economy towards the Pareto criterion. Any change typically makes some individuals better off at the same time making others worse off, therefore these tests ask what would happen if the gainer were to compensate the losers.

According to Kaldor’s welfare criterion, if change in policy or economic organization will make some individuals better off and others individuals worse off, the change will increase the social welfare if those who gain from the restructuring could compensation the losers and still can be better off than before. Hicks expressed that, ‘A could compensate B for his loss and still have something left over, if A is made better with the change, then the reorganization is an unequivocal improvement’. A hick has given his criterion from the loser’s point of view, whereas Kaldor had formulated this criterion from the gainer’s point of view. Though the two criteria are exposed differently, but they are really the same. Thus, that is why the two criteria are generally called by a single name, ‘Kaldor- Hicks Criterion’. (Nicholas Kaldor, 1939).

The utility possibility curve can help to explain the Kaldor-Hicks criterion. The ordinal utility of A and B (two individuals) is shown on Y and X axis respectively as utility possibility shown in the below diagram. The various combinations of utilities obtained by individuals A and B are represented the utility possibility curve for DE. The utility of A will increase while the utility of B will falls when we move the DE curve downward and vice versa.

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Assumed that the utilities obtained by individual A and individual B from the allocation of output or income between them is shown by point Q inside the utility possibil­ity curve DE. As a result of certain change in economic policy, the A and B will move from point Q to point T on the utility possibility curve DE.

At this movement, the utility of A will be declined and utility of B will increase. That is, individual A becomes worse off than before while B become better off. Thus, the movement from point Q to point T can’t assess by means of Pareto criterion. Certainly, points like S, G, R or other point on the segment RS of utility-possibility curve DE are socially preferred to point Q on the basis of Pareto criterion. However, the Kaldor-Hicks compensation principle has propounded that whether or not social welfare has increased is because the movement from point Q to point T.

Based on the Kaldor-Hicks criterion, we must see the movement from point Q to point T whether the B who gains at that movement could compensates the A who loses at that movement and still B can be better off than before. Based on the graph above, the utility possibility curve DE passes through the point S, G, and, R. This means that reallocation of income between the individual A and Individual B can move from point T to point R, if B can give some compensation to A for the loss suffered. It is evident from the graph above, at point R, B is better off as compared to point Q while A remain the same utility as at the point Q. Due to policy change and consequent movement from point Q to point T, the B (gainer) can compensates the A (loser) and still better off than at point Q. Thus, based on the Kaldor-Hicks criterion, the movement from point Q to point T will lead the social welfare increase because they could move from point T to point R through reallocation of income.

It is noteworthy that, based on the Kaldor-Hicks criterion, whether or not social welfare has increased may not be actually paid to judge though compensation. It is enough to know whether the winner could compensation the loser and still be better off. However, if it is possible for gainer compensates the loser and still better off, the economists can said social welfare has increased.

In addition, only when the change in economic policy will leads to the increase in real income or output can be noted the gainer could compensation the losers and still can be better off. That is why Hicks and Kaldor claim that they can distinguish between changes in output from the change in allocation. If the Kaldor-Hicks criterion is satisfied with a change in situation, this means the economy has moved to a potentially more efficient position and could say that the social welfare have increased.

Besides that, if through reallocation the point of the two individuals in change from point T to point G refer the graph above. The individuals A and individual B are better off at point G than at point Q. Therefore, the point T to which the individuals moved as results of certain change in policy is superior to the initial point Q from the perspective of social welfare, because from point T movement can be made simply through reallocation of income to point G where each are better off as compared to the point Q. It may be noted that the situation shown in the graph above, the certain change in the economic policy brings about a movement from a point inside the utility possibility curve to a point on it. Pareto efficiency indeed requirement making every individual better off or at least no worse off.

Criticisms

The Kaldor-Hicks criterion has not been without its critics. First, economic welfare could not be increased by a resource reallocation unless the compensation is actually paid. That is, an explicit decision about the desirability of the income re-distributional effects are needed before a statement can be made about the effect of net benefits on real welfare.

Next, the redistributions of gains and losses are not free of cost. Therefore, the informational costs of ascertaining beneficiaries and cost-bearers and the amount gain or lost might lead to the question the desirability of making the compensation and the desirability of the project itself, if the compensation payments were actually paid.

Furthermore, the Kaldor criterion alone is not antisymmetric which indicated by Tibor Scitovsky. Kaldor criterion may be inconsistent since it is possible to have a situation where an outcome A has greater improvement than outcome B and at the same time outcome B is also an improvement over A. Although a combined Kaldor-Hicks criterion does not have this problem, it can be non-transitive. That is, A better than B, and B better than C, but A may not be better than C.

Review newspaper articles and journal articles

This section will discuss about the Kaldor-Hicks criterion used by the researchers to examine the change is an improvement if those who gain from the change can fully compensate the losers and still retain some gain in the literature review. Discussions of these real-life scenarios are able to give a general idea and the view in the theoretical part.

Based on our studies, the sustainability in transport is more important issue for current and future generation. We found that the researcher by Bradley W. Lane ,Colin P. Sherman (2002) they use the Kaldor-Hicks Tableau has developed a framework for implementing cost-benefit analysis in transport projects to better assess sustainability. It has used the example of implementation of a rail line in a bus-only transit system to highlight key issues and distinctions. The project as a part of holistic, financial specifics of the individual project, integrated transport system and with consequences into other realms beyond the traditional economic as consider has attempted to develop the framework.

Besides that,the cost-benefit analysis using the Kaldor-Hicks Tableau to suggested that there is a valuable role are undervaluing sustainability concerns in typical analyses of transport project concern about the scenario where there is disagreement over the success and utility of the investment mode and provide a framework for benefits of sustainability concerns against traditional capital and operational costs, practitioners and scholars alike to consider the costs, to advance the academic and professional debate on valuation and also consideration of sustainability in public projects and policy.

