Numeraire Illusion: The Final Demise of the Kaldor-Hicks Principle

The Kaldor-Hicks principle (potential Pareto improvement) has fostered the modern revival of an older Marshall-Pigou tradition of welfare economics. That tradition was based on the parsing of a potential change into a change in the size of some "social pie" measured in money (e.g., Pigou's "national dividend") and a change in the distribution of the pie. By characterizing an increase in the size of the pie (i.e., a Kaldor-Hicks improvement) as an "increase in efficiency," this modernized Marshall-Pigou-Kaldor-Hicks (MPKH) tradition seeks to transcend the strictures of the Paretian treatment of efficiency (which would require actual compensation of the losers so that the whole change was a Pareto improvement). Economists can then with clear professional conscience make the policy recommendation for the increase in efficiency and put to one side the question of compensating the losers as a separate question of equity. However, this whole efficiency-equity analysis turns out to be vulnerable to a simple redescription of exactly the same total changes with a different numeraire or even a reversed numeraire (when only two goods are involved). Then the parsing into "efficiency" and "equity" parts will change and can even reverse itself so what was previously seen as the potential "compensation" is then recommended as the wealth-increasing change. Hence the "wealth maximization" principle breaks down in incoherence. The flaw is the numeraire illusion of evaluating changes in both non-numeraire goods and in the numeraire goods, and then misleadingly concluding that transfers in the numeraire goods have no effect on the size of the "social pie." Changes in a yardstick will never be revealed by the same yardstick - but are revealed by switching to a different yardstick (or numeraire). This result undercuts the major applications of the MPKH reasoning in the standard Chicago school (wealth maximization) of law and economics, cost-benefit analysis, policy analysis, and related parts of applied welfare economics.