Distributional Policy Impacts, WTP-WTA Disparities, and the Kaldor-Hicks Tests in Benefit-Cost Analysis

CEnREP Working Paper No. 21-002


I examine how inequality in the distribution of income and a quasi-fixed good (e.g. environmental quality or health) 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). In the case of 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 intuitive 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 increasingly concentrated among marginalized or privileged groups in society, leading to a widening gap in aggregate WTP versus WTA. Extending the analysis to general CES preferences, I find that when the goods are complements, these same forces can render the Kaldor-Hicks tests inoperable (e.g. when the goods are distributed lognormally). When the goods are substitutes, attenuation of WTP by individuals’ budget constraints can also push the Kaldor-Hicks tests in opposing directions. I conclude that greater inequality can increase the relevance of questioning whether to elicit WTP or WTA in nonmarket valuation for BCA.


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