According to Margarita Rubio & Jose A. Carrasco-Gallego (2013), they find that monetary and macroprudential policies acting together in coordinated and non-coordinated way which unambiguously improves the stability of the system. The interaction between both is welfare improving for society, especially in the case of non-coordinated one. Firstly, they concern on the welfare trade-offs between agents whether there is still room for Pareto improvements (Rubio et al, 2013). Then, they also find that an LTV (loan-to value) threshold below which there is room for Pareto-improving solution. The higher the value, the trade-off between borrowers and savers appear. Lastly, they proposed Kaldor-Hicks which borrowers can compensate savers welfare loss so that they are indifferent between having the macroprudential policy and in this case, they gain a Pareto-superior outcome. Based on the Kaldor-Hicks Criterion, sufficient compensation given from those are made better off to those are made worse off. As fitting to the theory, the article is mentioning that the borrowers compensate the savers’ loss in order to make no one worse off in the end.

Other researches like Piero Benazzo (2010), Pareto and Kaldor-Hicks Efficiency have an aspect of sustainability in relation to inequality. He mentioned that countries are implementing redistributive policies could implement Kaldor-Hicks movements which make some parts of the economic agents less well off. These movements with redistribution would though reinstate effective demand on the demand side and make in general all economic agents better off by increase output and wealth throughout the economy (Benazzo, 2010). Based on Benazzo (2009), a paradigm is presented which competition for meritocracy is good for total factor productivity (TFP) growth and cooperation in keeping inequality as low as possible is good for the outlet markets. In this article, the alternative Kaldor-Hicks Efficiency criterion which allows decreasing the wealth of others as long as the wealth in the economy increases. It can also be analyzed in light of the inequality decrease multiplier paradigm. Example given, State A is considered that there are two possible improvements. Both have benefits greater than costs after the losers potentially compensate for any loss incurred. These two states are state B and C, and in relation to each other they run into the Scitovscky paradox as they can be reversed one back to the other and still respect the Kaldor-Hicks Efficiency. So, Pareto and Kaldor-Hicks Efficiency have an aspect of social sustainability in relation to inequality, so that only efficiency equilibria that comply with certain equity criteria are sustainable in the long term.

According to the Kaldor-Hicks criterion state that a change is an improvement lead to increases social welfare and those who gain from the change can fully compensate the losers and still retain some gain. This theory also proved by a researcher Rastogi (2012) by using a real example that is the Indo and US mango trade case. India is the top of the mango production in the worldwide and supplying about 40 percent of the world mangoes. US are insignificant on production of mangoes and only can produce not exceeding 3000 tones mangoes per year. The US market is a much lucrative market compare with India market. However, the US banned import of Indian mango in 1989 due to excessive usage of pesticides and fear of invasion of fruit flies and stone weevils. After that, India offered Hot Water Treatment (HWT) to reduce pesticide levels and pest control. After prolonged negotiations in 2006, US permitted import Indian mangoes with nuclear irradiation and strict inspection. That will cost India increases the cost of mango, but it improves the quality of mangoes. However, the irradiation process is costly, but it leads to the net export of India increased significantly. Welfare impact of mango trade on both countries under different policy option has been estimated. India willing to compensate US for any losses emanating from changes the policy, but it has not been much problem for India because it will increase the their export of mangoes over USD 157 million, whereas the consequential loss borne by the US is about USD 50 million only. Therefore, India offer to compensate US mango producers directly in lieu of a more favorable policy regime. This would keep the US welfare economy at the same level and also increase the gain to India. Through this exchange, both countries will reach the Kaldor Hicks efficient outcome.

In addition, we also found the article apply the same theory, such as the study shows the urban resident’s willingness to pay for the conservation of Asian elephants to compensate farmers for the damage caused by elephants used by the researchers Bandara and Clem (2004).Urban resident’s changes the policy to save the Asian elephants due to compensate farmer field damaged by elephants. In the research, the author found that the Asian elephant is more precarious than the African elephants and it to be the most seriously endangered species of large mammals (Bandara & Clem, 2004). The policy changes lead to increase the urban environment and economic benefits, however it also cause the reduction in agricultures due to government conservation elephants. The important policy option is reduce the likelihood of farmers killing of elephants and allow elephants some access to their crops for food. The author also found that the return on the capitalized is exceeds the economic losses caused by the elephants. Therefore, the urban residents are the one who gain from the changes in policy and willing to compensate the loser (farmers) for the damage caused by the elephants. In fact, the annual return of the urban residents for conserving the elephant is more than twice of the compensation to the farmers. This case is proven the theory Kaldor-Hicks that the urban residents is the one who gain from the change in policy can fully compensate loser (farmers) and still retain some gain.

Environmental equity and sustainability are interpreted as imposing new decision criteria that require additional benefit-cost tests based on actual compensation to identify sub-groups of the population (Scott, 1997). This denies the pre-World War II compromise of economists about potential compensation embodied in Kaldor-Hicks criteria. Each project had been proposed to pass a benefit-cost test for both conditions. For environmental equity, the identified group either receives net benefits or more than compensated for its losses. However, for sustainability the compensation must be larger than the net value of the resource and the value of the resource is reinvested. They found that the actual concern is about some group based on income level bears the real cost of actions like emission fees, extraction of resources without receiving benefits. Therefore, they come out with Kaldor-Hicks criteria which approving of economic actions if the winners can compensate those bearing the costs. But at last they form a new decision criteria which requires a separate benefit-cost test based on actual compensation to sub-groups of the population (Scott, 1997). So, they choose to reject the Kaldor-Hicks criteria and replace with Pareto criteria.


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