The first of the above concepts, the Pareto efficiency criterion, states that a good or a service should be provided only if at least one person is made better-off and nobody is made worse-off. This situation may be referred to as a Pareto optimal outcome.  In practice, however, the Pareto criterion is somewhat limited, since it is very difficult to implement public services or activities without at least one person being worse-off. For example, consider the decision to construct a road segment that will substantially reduce commuter times for a large majority of people in an economic region. The net effect of such a project might be negative for a few people who live near the location where the road is planned to be built. Unless these few individuals are compensated economically for the adverse effects that the project would impose on them, they would be worse-off, and the project would not meet the Pareto criterion.

The second criterion, the Kaldor-Hicks efficiency criterion, named for economists Nicholas Kaldor and John Hicks, captures some of the intuitive appeal of the Pareto efficiency criterion, but is applicable to more circumstances. It states that a good or a service should be provided if a Pareto optimal outcome can be reached by arranging sufficient compensation from those who are made better-off to those who are made worse-off. In this manner, everyone would end up no worse-off than before. More simply put, a good or service should be provided as long as the total (aggregate) benefits of the project outweigh the total costs. If this is the case, the provision of the good or service will increase societal welfare and society as a whole will be better off.

A major challenge associated with the Pareto and the Kaldor-Hicks criteria is that they both assume that it is possible to assess the value that individuals in a community place on a particular project, public good, or service that is being considered. In the absence of market prices, assessing the value that different people place on a particular good or service is very difficult. Nevertheless, economists and analysts often attempt to estimate these values so that they can determine the total benefits (i.e., the aggregate benefits for all individuals in a community) that will result from producing a particular public good or service. As will be discussed in Lesson 6, they do this by applying a variety of techniques aimed at determining the perceived benefits to each individual and then expressing them in dollar terms. The aggregate value of all the individual perceived benefits are then compared with the aggregate costs. If the benefits exceed the costs, the Kaldor-Hicks criterion is met.

A simple illustration of the Kaldor-Hicks criteria would be if 10 individuals who live on a particular street decide to invest in a street light. Let's say that each of five of the individuals perceives the value (i.e., what they are willing to contribute in dollars) of the light to be $500. That is, they would be willing to pay $500 each for this good if it were sold on the private market. Furthermore, let's say that four of the individuals perceive the value to be $400, and the remaining individual perceives it to be $100. In this example, the Kaldor-Hicks criterion would be met as long as the total cost of the street light were less than $4,200, which is the total value of the perceived benefits: ($500 x 5) + ($400 x 4) + ($100 x 1). For example, if the cost were $3,200, the net benefit to society would be $1,000.