Kaldor-Hicks efficiency criterion

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A particular allocation of resources, or a particular arrangement, is said to be Kaldor-Hicks efficient or Kaldor-Hicks optimal (or equivalently, is said to have Kaldor-Hicks efficiency or Kaldor-Hicks optimality) if there is no Kaldor-Hicks improvement possible.

Here, a Kaldor-Hicks improvement is an alternative allocation from which, after some compensation by gainers to losers (i.e., some transfer of resources between parties), the new outcome is a Pareto improvement: at least one party is better off than with the original allocation, and no party is worse off.

The Kaldor-Hicks efficiency criterion combines the Pareto efficiency criterion with the compensation principle, which allows us to equate two outcomes if one could be attained from the other through transfer of resources between parties, i.e., through compensation.

Relation with Pareto efficiency

  • Every Pareto improvement is a Kaldor-Hicks improvement, but a Kaldor-Hicks improvement need not be (and need not correspond to) a Pareto improvement. The key difficulty is that the compensation following a Kaldor-Hicks improvement may not be possible in practice, making it difficult to convert it into an actual Pareto improvement.
  • Thus, the Kaldor-Hicks efficiency criterion is stronger than the Pareto efficiency criterion: a Kaldor-Hicks optimal arrangement must also be Pareto optimal, but a Pareto optimal arrangement need not be Kaldor-Hicks optimal.