The Compensation Principle: The Possibility of Compensation
As was noted above, there are really two versions of the Compensation Principle. We have discussed the first, under which actual welfare changes are its analytic grist. In this second, it is the concept of potential welfare change which is central. As initially conceived by Kaldor and Hicks, a potential increase in welfare would occur in the situation where, as a result of some new element operating in the economy (e.g., a change in public policy, an innovation, etc.), social state A is changed into B, B differing from A in that some individuals are better off and some worse off, and by the gainers paying the losers compensation a new situation B′ could be achieved such that no one is worse off than in A, while at least someone is better off. Unlike the previous version, where our comparison would be simply between A and B′ (i.e., welfare improvement due to the change plus compensation), our comparison here is between A and B. B is said to be "potentially better" than A because it would take only a lump-sum redistribution of the goods and services in B (i.e., a movement along the same utility-possibility curve) to bring about an actual welfare improvement.
As we noted above, the analysis here is quite sharply distinguishing between the commodity bundles at A and B and the distribution of income at A and B. Commodity bundles can be ordered; relative income distributions can not. Calling B "potentially better" than A, therefore, is asserting