Compensating And Equivalent Variations

In 1943, Hicks proposed the compensating variations (CV) and equivalent variations (EV) tests as money measures of changes between different welfare positions. Hicks adopted these measures to make welfare change measurable and to furnish measures to use in KH tests. They are money measures of welfare change (sometimes called 'exact utility indicators') that order choices for individuals. The CV measures the value of a change at the prices holding in the new situation, the EV measures the value of a change at the original prices. The CV assumes the original utility level as the status quo; the EV assumes the final utility level as the status quo. For both of these tests, if the money measure of value for a move from position A to position B is positive for an individual, it is assumed that the individual will prefer position B to position A. To use the EV measure for a welfare gain implicitly assumes that one has a right to that gain. To use the CV measure assumes no such right. For a negative change, the CV assumes a right to the status quo, so that one has a right to avoid the loss; the EV assumes no right to avoid the negative change (for an elaboration, see Zerbe and Dively 1994, pp. 74-80 or Boadway and Bruce 1984).

The advantages of the CV and EV values were, first, that they were measurable and, second, that they appeared to have intuitive meaning, in terms of the willingness to pay (WTP) and the willingness to accept payment (WTA). The WTA reflects the price that someone who has the good would accept to sell it. The WTA is also the minimum amount of money one would accept to forgo some good or to bear some harm. The CV measure (for consumers) is the sum of the WTPs for a beneficial change plus the sum of the WTAs for a negative change. The EV measure (for consumers) is the sum of the WTAs for a positive change plus the sum of the WTPs for a negative change. The CV measure is associated with the Kaldor compensation test, and has generally been the standard for benefit-cost analysis, on the grounds that a change should be made only when the potential losers of a good could potentially be compensated on the basis of their values, as reflected by their willingness to sell that good.19 For a normal good, the WTA is greater than the WTP, for reasons that I will discuss later. Therefore, it was thought that the use of the CV ensured that potential compensation of losses was possible. We shall see in Chapter 3 that the relationship among the WTP and the WTA, and the EV and the CV and potential compensation tests is more complex than usually indicated.

For the economists of the late 1930s and early 1940s, the critical question became whether or not a policy could pass a Kaldor or a Hicks compensation test, in terms of whether the sum of the compensating or equivalent variations was positive. In the case of the Corn Laws, the question was, then, whether or not the gainers from the laws' repeal could, in principle, compensate the losers (the landlords), and still have something left over for themselves. These tests were then to be regarded as 'objective test[s] of economic efficiency; prescriptions based on it were thought to have a scientific status and to be free from value judgments' (Mishan 1981, p. 303).20

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