In real-world practice, the compensation principle

In real-world practice, the compensation principle often appealed to is hypothetical. That is, for the alleged Pareto improvement (say from public regulation of the monopolist or removal of tariffs) some losers are not (fully) compensated. The change thus results in distribution effects in addition to any Pareto improvement that might have taken place. The theory of hypothetical compensation is part of Kaldor-Hicks efficiency, also called Potential Pareto Criterion.[3]
Under certain idealized conditions, it can be shown that a system of free markets will lead to a Pareto efficient outcome. This is called the first welfare theorem. It was first demonstrated mathematically by economists Kenneth Arrow and Gerard Debreu. However, the result does not rigorously establish welfare results for real economies because of the restrictive assumptions necessary for the proof (markets exist for all possible goods, all markets are in full equilibrium, markets are perfectly competitive, transaction costs are negligible, there must be no externalities, and market participants must have perfect information). Moreover, it has since been demonstrated mathematically that, in the absence of perfect information or complete markets, outcomes will generically be Pareto inefficient (the Greenwald-Stiglitz theorem).[4]


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