CHAPTER

Shadow Prices

INTRODUCTION

In underdeveloped countries, for project evaluation and programming, the

distribution of factors on the basis of market prices is imperfect because there
exist fundamental disequilibria which is 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.

NEED FOR THE USE OF SHADOW PRICES

The price mechanism operates imperfectly in underdeveloped 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; and
prices fail to reflect and transmit the direct and indirect influences on the
supply side and the demand side. Markets are not in equilibrium due to
structural rigidities. Labour cannot be usefully employed because of the
shortage of other cooperant factors. The rate of interest understates the value
of capital to the economy. And disequilibrium persists in the balance of
payments which cannot be reflected in the official rate of exchange. For
instance, in such economies wages are much lower in the non-organized
agricultural sector while they are even higher than the opportunity cost of
labour in the industrial sector where labour is organised in strong trade
unions. In capital market; the market rate of interest is much higher than the
bank rate, and the current rate of foreign exchange is much lower than in the
black market. Thus “market prices, particularly those of the factor of
Production form a very imperfect guide to resource allocation in
underdeveloped economies, because there exist fundamental disequilibria
which are reflected in the existence of massive underemployment at present
levels of wages, the deficiency of funds at prevailing interest rates and the
shortage of foreign exchange at current rate of foreign exchange.”1 To
overcome these problems, the use of shadow prices has been suggested by
economists for the allocation of resources in development planning, for
evaluating projects and as a device in programming. To conclude with
Streeten, “The call for the use of shadow prices (or accounting prices) in
planning for development stems from the obvious fact that actual market prices
do not reflect social benefits and social costs. Some are fixed by administrative
fiat. Others are ‘free’, but influenced by restrictive practices or monopolies.
Others again are influenced by quantitative controls. The shadow price is the
price which would prevail if prices were equilibrium prices....”

The fixation of shadow price for irrigation water is

illustrated in Fig. 1. The supply and demand for
irrigation water is taken on the horizontal axis and
price in the accounting period is taken on the vertical
axis. In the initial accounting period, OQ1 quantity of
water is needed by the farmers of the area. But the
government is supplying only OQ2 quantity of water
from the irrigation project at OP1 price. In the next
accounting period, the government may set the price
equal to marginal cost or charge the price of irrigation
water too low as part of its strategy of regional
development. After the low price OP2 is charged by the government, the
demand for irrigation water will exceed its supply. In such a case the
government may adopt the policy of rationing of water. It may ask each farmer
to limit their land-area for irrigating. In the next accounting period, the
government uses OPS as the shadow price which is the equilibrium price when
OQS of irrigation water is supplied and demanded.

MEANING OF SHADOW PRICES

Shadow prices reflect intrinsic or true value for factors or products. J.
Tinbergen defined them for the first time in 1954 in these words: “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.”2 In 1958, Tinbergen
defined shadow prices as those that correspond to intrinsic values and “that
would prevail if: (i) the investment pattern under discussion were actually
carried out; and (ii) equilibrium existed on the ,markets just mentioned (i.e.,
labour, capital, foreign exchange markets)”3 This definition is clear and
exhaustive, but is silent about the behaviour of accounting prices over time.

1. UN, ECAFE. “Criteria for Allocating Investment Resources among Various Fields of Development in
Underdeveloped Countries,” Economic Bulletin for Asia and Far East, June, 1961.

2. Investment Criteria and Economic Growth, (ed.) M. Millikan, 1955.

A UN report defines shadow prices in terms of the opportunity cost of the

factor or product. The shadow price of an output such as capital labour or
foreign exchange represents its “opportunity cost” or the loss to the economy
that would result from a reduction in its supply by one unit. A factor that is
expected to be in short supply should have an accounting price higher than its
market price, while one that is surplus should have a valuation that is lower
than its market price.4 A. Qayyum, however, defines shadow prices in terms of
the marginal productivity of factors. In his words, ‘accounting prices are the
values of the marginal productivity of factors when a selection of techniques
has been made which produces the maximum possible volume of output, given
the availability of resources, the pattern of final demand and the technological
possibilities of production.’5 It would require the calculation of the marginal
productivity of factors by the government manipulating the system of subsidy
and taxation in such a way that the supply prices of factors to the producers
equal the value of their marginal productivity. E.J. Mishan gives the simplest
definition in these words, “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.”6 Thus there is hardly any unanimity over defining accounting prices and
the different concepts present so many difficulties in their calculation that the
concept becomes ambiguous.

