According to Kaldor, the test of increase in social welfare is that if some people are made better off and others worse off, the gainers from the change could more than compensate the losers and yet be better off themselves. The actual payment of compensation is regarded as a political or ethical decision.
Kaldor does not require that the losers should actually be compensated. Rather he requires that the gainers should be able potentially to compensate the losers out of their gains. Hicks presents the same criterion in a little different way thus: “If A is made so much better off by the change that he could compensate B for his loss, and still have something left over, then the reorganisation is unequivocal improvement. “
Thus the Kaldor Hicks criterion implies that if an economic change leads to the production of more goods and services they can be so distributed as to make some people better off and none worse off. Actual redistribution being a political or ethical issue, need not take place. It is enough that reorganisations create such conditions that redistribution can be effected.
This criterion is illustrated with the help of utility possibility curves for two individuals. If A and B are two individuals, each utility possibility curve represents the locus of all combinations of their utility levels. Each curve is related to a given fixed bundle of goods and the various points on each curve are obtained by costless lump sum redistribution of a fixed commodity bundle.
Let X and Y be the two bundles of goods represented by the utility possibility curves B1A1 and B2A2 respectively as utility possibility shown in the below diagram. Starting from a given bundle of goods represented by Q2 in terms of the Paretian criterion any change which leads to a movement to any one of the points C,D and E is a Pareto improvement on the B1A1 curve because it makes both individuals better off or atleast one better off without making the other worse off. But any movement outside C and E to Q1 cannot be evaluated by the Paretian criterion for the reason that it improves A’s welfare at the expense of B. Nevertheless, a move from Q2 to Q1 can be evaluated in terms of the Kaldor-Hicks criterion.
This can be done by (i) asking B how much he would be willing to pay A to prevent this move and (ii) asking A how much he would be willing to pay to B to forgo it. If (ii) > (i), the change increases welfare for the reason that A would potentially compensate B for his loss and still be better off at Q1 than at Q2.