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 is to 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: Welfare economics is a branch of economics that uses microeconomic techniques to simultaneously determine the allocational efficiency of a macroeconomy and the income distribution consequences associated with it. ... Pareto efficiency, or Pareto optimality, is an important notion in economics with broad applications in game theory, engineering and the social sciences. ...

• 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.

In non-hypothetical contexts such that the compensation occurs (say in the marketplace), invoking the compensation principle is unnecessary to effect the change. But its use is more controversial and complex where full compensation is feasible but not made and in selecting among more than two feasible social states. In its specifics, it is also more controversial where the range of the decision rule itself is at issue.

Uses for the compensation principle include:

• comparisons between the welfare properties of perfect competition and imperfect competition
• the Pareto principle in social choice theory
• cost-benefit analysis.

Perfect competition is an economic model that describes a hypothetical market form in which no producer or consumer has the market power to influence prices. ... In economic theory, imperfect competition, is the competitive situation in any market where the conditions necessary for perfect competition are not satisfied. ... Social Choice and Individual Values is a book written by Kenneth Arrow first published in 1951. ... Cost-benefit analysis is the process of weighing the total expected costs vs. ...

See also

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

Cost-benefit analysis is the process of weighing the total expected costs vs. ... Kaldor-Hicks efficiency is a type of economic efficiency that occurs only if the economic value of social resources is maximized. ... Pareto efficiency, or Pareto optimality, is an important notion in economics with broad applications in game theory, engineering and the social sciences. ... Social choice theory studies how individual preferences are aggregated to form a collective preference. ... Welfare economics is a branch of economics that uses microeconomic techniques to simultaneously determine the allocational efficiency of a macroeconomy and the income distribution consequences associated with it. ...

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