Compensation principle

The compensation principle in welfare economics refers to a decision rule used to select between pairs of alternative feasible social states. One of these states is the the hypothetical point of departure ("the original state"). According to the compensation principle, if the prospective gainers could compensate (any) prospective losers and leave no one worse off, the other state would be selected (Chipman, 1987, p. 524). An example of a compensation principle is the Pareto criterion in which a change in states entails that such compensation is not merely feasible but required. Two variants are:

• The Pareto principle, which requires any change such that all gain.
• The (strong) Pareto criterion, which requires any change such that at least one gains from the change.

More controversial and complex is application of the compensiation principle when compensation is feasible but not made in selecting among more than two feasible states.

Uses for the compensation principle include:

• comparisons between the welfare properties of perfect competition and imperfect competition
• requirement of the Pareto principle in social choice theory
• application to public-policy choices.

See also

• Compensating variation
• Kaldor-Hicks efficiency
• Pareto efficiency
• Social choice theory
• Welfare economics

References

• John S. Chipman, 1987, “compensation principle," The New Palgrave: A Dictionary of Economics, v. 1, pp. 524-31
• Kenneth J. Arrow, 1963, Social Choice and Individual Values, ch. IV