Compensation principle has its roots in the work of French engineer and economist Jules Dupuit (1804-1866), English political economist Alfred Marshall (1842-1924) and Italian sociologist and economist Vilfredo Pareto (1848-1923).
It refers to a transfer mechanism by which total economic welfare is maximized when individuals who gain from a change in the economy compensate those who have suffered because of the change.
Compensation principle was subsequently developed into an important feature of welfare economics through the work of Hungarian-born economist Nicholas Kaldor (1908-1986) and English economist John Hicks (1904-1989). Since it does not rely on the physical transfer of money, critics maintain that the compensation principle lacks a quantifiable verification of the relative gains and losses.
In welfare economics, the compensation principle refers to a decision rule used to select between pairs of alternative feasible social states. One of these states is 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 alternate 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:
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 and no one loses 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 with some losers (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
Also see: cost benefit analysis, pareto optimality, scitovsky paradox, social welfare function