When faced with decision making, we rarely ever weigh economic efficiency concerns. This disregard for economic efficiency ultimately causes distorted and undesirable outcomes. Economic efficiency results when the costs incurred in the emergence of a final outcome (a good, a service, or an event) is the lowest. There are many measures for this economic efficiency, of which two are important for us - Pareto efficiency and Kaldor-Hicks criterion. It is appropriate if all the possible outcomes or options are tested against these tests, before we finalize our preferences.
An outcome is said to be Pareto optimal, if we cannot make one person better off without making another person worse off. This criterion for efficiency is thought to impose a very strict standard, since there are very few transactions in the real world which will stand this test. Most exchanges or transactions involve external costs, which on most ocassions imposes substantial costs on the society and its inhabitants.
The Kaldor-Hicks criterion, formulated by Nicholas Kaldor and John Hicks, imposes less stringent conditions and can be applied to many practical situations. The Kaldor-Hicks criterion is itself a mixture of the separate Kaldor and Hicks tests. Under the Kaldor test, an outcome will be efficient if the maximum amount the gainers are prepared to pay is greater than the minimum amount that the losers are prepared to accept. The Hicks test stipulates an outcome to be efficient if the maximum amount the losers are prepared to offer the gainers in order to prevent the change is less than the minimum amount the gainers are prepared to accept as a bribe to forego the change. The Hicks test is from the loser side and the Kaldor test the gainer side reasoning.
The combined test stipulates that an outcome is more efficient if those made better off could in theory compensate those made worse off, thereby resulting in a Pareto optimal outcome or atleast a Pareto improvement. It needs to be emphasised that, unlike a Pareto optimal solution, a Kaldor-Hicks efficient outcome can leave some people worse off. In so far as most exchanges end up making some people better off while making atleast a few people worse off, Kaldor-Hicks tests ask what would happen if the winners were to compensate the losers.
Further, while the Pareto efficiency requires that no party is actually made worse off, the Kaldor-Hicks efficiency only requires the possibility of compensation to exist. It is the discretion of the participants to execute the mutually beneficial transaction. We can conclude that any economically efficient decision should ideally conform to the Pareto efficiency test, or atleast to the Kaldor-Hicks test.
We need to be certain that the alternative chosen from a bouquet of options shoud be the most ideal and efficient solution to the particular problem. The Kaldor-Hicks criterion can be widely applied to policy and decision making situations. It can be the basis for cost-benefit analysis on investment decisions, redistribution policies (like subsidies), taxation policies and many other decisions.
Consider, Mr Polluter who wants to set up Pollution Factory at Nature Village. He has chosen Nature Village, because it confers on him certain advantages, as compared to other locations (Maybe, Nature Village has cheap land, or a rivulet stream which provides adequate water round the year). We are concerned about the costs imposed by Mr Polluter's factory on Nature Village, and how much the residents of the village have to be paid to persuade them to accept setting up the Plant there. Assume, Pollution Factory inflicts net external costs amounting to about Rs X, which is also the minimum amount demanded by the villagers to put in place the mechanisms to remedy the costs inflicted by the factory. Also assume, it would cost Mr Polluter and additional Rs Y to establish the Plant at the next best location. If Rs Y > Rs X, then there is the poossibility of a mutually beneficial bargain between the two parties.
Similar examples galore in urban areas. It is commonplace to have complaints against some objectionable shop or commercial establishment located in predominantly residential areas, causing inconvenience to its neighbours. (The Corporation typically gets 5-10 such complaints every day) There is a simple solution to this problem. Assume Mr Welder wants to set up a welding shop in Soundfree Colony. Assume also that the Plant generates costs on the neighbours amounting to Rs A, and it would cost Mr Welder Rs B to relocate elsewhere. If Rs B > Rs A, then there is a possibility for a mutually beneficial bargain between the parties and Mr Welder continuing his business in Sound free colony. (The cost could for example be the amount required for setting up sound proofing system)
I believe that instead of blanket regulation by the Government, we should encourage similar market negotiation between the parties so as to solve such problems. But this would require putting in place formal and informal mechanisms like Residents' Welfare Associations (RWAs), which can facilitate such negotiations and its enforcement.
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