What is Scitovsky Paradox? Explain it in the context of Kaldor-Hicks compensation test.

What is the Scitovsky Paradox?

The Scitovsky Paradox, named after economist Tibor Scitovsky, describes a situation in welfare economics where a policy change from state A to state B might be deemed an improvement by the Kaldor-Hicks compensation criterion, but a reverse movement from state B back to state A could also be considered an improvement by the same criterion. This implies that society could prefer A over B and B over A simultaneously, leading to logical inconsistency and undermining the reliability of the compensation test as a definitive measure of welfare improvement.

The paradox arises because the evaluation of gains and losses is dependent on the prevailing prices and income distribution in each state. When a policy shifts the economy from A to B, the relative prices and income distribution change. Consequently, the ability of winners to compensate losers, and vice-versa, can be different in the two states, leading to contradictory results when applying the compensation test in both directions.

Kaldor-Hicks Compensation Test

The Kaldor-Hicks compensation test is a criterion in welfare economics used to assess whether a change in economic policy or resource allocation leads to an improvement in social welfare, even if it makes some individuals better off and others worse off. It is less stringent than Pareto optimality, which requires that no one is made worse off.

Core Principles of Kaldor-Hicks Compensation Test:

• Kaldor Criterion: Proposed by Nicholas Kaldor, this criterion states that a change is an improvement in social welfare if those who gain from the change could hypothetically compensate the losers and still be better off. The actual compensation does not need to occur; it only needs to be *possible*.
• Hicks Criterion: Proposed by John Hicks, this is the reverse of the Kaldor criterion. It states that a change is an improvement if the losers from the change could not profitably bribe the gainers to prevent the change from occurring and still be better off.

Together, the Kaldor-Hicks criteria suggest that a policy is socially desirable if the total benefits outweigh the total costs, enabling a hypothetical compensation to make everyone at least as well off as before, with some people better off. This forms the basis for cost-benefit analysis in public policy.

Scitovsky Paradox in the Context of Kaldor-Hicks Compensation Test

The Scitovsky Paradox directly challenges the consistency and transitivity of the Kaldor-Hicks criterion. Here's how it manifests:

• The Contradiction: Scitovsky demonstrated that it's possible for a movement from an initial state A to a new state B to satisfy the Kaldor-Hicks criterion (gainers in B could compensate losers and still be better off). However, simultaneously, the reverse movement from state B back to state A could also satisfy the same criterion (gainers in A could compensate losers from B and still be better off). This creates an anomalous situation where B is "preferred" to A, and A is "preferred" to B, which is a logical inconsistency.
• Reason for the Paradox: The inconsistency arises due to changes in relative prices and income distribution between the two states. When moving from A to B, the calculations for potential compensation are based on the price structure and distribution in state A. If the move to B significantly alters these, then when considering a return from B to A, the compensation calculations would be based on the new price structure and distribution in state B. These different bases can lead to conflicting results regarding who can compensate whom.

To overcome this paradox, Scitovsky proposed his "Double Criterion."

Scitovsky's Double Criterion:

For a policy change from state A to state B to be considered a genuine welfare improvement, Scitovsky's double criterion requires two conditions to be met:

1. The Kaldor-Hicks criterion must be satisfied when moving from A to B (gainers in B can compensate losers in A and still be better off).
2. The reverse Kaldor-Hicks criterion must NOT be satisfied when attempting to move back from B to A (losers in B should NOT be able to bribe gainers in A to prevent the move from B to A, meaning a return to A is not an improvement).

Only if both conditions are met can a change be unequivocally declared a welfare improvement. This ensures that the preference ordering is transitive and consistent, preventing the paradoxical situation where both states are superior to each other.

The following table summarizes the essence of the criteria:

Criterion	Condition for Welfare Improvement (A to B)	Key Limitation / Paradox Addressed
Kaldor Criterion	Gainers in B *can* compensate losers in A and still be better off. (Potential compensation).	Can lead to the Scitovsky Paradox if reversal is also possible.
Hicks Criterion	Losers in B *cannot* bribe gainers in A to prevent the change. (Potential prevention).	Can lead to the Scitovsky Paradox if reversal is also possible.
Scitovsky Double Criterion	Kaldor-Hicks from A to B is met, AND reverse Kaldor-Hicks from B to A is NOT met.	Resolves the Scitovsky Paradox by ensuring consistent preference ordering.