Compensation principle:

Pareto criterion  simply states  that  an economic change,  which  harms no  one  and  makes someone better off, indicates an increase in  social welfare. This does not apply to those economic changes, which harm  some and benefit others.  In  terms of Edgeworth Box diagram,  Pareto criterion  fails  to  say  as  to  whether  or  not  social welfare increases as movement  is made  in  either direction along  the  contract curve because it rejects the notion of interpersonal comparison of utility. Thus, this criterion leaves a considerable indeterminacy, for, there are numerous Pareto optimum  points  on the  contract curve. Economists  like Kaldor,  Hicks and Scitovsky have made efforts  to  evaluate  the  changes  in  social welfare resulting  from  any economic reorganisation, which  harms somebody  and benefits others. They have put forward a criterion known as the Compensation Principle based on the following assumptions:

- The satisfaction of an individual is independent of others and she is the best judge of her welfare.

- There exist no externalities of consumption and production.

- The tastes of individuals remain constant.

- The problems of production and exchange can be separated from those of distribution. Compensation principle accepts the levels of social welfare to be a function of the production. Thus, it ignores the effects of change in distribution on social welfare.

- Utility can be measured ordinally and interpersonal comparisons of utilities are not possible.

Given the above assumptions, Hicks, Kaldor and Scitovsky have claimed to formulate a value free objective criterion of measuring the changes  in social welfare with the help of the concept of 'compensatingpcryments'.