The Compensation

Principle and Social

Welfare Function
Chapter 3
Incompleteness of Pareto Criterion

 Pareto criterion is useless as a criterion for social

choices in many real-world situations since most
policy changes produce both gainers and losers

 We employ two approaches to handle the inability of

Pareto criterion to handle mixed outcomes

 Compensation principle

 Social welfare function

 The Compensation Principle

 Hicks (1939) and Kaldor (1939)

 Consider a project that moves economy from

state A to state B

 This movement produces both gainers and

losers

 Incomes can be costlessly redistributed

across individuals
Kaldor Compensation Criterion

The project is desirable according to

Kaldor compensation criterion if gainers
can compensate losers in state B in
such a way that everyone becomes
better off compared to state A
 Kaldor Criterion: An Example

State B after
State A State B redistribution

John Bill John Bill John Bill

$100 $100 $300 $0 $150 $150

$150

Since both John and Bill are better off in state B after the redistribution
compared to state A, the project that replaces state A with state B is
desirable according to the Kaldor criterion
Hicks Compensation Criterion

The project is desirable according to

Hicks compensation criterion if the
would-be losers are unable to bribe the
would-be winners not to make the
move from state A to state B
Pareto and Compensation Criteria

 The compensation principle is stated in terms of potential

compensation rather than actual compensation

 If compensation were required, the compensation principle

would be equivalent to Pareto principle (consider example for
Kaldor compensation criterion)

 Considering the hypothetical compensation allows one to focus

on the efficiency aspects of the policy change

 In other words, a policy change is desirable according to the

compensation criterion if total revenue resulting from the policy
change exceeds total cost
 Compensation Principle and
General Equilibrium

We can further illustrate the meaning and

limitations of the compensation
principle by considering redistributions
of income between two households in
the framework of general equilibrium
 Utility Possibilities Frontier
 Each point on the UPF corresponds to some general
equilibrium

 Imagine a redistribution of income among households

 Quantity demanded by both households change
for both goods
 Shortages and surpluses created

 Prices adjust to establish a new equilibrium

 This new equilibrium will be another point on the PPF

Change in Consumer Choice

• At A3 a consumer faces the budget

constraint B3
• Budget constraint B2 corresponds to
the case of more expensive housing
and a different income
• Consumer choice under B2 is A2
• Housing becomes more expensive
because of the mismatch in
demands of the two households
• Excess demand/excess supply for
housing and all other goods change
the slope of the budget constraint
 Utility Possibilities Frontier
V
U = utility of household 1
V = utility of household 2 Utility Possibilities Frontier
VA
AA = budget line in state A
BB = budget line in state B

Good 2
VB

VB
A UB UB U
UA

UA
VA
A Good 1
 Utility Possibilities Frontier:
Properties
 All points on the utility possibilities frontier satisfy the
Pareto condition, i.e. you cannot increase both
households’ utilities by moving along this frontier
away from any point on it

 Any movement along the frontier involves

redistribution of wealth (any improvement in one
household’s welfare necessarily requires a reduction
in the other household’s welfare)

 No two points on the utility possibilities frontier can

be compared by Pareto or the compensation criterion
 Compensation Criterion in
General Equilibrium Setting
V
1. Initially economy is at point O, which is Pareto-
inefficient since it is not on the utility possibilities
frontier
A 2. A move to point B is a Pareto
B improvement for both households

3. A move to point A or C is a Pareto

improvement for at least one of the
C households
O
D Utility Possibilities Frontier
What about movement
to point D?

U
 Compensation Criterion in
General Equilibrium Setting
V
1. A movement from O to D is NOT a Pareto-improvement since
utility of household 2 (or V) goes down

A 2. According to (Kaldor) compensation criterion, a

movement from O to D is an improvement because we
B can move along the utility possibilities frontier (by
redistributing wealth among the two households) to point
B, which is a Pareto improvement compared to O

3. Remember: those compensations are

C
O hypothetical! The move from O to D is still NOT a
Pareto improvement
D

Utility Possibilities Frontier

U
Comparing Pareto-Efficient
Allocations
 Compensation criteria always rank
Pareto-optimal states above Pareto-
inefficient states

 BUT: Different Pareto-optimal (efficient)

allocations are not comparable
according to compensation criteria
 Compensation Principles:
V
Limitations
1. Frontier PP represents the old technology,
while frontier RR represents the new one
R
C 2. B is preferred to A according to the new technology since
a movement along the RR utility possibilities frontier to C will
result in a Pareto improvement relative to A (Kaldor)
P
3. However, A is also preferred to B since
A a movement along the PP frontier to D will
result in a Pareto improvement as well
D (Hicks)
5. Thus, the compensation
principle cannot
completely order social
B states

