Shadow prices reflect true values for factors and products for the calculation or estimations of prices in social cost-benefit analysis. J. Tinbergen defines them, “Shadow prices are prices indicating the intrinsic or true value of a factor or product in the sense of equilibrium prices. These prices may be different for different time periods as well as geographically separate areas and various occupations (in the case of labour). They may deviate from market prices.”
According to E.J. Mishan, “A shadow or accounting price…. is the price the economist attributes to a good or factor on the argument that it is more appropriate for the purposes of economic calculation than its existing price if any.”
Need and Determination of Shadow Prices:
In developing countries for project evaluation the distribution of factors on the basis of market prices is imperfect because there exist fundamental disequilibria which are reflected in mass underemployment at existing wage levels, in the deficiency of funds at existing interest rates and in the scarcity of foreign exchange at the prevalent exchange rate.
In such a situation, the equilibrium level of wages would be much below the market wage, the equilibrium interest rates would be higher than their market rates, and the equilibrium rate of exchange would be lower than its market rate.
In order to overcome these difficulties, J. Tinbergen, H.B. Chenery and K.S. Kretchemer have emphasized the use of shadow or accounting prices for the following reasons:
1. Imperfect Market Mechanism:
The price mechanism operates imperfectly in developing countries. Market prices do not correctly reflect relative scarcities, benefits, and costs. This is because perfect competition is entirely absent. Structural changes do not respond to price changes.
Institutional factors distort the existence of equilibrium in the product, labour, capital and foreign exchange markets. Thus prices fail to reflect and transmit the direct and indirect influences on the supply side and the demand side.
All such difficulties are overcome with the help of shadow prices. Fiscal, monetary and other policies also help in bringing the market prices of products labour, capital and foreign exchange in conformity with their shadow prices and thus make investment projects a success.
2. Wage Rates:
In developing countries, there exist fundamental disequilibria in the labour market which are reflected in mass underemployment and unemployment at existing wage rates. In such economies, wages are much lower in the non-organised agricultural sector.
There is also surplus labour in rural areas whose marginal product is zero or negligible. But it cannot be assumed to be zero in calculating the cost of such labour on construction works. On the other hand, wages are much higher than the opportunity cost of labour in the industrial sector where labour is organised in strong trade unions.
Therefore, unadjusted market wages of labour cannot be used for calculating the cost of such labour on investment projects. In such a situation, the equilibrium level of wages would be much below the market wage in the rural sector.
Economists suggest that the shadow price of such labour can be fixed anywhere above the zero marginal product of labour, and with the increase in the marginal product of labour, its shadow price can also be raised to the market level of wages.
3. Capital Costs:
In developing countries, funds for investment are deficient at prevailing interest rates. The main cause is the deficiency of savings. The majority of people are poor having low income levels, low rate of savings and hence low propensity to invest. Moreover, there is little relationship between the supply of capital and interest rates prevalent in the country.
There is also wide disparity between the prevailing interest rates in different regions and areas. In the capital market, the market rate of interest is much higher them the bank rate. Therefore, the equilibrium interest rate would be much higher than its market rate. If unadjusted market price of capital is used in calculating the cost of capital on investment projects, it would underestimate the real cost of such projects.
To overcome this problem, the shadow rate of interest can be estimated on the basis of interest rates paid by private investors. But while so doing, it is essential to allow for a social rate of discount for calculating the social benefits and costs of an investment project where its net present value (NPV) is calculated as
NPV = Σt Bt-Ct/ (1+i) t
Where Bt is the expected gross benefit of the project at time t, Ct is expected gross cost of the project at time t, and i is the social discount rate at time t. The social discount rate is the government’s borrowing rate on long-term securities. So it differs from the market rate of interest. If the social discount rate is higher, short- period projects with higher net benefits are preferred, and if it is low, long-period projects with lower benefits are chosen.
4. Exchange Rate:
There is acute scarcity of foreign exchange leads to balance of payments difficulties in developing countries. As a result, the current rate of foreign exchange is much lower than in the black market and the equilibrium exchange rate is lower than its market exchange rate.
To solve this problem, an artificial equilibrium is achieved in the balance of payments by fixing a higher shadow exchange rate than the official exchange rate. For this, weight is attached to the cost of foreign exchanges in the project.
Suppose the shadow price of foreign exchange is 50% higher than its market value, the net effect of a project on the balance of payments should be given a weight of 0.5. This is equivalent to valuing foreign exchange costs and earnings at a price of 1.5. Tinbergen suggests the calculation of the shadow foreign exchange rate based on the ‘black’ and ‘free’ rates of exchange.
If the free (official) exchange rate is Rs.50 a dollar and the black rate is Rs.75 a dollar and the conversion of the official rate is four times as great as that at the black rate, then the shadow exchange rate would be the weighted average,
4 × 50 + 1 × 75/5 = Rs.55
Thus Rs.55 per dollar would be the shadow rate instead of the official rate of Rs.50.
5. Inflationary Pressures:
Developing countries suffer from inflationary pressures because the market mechanism operates imperfectly due to a number of socio-economic and administrative obstacles. Even otherwise, rise in prices are inevitable in the development process.
So actual market prices do not reflect social benefits and costs. Some prices are fixed by the government. Others are free, but are influenced by restrictive trade practices or monopolies. Still others are influenced by quantitative controls.
When prices rise, there is overvaluation of domestic currency. The prices of imported goods for projects underestimate their real cost. Thus there is need for shadow prices in the case of investment projects in different sectors of the economy.
A factor that is expected to be in short supply should have a shadow price higher than its market price, while a surplus factor should have a lower shadow price than its market price. Thus the shadow price is the price which would prevail if prices were equilibrium prices.
Limitations of Shadow Prices:
The following are the limitations in the determination of shadow prices:
- The calculation of shadow prices pre-supposes the availability of data. But adequate data are not easily available in less developed countries.
- In order to establish the intrinsic value of a factor or product requires the existence of full equilibrium in all markets. In an underdeveloped economy which is characterized by a number of fundamental disequilibria, the knowledge of full equilibrium conditions for the entire economy is not possible. Thus the notion of shadow prices corresponding to intrinsic values is arbitrary.
- The assumption of full employment equilibrium in the whole economy makes the concept of shadow prices indeterminate. It requires a complete knowledge of demand and supply functions which are based on the existing socio-economic institutions in the economy. Thus shadow prices are difficult to ascertain under the existing institutional framework of underdeveloped countries.
- Another problem arises with regard to the time dimension. The concept of shadow prices is static and timeless, because shadow prices are used to overcome the difficulties involved in project evaluation when factor prices change over time. All inputs and outputs are valued at fixed shadow prices in such cases. This is not realistic because investment projects relate to long periods. Hence the concept of shadow prices remains a static one.
- Another practical difficulty relates to the use of shadow prices in the economy where the private enterprises buy inputs and sell outputs at market prices. The government, on the other hand, uses shadow prices for the evaluation of its projects but buys all inputs at market prices and sells outputs at competitive market prices where it does not possess a monopoly.
- The determination of shadow prices is difficult in the case of projects with high capital-intensity and which are substitutes and complementary to each other. Suppose there are two projects in which the input of one is the output of the other and vice-versa.
In such cases, the determination of the shadow prices of the inputs of labour, capital and foreign exchange will not only be difficult but impossible because the decisions about the construction plans of the two projects cannot be the same.