Definition of Compensation Principle
This is the amount that must be paid to another economic agent to pay for their loss of economic welfare.
If sufficient compensation is paid it can enable a pareto improvement to society
Compensation for externalities.
If a firm pollutes a river, the fishermen will lose out on income. If this income loss is worth £10,000 a year, then the chemical firm who pollutes should pay at least £10,000 to the fishermen. This then compensates for the negative externality.
The problem with this principle is that it ignores the rights of fish and how to measure the external cost of pollution
Example of compensation for externalities
An airport paying local residents to have double glazing fitted to compensate for noise pollution.