Definition of Kaldor–Hicks efficiency
Pareto efficiency occurs when one party benefits from a decision, but others aren’t made worse off. In other words, no one loses out.
Kaldor Hicks states that a decision can be more efficient as long as in theory, everyone can be compensated to offset any potential costs.
Example of Kaldor Hicks.
Suppose building a new airport led to a net utility of 100 units to the wider society.
However, building a new airport would make local residents worse off (air pollution, noise pollution). This welfare loss might be calculated at 10 units.
Therefore, in theory the new airport could be efficient according to Kaldor-Hicks by compensating local residents from some of the net gain.
Under Kaldor Hicks, the key principle is the idea that in theory people could be compensated. This compensation doesn’t actually have to occur. Whereas under pareto efficiency, this compensation would have to occur through voluntary agreements between two parties.
Kaldor-Hicks criteria may be used to judge the effectiveness of a Cost-Benefit Analysis scheme.
Problems of Kaldor Hicks.
Just because in theory, compensation may be given to those who lose out, in practise in may not.
This can lead to an increase in inequality and be perceived as unfair. For example, those under flight path may feel it is unfair they have been singled out to have to put up with an airport nearby.
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