R P U
Kaldor-Hicks Compensation
and Scitovsky’s Paradox
 Hicks: the losers of the project could not bribe the winners not to undertake
the project (so a move to B is NOT desirable since such a bribing is possible)

Change: PP  RR (AB)
Uk Kaldor: B > A
R Hicks: A > B
C
Kaldor: Since winners at B can compensate
P the losers (by moving to C), a movement to B
A
IS desirable
D
B

R P Un
Scitovsky Paradox and
Incompleteness of Kaldor-Hicks
• One solution: require that AB is desirable according to Kaldor, but not
to Hicks

• While this solution works in some specific cases, these entail

non-transitive preferences

• In general, Kaldor-Hicks compensation criterion does not work in the

general case, so we say its ranking of economy states is incomplete
 Social Welfare Function
 Whenever there is a utility conflict among households, we need
more than a Pareto or compensation principle in order to be
able to rank social states

 Such a complete and consistent ranking of social states is

called a social welfare ordering

 If the social welfare ordering is continuous, it can be translated

into a social welfare function

 Social welfare function relates individual utility levels to one

number called social welfare level so that the combinations of
individual utility levels that translate into higher levels of social
welfare are preferred to the combinations that result in lower
levels of social welfare.
 Social Welfare Functions:
Properties
 Welfarism: social welfare depends only on the utility levels of
the households (distribution not involved)

 Social welfare function is increasing in each household’s

utility level (ceteris paribus), so that an isolated increase of
any household’s utility level increases welfare of the whole
societysocial welfare indifference curves are negatively
sloped

 Social welfare indifference curves are convex to the origin

 Anonymity: It does not matter who gets a high or low level of

utility
Social Welfare Indifference Curves
V

1. Social welfare increases as we move North-

East from the origin so that a move from A to B
increases social welfare
2. Note that even if moving from A
to B makes household 2 lose (V
decreases) and no actual or
hypothetical compensation is paid,
A the move is still socially desirable

B
W3
W2
W1
U
 Social Choice using Utility Possibilities Frontier
and Social Welfare Function
V 1. Maximum achievable welfare is attained at the
tangency of the utility possibilities frontier and the
highest attainable social welfare indifference curve

2. Using the social welfare function, we Utility possibilities frontier

have reduced the infinite number of
possible general equilibria to a single
equilibrium point

U
 A Simple Utility Function

 Consider an unweighted average of the

individual household utilities: W=U1+U2

 This welfare function is called utilitarian or

Benthamite. It is double the unweighted
average of the individual household utilities

 Assume both households are equipped with

ordinal utility functions (as opposed to
cardinal utility functions).
 Ordinal and Cardinal: a Re-Cap

 The values of ordinal utility functions are only used

for the comparison of two different utility levels
attained by the same individual

 In contrast, the values of cardinal utility functions can

be interpreted so that comparisons between different
individuals become possible

 Because it is very difficult to measure utility in a

cardinal way, in most of the cases the ordinal utility
functions are being used
 Individual Utility Functions
 We consider two different individual utility
functions:

U  x1  x2

u  0.5  ln x1  ln x2 
 Ranking of the social states will depend on
the kind of individual utility function we use
for each household
 Ranking of States by Different
Welfare Functions
State 1 State 2
Household 1 Household Household Household
2 1 2
Consumptio (2,2) (2,2) (1,1) (3,3)
n (x1,x2)
Utility
U 2 2 1 3
u 0.69 0
Welfare
W=U+U 4 4
W=u+U 2.69 3

•According to the first welfare function, state 1 and state 2 are given the
same rank
•According to the second welfare function, state 2 is preferable to state 1
Rankings by Social
Welfare Function
 Households rank different states consistently
according to their individual utility functions

 Depending on the social welfare function,

rankings of social states can be different

 Do welfare functions make sense?

 Do Welfare Functions Make
Sense?
 The ranking of states produced by the social welfare
function depends on the way in which we choose to
represent individual preferences

 According to one social welfare function society is

indifferent between state 1 and state 2, while the
other social welfare function says that state 2 is
preferable to state 1

 It thus does not make much sense to define a social

welfare function
Arrow’s Impossibility Theorem

 If utility functions are ordinal and non-comparable,

then the only possible consistent social welfare
function is a dictatorship (i.e. a welfare function that
coincides with the ordinal utility function of some
individual regardless of the preferences of the
others).

