Table of Contents
Use as justification for state action
In this essay, I will first describe the Pareto and the Kaldor-Hicks standard of efficiency. I will then elaborate on the relationship and the differences of the two concepts and finally investigate how the acceptance and application of the two standards shapes evaluation and justification in state action.
In general, a Pareto optimum or Pareto efficient state, named after the Italian engineer and economist Vilfredo Pareto (1848–1923), is a state in which it is not possible to improve one target characteristic without having to worsen another at the same time. If there is such a transfer, the reallocation is called Pareto improvement. Figure 1 depicts the Pareto optimal allocations in a simple two-dimensional allocation problem. Out of all possible allocation points, the red points are Pareto optima and form a Pareto set, the greens are not. In the social sciences a Pareto optimum is consequently understood as a societal situation in which it is not possible to increase the welfare of an individual by re-allocating resources without simultaneously reducing that of another individual. (Coleman 1979; Barr2012, p. 46).
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Figure 1: Pareto Set
In new or Paretian welfare economics1, the concept is used as a criterion for the welfare optimum. Therefore it is assumed that individuals are independent of each other in their ideas of utility (no demand interdependencies such as demonstrative consumption or bandwagon effects) and that benefits increase with increasing ownership of goods and factor quantities. In economic history, the criterion of Pareto optimality superseded the utilitarian objective of the maximal sum of individual benefits that had prevailed until then (Coleman 1979).
The inherent problem with using the Pareto Optimum as a welfare criterion is that the Pareto points cannot be compared without an additional welfare criterion, i.e. the “optimal” Pareto optimum (the best of the seven red possibilities in figure 1) cannot be derived. Moreover, it largely limits any change, because it doesn’t allow non-win-win interpersonal or intertemporal shifts and trade-offs.
The Kaldor-Hicks criterion, named after economists Nicholas Kaldor (1908-1986) and John Richard Hicks (1904-1986), is a welfare criterion based on the idea of potential interpersonal compensation for reallocation of welfare. It is based on the idea and the shortcomings of the Pareto principle but in contrast to the Pareto criterion (without interpersonal benefit comparison), this compensation criterion attempts to assess changes in the welfare of a society as a whole in which the welfare of some individuals increase while that of others decrease. The Kaldor-Hicks criterion thus extends the applicability of the Pareto optimum within the framework of Paretian welfare economics by considering the principle of compensation. (Coleman 1979)
The basic idea is that the welfare optimum has not yet been achieved if welfare gains can be realised through subsequent allocation-neutral redistribution in the form of a compensation payment. If the potential winners of a specific redistribution are able to compensate the potential losers through compensatory payments, the redistribution accompanied by compensation will increase welfare. The total welfare gains must therefore be large enough that even after the full compensation of the losers of redistribution at least a marginal positive net gain remains and consequently a pareto-superior situation is achieved. (Varian 2014, p. 15; Coleman 1979).
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Figure 2: Kaldor-Hicks Improvement
Figure 2 shows possible allocation of utility of two individuals 1 and 2 with the red and green lines. In the initial situation the red line and the distribution F is relevant. After a change in the economic situation the green curve applies and the corresponding distribution situation is L. According to the Pareto criterion, the new situation cannot be compared with the old situation with regard to the welfare aspect, because while the welfare of the individual 1 has increased, that of the individual 2 has decreased. According to the Kaldor-Hicks criterion, however, the change in the distribution situation increases welfare for society as a whole, because starting from situation L, the real allocation of the new bundle of goods could take place in such a way that point M is reached at which the welfare of 2 is unchanged compared with the situation in F, while the welfare of 1 has risen.
The Kaldor-Hicks allows to offset gains in prosperity against losses in prosperity. It needs the implicit assumption of free redistribution activities to enable that the loss of utility or any other quantity of the disadvantaged economic subjects can be compensated by the advantaged economic subjects. It does not require, however, that the compensation payments are actually made; an additional value judgement is needed to assess the desirability of such a measure (Markovits 1993). Scitovsky (1941) showed that the Kaldor-Hicks criterion is reversible in certain situations and thus inconsistent. The change of an economic situation, which according to this criterion is welfare-enhancing for society as a whole, can also lead to an increase in prosperity if it is carried out in the opposite direction, i.e. if it is reversed.
The Kaldor-Hicks criterion for improvement is similar to and a weaker version of the Pareto criterion with compensation possibilities. Therefore, each Kaldor-Hicks optimum is also a Pareto optimum but not each Pareto optimum is a Kaldor-Hicks optimum because there might still be ways of improvement. Both are ways of operationalising efficiency, while the Kaldor-Hicks criterion tries to amend and improve the older Pareto criterion. Many attempts have been made to further develop efficiency criteria since then. Nevertheless, the Pareto criterion is still the most commonly used understanding of efficiency especially in economics and economic policy.
Use as justification for state action
Due to the increasing importance of economic principles in all public spheres2, efficiency became a main dimension in evaluating and justifying state action and rule making. Therefore an operationalisation of efficiency is inevitable, for which the two presented concepts are often used. Besides the use in economic and political science3, both principle are used in politics to justify state action without normative, value-based discussions, because it appeals to the common sense that any action increasing the efficiency of resource allocation is generally perceived as good.
State action that appeals to the Pareto criterion will not worsen the situation of any single individuum which is a very strict criterion. This kind of action is therefore unanimously accepted and easy to justify. But since there is no change in the status quo as long as only one person suffers a disadvantage from a change, the Pareto criterion works in favour of the existing conditions. In practice, there will only rarely be the possibility of government action or a change in the law that actually does not put anyone at a disadvantage. So if the Pareto criterion is used as a criterion for identifying welfare-enhancing policies, it is difficult to find any. Calabresi (1991) argues that the criterion of Pareto optimality could not be a guideline for the state simply because rational individuals under the assumptions of the Coase theorem4 have always found Pareto-optimal solutions among themselves in private negotiations. State decisions would therefore necessarily always also have a distributive effect, some of the citizens concerned would be better and some worse off.
State action that appeals to the Kaldor-Hicks criterion, however, can make people worse off and allows to compare welfare gains and losses of action. It is the principle behind the idea of cost-benefit analyses which is widely applied in state action (Quah & Haldane 2007, p. 104). On the one hand, it thus allows efficiency-justification of action that is actually beneficial for society but not justifiable with the Pareto criterion because it makes some people worse off, on the other hand, it bears the danger to become an utilitarian approach of just looking at the total sum of utility. Without any mechanism to ensure the crucial compensation many actions can be depicted as efficient and a Kaldor-Hicks improvement can be far away from a perceived societal improvement but any enforced compensation would make it identical to the Pareto criterion.
1 In contrast to the “old” welfare economics, Paretian welfare economics measures and compares welfare on an ordinal scale (ranking different situations) instead of a cardinal scale (absolute welfare values of situations).
2 A phenomenon sometimes called and criticized as economic imperialism (Lazear 2000).
3 Wang et al. (2018) for example use both principles to evaluate coal savings attempts in China, Sharma et al. (2018) to evaluate a land law in India under which buyers can acquire land for industrialization.
4 The Coase theorem defines the conditions under which market players can efficiently resolve the allocation of resources through negotiation (Markovits 1993).