Richard O. Zerbe Jr.1, a, E-mail the corresponding author,
Yoram Baumanb, Corresponding author contact information, E-mail the corresponding author,
Aaron Finkle
The Kaldor–Hicks (KH) criterion arose out of discussions among prominent British economists during the late 1930s.2 Before that time, it was generally assumed that each individual had an “equal capacity for enjoyment” and that gains and losses among different individuals could be directly compared (Mishan, 1981, pp. 120–121; Hammond, 1985, p. 406). Robbins, 1932 and Robbins, 1938 disturbed this view by arguing that interpersonal comparisons of utility were unscientific. Kaldor (1939, pp. 549–550) acknowledged Robbins' (1938, p. 640) point about the inability to make interpersonal utility comparisons on any scientific basis, but suggested it could be made irrelevant. He suggested that when a policy led to an increase in aggregate real income,
…the economist's case for the policy is quite unaffected by the question of the comparability of individual satisfaction, since in all such cases it is possible to make everybody better off than before, or at any rate to make some people better off without making anybody worse off.
Kaldor went on to note (1939, p. 550) that whether such compensation should take place “is a political question on which the economist, qua economist, could hardly pronounce an opinion.”3Hicks (1939) accepted this approach, which came to be called KH.
Thus, it came to be thought that including considerations of income distribution or of compensation would involve interpersonal utility comparisons, and that such comparisons should be avoided by excluding consideration of actual compensation or of income distribution.4 It was thought that this exclusion would lead to a measure of efficiency that was more scientific.5
KH separates efficiency and equity and proposes to leave the latter to the politicians. Undoubtedly, there is some merit in separate accounting, but it does not follow that economists should refrain from providing information on equity and on moral sentiments. Increasingly, economists have not refrained (e.g., Andreoni, 1995, Palfrey and Prisbey, 1997 and Office of Management and Budget, 2003).
The modern version of KH may be reasonably characterized by the following assumptions: (1) every dollar is treated the same regardless of who receives it, i.e., equal marginal utility of income;6 (2) a project is efficient if it passes the Potential Compensation Test (PCT), i.e., if the winners could hypothetically compensate the losers (Kaldor, 1939, pp. 549–550);7 (3) gains are measured by willingness to pay (WTP) and losses by willingness to accept (WTA); and (4) equity effects are to be disregarded. More controversial is whether or not moral sentiments, under which equity effects are a sub-category, are to be excluded in a KH test. To ignore moral sentiments imposes a substantial cost-it amounts, for example, to a dismissal of existence values in those instances in which they arise from moral sentiments. This topic is of interest because analyses that include moral sentiments can differ materially from those that do not (Portney, 1994).
This paper has demonstrated that value is added by including moral sentiments in economic analysis and that the objections that have been raised to it are not persuasive. Of course, the ability to include such sentiments in practice is limited by the difficulty of measurement. But this is true of any values, particularly non-market ones, and not just moral ones.
In the long run, it seems likely that an aggregate measure that includes moral sentiments will be adopted either in addition to or as a substitute to KH. As a practical matter, it is neither possible nor efficient for benefit–cost analysis to consider all relevant goods and affected individuals, so any analysis will fail to meet the requirements of theoretical perfection, whether for KH or KHM. Nonetheless, in performing practical analysis it is always desirable to have in mind the best theoretical template so that practical decisions can be well-considered and not ad hoc. Our purpose has been to contribute to this template.