 Arrow’s impossibility theorem for the case of two

households: In order to rank social states we must
use either the utility function of household 1 or the
utility function of household 2
 Consistent Preferences
 Preferences must be consistent,
not self-contradictory

 Preferences are consistent if they are

 Complete

 Transitive

 Completeness: we can rank any two states

 Transitivity: if A>B and B>C, it must follow that A>C

 An Example: Majority Voting
Tax Schedule
A B C
Poor 25% 27% 30%
Middle 32% 27% 30%
Rich 33% 36% 30%
•Three groups of individuals: the poor, the middle class, and the rich
•The three groups vote among three tax schedules: A, B and C that raise
the same revenue
•The poor prefer schedule A, the middle class prefer schedule B, while the
rich prefer schedule C
•The poor and the rich prefer A to B: a majority prefers A to B
•The poor and the middle class prefer B to C: a majority prefers B to C
•By transitivity, the majority must prefer A to C
•But: the middle class and the rich (another majority!) will vote for C
 Whither Democracy?

The use of a democratic voting process

in an attempt to formulate social welfare
function can produce contradictory
welfare criteria
 Bergson-Samuelson Social
Welfare Functions

 The following three properties have to be

satisfied for welfare functions to produce a
consistent ranking of social states:

 Full measurability of household utilities (utilities

that are cardinal)

 Welfarism (social welfare only depends on the

level of individual utilities)

 Pareto principle
Partial Measurability
and Comparability
 Utility functions can be made cardinal by allowing for
affine transformations

 An example of an affine transformation:

 F=32+1.8C, F stands for Fahrenheit, C for Celsius

 Generally, U=a+bu, where a and b are constants,

is an affine transformation

 In this way we can measure social utility as a

function of one individual’s utility
 Choosing a Specific Form of
Social Welfare Function

 Under most measurability and

comparability assumptions no unique
social welfare function emerges

 The choice of a specific form involves a

further ethical judgment on aggregation
of individual utilities
 Utilitarianism
 Society’s welfare is equal to the sum of
the individual members’ utilities

 This view is called utilitarianism

 Jeremy Bentham (1748-1832)

 Joseph Priestley (1768): ”The good and happiness of the members, that is
the majority of the members of the state, is the great standard by which
every thing relating to that state must finally be determined."
 “The greatest happiness of the greatest number”
 Utilitarian Utility Function
 U=U1+U2
 Implicitly assumed:
 Cardinal measurability
 At least partial comparability
 For example, U1=a+bU2 where b is common,
but a is different for different households
 Utilitarian Indifference Curves
U2
1. Society is willing to give up one unit of
1 household 1’s utility for a gain of one unit of
household 2’s utility.
u
n
2. This holds regardless of the level of utility of
i
either one of the two households
t
!! Inequality of incomes is NOT the same as
inequality of utilities: marginal utility from an
additional 1$ may differ across individuals

W1 W2

1 unit U1
 Convex Social Welfare
Indifference Curves
U2

1. Society is willing to accept a decrease in

the utility of the poor only if there is a much
larger increase in the utility of the rich

2. Poverty is understood in terms of utility

units, NOT incomes
3. If U1 is utility of the poor,
decreasing utility of the poor results
in large increases in U2, utility of the rich

W2
W1

U1
 John Rawls
 Welfare of society only depends on the welfare of the
poorest household

 Society gains nothing from improving welfare of rich

household

 However: a policy change making a poor person a

little richer, while making a rich guy richer by a lot, is
desirable

 Naturally, egalitarians do not like Rawlsian ideas

 Rawlsian Utility

1. Welfare of society only

depends on the utility of the
poorest households

W2

W1
2. Society gains nothing from
45 improving the welfare of the richer
household
 Maximization of Welfare by
Reallocating Income
 If the social welfare function produces (strictly) convex social
welfare indifference curves, social welfare can be increased by
reallocating income between households if their marginal
utilities of income differ

 Re-cap: marginal utility of income shows the amount by which

one’s utility increases for each additional dollar received

 Social welfare is maximized by distributing total income in such

a way that all households get the same utility from an extra
dollar
 Redistributing Income and General Equilibrium
V At point A, the extra utility the payee gets from a
dollar is equal to the loss of utility to the payer

Utility possibilities frontier

U
 L-Shaped Preferences
 How do we determine the maximum
welfare state when preferences are
L-shaped?

