SummaryThe analysis of welfare economics is built around the concept of Pareto efficiency. However, this efficiency criterion does not always represent a satisfactory answer. In order to solve this problem, and to find a new way to establish which allocation is best, economists have been since searching for new criteria to make a more informed decision. In this Learning Path we learn about some of these criteria.
The Hicks criterion is a compensation criterion developed by John Richard Hicks in his paper “The Valuation of the Social Income”, 1940. It is similar to that of Kaldor’s, with different implications although with the same limitations. In this criterion, state Y is preferred to X, if there is not a potential reassignment that turns X into Xˈ, that is at least as good as Y in Pareto terms. In the following graph we consider the utility of two individuals (A on the x-axis and B on the y-axis), which we will compare using the utility possibility frontier of two different moments.
When moving from state X to Y, individual A’s utility decreases while it increases for individual B. Due to this, individual A should compensate individual B so the change of states does not happen, going from X to X’, which will increase B’s utility as much as going from X to Y, while the drop in A’s utility would not be as large. The same would happen if moving from Y to X. Since this ex-ante compensation is possible, neither X is preferred to Y nor Y will be preferred to X.
When moving from state Y to Z, again individual A´s utility decreases while it increases for individual B. When going from Y to Z, there is no possible compensation from individual A to individual B, since to the left of Y the utility possibility frontier is always higher. Individual A therefore can not compensate individual B, so Z is preferred to Y in Hicks’ terms. However, when comparing movement from Z to Y, the opposite logically occurs. Individual A’s utility increases while individuals B’s decreases. Individual B would compensate individual A going from Z to Z’ , and hence Y is not preferred to Z.
If we compare this with Kaldor’s criterion we see some significant changes but still both criteria fall under the Scitovsky paradox. This paradox is centred in the phenomenon that while Y can be preferred to X the opposite can also be true. This does not give a truly asymmetric result as it could just mean that going back to the initial situation is preferred. The economy would therefore oscillate between both points.