A Basic Fallacy in Law & Economics and Cost-Benefit Analysis

Abstract

There is a fatal logical-methodological fallacy involved in the Kaldor-Hicks principle which analyzes a Pareto into an part and an part--so that economists can supposedly recommend the efficiency part in their scientific role as economists while leaving the equity part to politicians, moral philosophers, and the like. In the simplest case of a Pareto-improving exchange of an apple for some nuts (the numeraire), the apple transfer is the efficiency part and the numeraire transfer is the equity part. By a simple redescription of the same exchange reversing numeraires (so apples become the numeraire), the efficiency and equity parts are reversed. Then the principle would recommend the transfer of nuts on efficiency grounds, leaving the transfer of the apple as a non-economic matter. Hence the principle is not stable under a trivial redescription of the same situation. Measuring the effect on social wealth (denominated in the numeraire) of a transfer in the numeraire is the same-yardstick fallacy. When the situation is described using some numeraire not involved in the exchange (neither apples nor nuts), then both the apple and nuts transfers increase social wealth and thus are the efficiency part while there is no equity part. Hence when the fallacy is avoided by using a non-involved numeraire, then the notion of a KH improvement just collapses back to the usual notion of a Pareto improvement. This removes the foundations for the principle and wealth maximization in Law & Economics, as well as the 'economic' basis for recommending a positive net-benefit project sans-compensation in Cost-Benefit Analysis.