 We do not talk about tangencies, but

we look for a point on the UPF such
that the welfare indifference curve
corresponds to the maximum utility level
 Social Welfare and the
Distribution of Income

 So far, we have implicitly assumed that the

higher the initial income, the less is the utility
derived from an extra dollar (diminishing
marginal utility of income)

 If all households have identical utility

functions, an equal distribution of a given
total amount of income maximizes social
welfare
 Lorenz Curve

 Lorenz curve plots the percentage of total income

earned by various income groups within the
population

 With complete equality, the poorest 25% have 25% of

total (national) income, the poorest 50% have 50%,
and so on

 If inequality is great, the poorest part of the

population gets a disproportionately small percentage
of total income, while the rich get the most
 Poorest 20 Second 20 Richest 20
Country (Year of Study) Percent Percent Third 20 Percent Fourth 20 Percent Percent

Lesser-developed          

Chile (2003) 3.8% 7.3% 11.1% 17.8% 60.0%

China (2004) 4.2 8.5 13.7 21.7 51.9

Columbia (2004) 2.9 6.9 11.0 18.3 60.9

Egypt (2004) 8.9 12..7 16.0 20.8 41.5

El Salvador (2002) 2.7 7.5 12.8 21.2 55.9

Ethiopia (2000) 9.1 13.2 16.8 21.5 39.4

India (2004) 8.1 11.3 14.9 20.4 45.3

Indonesia (2005) 7.1 10.7 14.1 20.5 42.5

Kenya (1997) 6.0 9.8 14.3 20.8 49.1

Mexico (2004) 4.3 8.3 12.6 19.7 55.3

Nigeria (2003) 5.0 9.6 14.5 21.7 49.2

Peru (2002) 3.7 7.7 12.2 19.7 56.7

Philippines (2003) 5.4 9.1 13.6 21.3 50.6

South Africa (2000) 3.5 6.3 10.0 18.0 62.2

Thailand (2002) 6.3 9.7 14.0 20.8 49.0

Zambia (2004) 3.6 7.9 12.6 20.8 55.1

Average 5.3 9.2 13.4 20.3 51.8

Developed          

Canada (2000) 7.2 12.7 17.2 23 39.9

France (1995) 7.2 12.6 17.2 22.8 40.2

Germany (2000) 8.5 13.7 17.9 23 36.8

Italy (2000) 6.5 12 16.7 22.8 42.0

Japan (1993) 10.6 14.2 17.6 22 35.7

Singapore (1998) 5.0 9.4 14.6 22.0 49.0

Sweden (2000) 9.2 14 17.6 22.7 36.6

Switzerland (2000) 7.6 12.2 16.3 22.6 41.3

United Kingdom (1999) 6.1 11.4 16.0 22.5 44.0

United States (2000) 5.4 10.7 15.7 22.4 45.8

Average 7.3 12.3 16.7 22.5 41.1

 Examples of Lorenz Curves
% of income

1. If one Lorenz curve (A) lies North-West of

another (B), the distribution of income in B is
more equal compared to A

2. If two Lorenz curves cross

each other, ranking is
impossible (e.g. A and C)

B
% of
C population
sorted by
wealth
Comparing Income Distributions
 If one Lorenz curve lies North-West of
another, the distribution of income
corresponding to the first curve is more
equal compared to the second

 Lorenz curve ranking is incomplete

 Equality and Welfare

 It can be shown that for a quite broad class of social

welfare functions, moving towards a more equal
distribution of incomes will increase social welfare
 Marginal utility of one dollar for the poor is greater than that
for the rich

 However:

 Achieving a certain distribution of income entails some costs

 Disincentive effect (highly productive people may choose to

work less if their income is reduced)
Equality and Marginal Utility of Income
Total Income Y

Marginal Utility Marginal Utility

M’2

M2

M1

Income of household 1 Income of household 2

Inequality as a Result of Different
Utilities

 Differences in the individual schedules of

marginal utilities of income account for the
unequal distribution of income

 If schedules of marginal utilities of income are

identical among all households, the resulting
equilibrium distribution of incomes is perfectly
equal
 Inequality is not the Same as
Poverty

 Since the concept of daily necessities varies with the course of time,
some economists argue that poverty is a relative concept that must be
related to some measure, like the average income in the society

 Policies that reduce poverty do not necessarily reduce inequality

 Disincentive effect (why work if you get your food anyway)
 Targeting transfer income to those just below poverty level, not the poorest
households

 The capability argument

 Consumption of minimum amounts of certain commodities is required to
achieve certain basic needs
 Poverty thresholds defined according to the capabilities argument may be
very different from the conventional “minimum essential basket” definition
 Summary
 Social welfare indifference curves are useful in discussions about the
tradeoffs facing society

 Most policy changes will produce gainers and losers

 To make policy choices that involve gainers and losers, we need to

have a universally acceptable principle for making interpersonal utility
comparisons

 Such universal comparison principle does not exist

 Arrow’s Impossibility Theorem states that under most general

assumptions, dictatorship is the only meaningful social welfare utility
function

 Even if there are many ways to construct social welfare functions,

together with compensation criteria they provide useful tools for
evaluating the effects of policy changes