Kaldor-Hicks Efficiency
If you go to law school today, you’ll rarely hear the words “justice,” “morality,” or “fairness.” No, the word used most often to assess the legal order is “efficiency.” From the ever-forthcoming William Allen & Reinier Kraakman, Introduction to the Law of Enterprise Organizations:
Pareto reasoned that a given distribution of resources is efficient when and only when resources are distributed in such a way (within a different group or territory) that no reallocation can make at least one person better off, while leaving no person worse off. Economists refer to this hypothetical state as Pareto Efficient or a Pareto Optimal state…
[This is] a difficult definition to use in non-theoretical settings. Another definition of efficiency loosens the constraint of this condition. Two English economists, Nicholas Kaldor and John R. Hicks, each addressed the problem of externalities in their conception of efficiency. Under their definition, an act (or a rule) would be said to be efficient if the transaction produced total gains to those who consented to it that are sufficient to permit the payment of compensation all of those who suffered any losses as a result of the transaction. Note that it is not stipulated that any compensation actually be paid. Kaldor-Hicks is simply attempting to identify transactions that are efficient, not to establish a principle of justice. The idea here is that we live in a world of imperfect and costly information. Third parties who incur losses of some sort as a result of the transaction may not know of their losses. Or if they know of them, the law may give them no recourse for damages, or such recourse as the law provides may be too expensive in light of the size of their loss. In all events, there will be uncompensated losses from certain transactions. These are in principle and in fact made worse off by the trade. Under Kaldor-Hicks’ conception, however, so long as the transactions gains are great enough to compensate them in principle, the transaction would be regarded as efficient: as moving closer to an optimal distribution. In other words, Professors Kaldor and Hicks posited that total (net) wealth creation is the sign of an efficient transaction…
[Kaldor-Hicks efficiency] is the standard definition employed when law and economics scholars criticize corporate law doctrine or practice.
