Distributional policy impacts, WTP-WTA disparities, and the Kaldor-Hicks tests in benefit-cost analysis

Abstract

I examine how inequality in the distribution of income and a quasi-fixed good (e.g. environmental quality) can affect the disparity between aggregate willingness to accept (WTA) and willingness to pay (WTP) for policies that induce joint, nonmarginal and heterogeneous changes to income and the quasi-fixed good. These disparities can generate divergent conclusions from benefit-cost analysis (BCA). With Cobb-Douglas preferences, I show that greater inequality in policy impacts to the quasi-fixed good generally increases the range of conflicting conclusions from BCA using the Kaldor criterion (compensating variation) versus the Hicks criterion (equivalent variation). In two examples, I show that for any set of impacts to the quasi-fixed good there exists a degree of inequality in which the Kaldor-Hicks tests disagree. This disagreement arises because, with inequality, seemingly marginal policy changes can become nonmarginal when concentrated among marginalized or privileged groups, which can widen the gap between aggregate WTP and WTA. With CES preferences, when the goods are complements, WTA may be infinite, and when they are substitutes, budget constraints attenuate WTP: Both effects push the Kaldor-Hicks tests in opposing directions. I conclude that greater inequality increases the relevance of questioning whether to elicit WTP or WTA in nonmarket valuation for BCA.