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Compensation principle

A criterion for the social desirability of’ an economic policy, which. states that if those who gain from the policy could fully compensate those who lose and still remain hetter off, then the policy should be implemented. The fact that the compensation is hypothetical and not actually paid distinguishes this principle froin that underlying the Pareto criterion, which states that the policy is socially beneficial if no one is made worse off and someone is made better off. The compensation principle can be viewed as an attempt to deal with cases which cannot be assessed on the Pareto criterion, i.e. cases in which there are losers as well as gainers. However, there are two powerful sets of criticisms of the principle, one of which questions its logical consistency, the other its practical relevance. The first, proposed by T. Scitovsky and termed the ‘Scitovsky paradox’, shows that if in moving from situation A to situation B the gainers in B can hypothetically compensate the losers, it might then be possible, in the reverse move from B to A, for the gainers (previously the losers) now to compensate the losers (the previous gainers). Scitovsky shows that this possibility arises because compensation is not actually paid, and so A and B are associated with different disJributions of income. The compensation principle could ‘approve’ a policy which moved the economy from A to B, and then one which moved it back again. The second criticism begins with the observation that as a fact of life people, and the governments which represent them, do hold value judgements about income distribution. For example, a policy which made the very rich richer and the very poor poorer is unlikely to gain widespread approval from the demonstration that the gainers could compensate the losers and still remain hetter off, since compensation is not actually paid. Attempts to design a criterion which abstracts from distributional considerations meet the obstacle that economic policy-making in practice is often explicitly concerned with such considerations.

Reference: The Penguin Dictionary of Economics, 3rd edt.