DETERMINATION OF SHADOW PRICES

The determination of shadow prices can be done through the general

equilibrium method or the partial equilibrium analysis:

1. General Equilibrium Method. In the general equilibrium method,

equilibrium is established among all factors by taking their final demand and
supply. For this, the data relating to the different sectors of the economy is
collected and the accounting price of every factor is expressed in algebraic
symbols, and added up for the whole economy. A number of simultaneous
equations are required to be solved for which correct and adequate data are not
available. Since the shadow price is the price which would prevail if prices
were equilibrium prices, the existence of full equilibrium is essential for the
establishment of an equilibrium price for every factor of production. The
evaluation of shadow prices can be done in two ways: one by trial and error,
and two, by a systematic method. If the method of trial and error is adopted the
evaluation of accounting prices may be based on arbitrary values for products,
factors and foreign exchange, calculating the priority figures for all
investment projects and finding out whether equilibrium has been attained in
the markets or not. If this method fails, a systematic method is required which
consists “in introducing algebraic symbols for each of accounting prices,
trying to express supplementary demand for the factors and supply of the
products concerned, and then equating total demand to total supply.” But the
existence of full equilibrium situation for the entire economy is not realistic
because in order to find out the equilibrium prices, the knowledge of total
demand and supply curves and the production and consumption functions
underlying them is essential. These functions depend upon the varied social
institutions. So the determination of accounting or shadow prices through the
general equilibrium method is a difficult affair.

3. The Design for Development., p., 39

4 . Formulating Industrial Development Programmes, 1961

5. Theory and Policy of Accounting Prices, 1959.

6. Cost-Benefits Analysis, 1971.

2. Partial Equilibrium Method. According to the partial equilibrium method,
the shadow prices of capital, labour and foreign exchange are determined
separately. This is, therefore, a simple and correct method of determining
shadow prices. We discuss below the determination of the shadow or
accounting prices of capital, labour and foreign exchange.

(a) Determination of the Accounting Price of Capital. To determine the shadow

price of capital or the accounting rate of interest, it is essential to study the
factors which influence the demand and supply of capital. But in
underdeveloped countries, the knowledge of these factors is imperfect.
Moreover, there is little relationship between the supply of capital and the
interest rates prevalent in such economies. There is wide disparity between the
prevailing interest rates in different regions and areas. As such, the accounting
or shadow rate of interest can be estimated on the basis of the interest rates
paid by private investors. But while so doing, it is essential to make allowance
or allow discount on different types of loans for differences in risks involved.
In the UN Manual of Economic Development Projects, the following formula
has been used for calculating the shadow price of capital.

Social return to capital used in the sector

Value of output minus cost of materials,

In this, the costs of materials, labour, foreign exchange and other inputs are
valued at accounting prices, and to calculate the return on capital invested (rate
of interest) these costs are deducted from the value of output. Thus the
accounting price of capital can be known for a sector. Tinbergen opines that it
is better to take a higher price of capital than interest rates at which limited
sums can be borrowed under certain conditions in underdeveloped countries.
He, therefore, suggests an interest rate of 10 per cent for underdeveloped
countries on the plea that even some of the developed countries were having an
interest rate of 7 to 8 per cent till recently, whereas personal loans are being
made now at an interest rate of 25 to 30 per cent in the former.

Its Difficulties. But there are certain difficulties in the calculation of the
shadow rate of interest in underdeveloped countries.

First, to base the shadow rate of interest on what is paid by private investors
understates the value of capital to the economy because an integrated
development programme may raise the interest rate over the long run.

Second, the calculation of the marginal product of capital as the basis of the
shadow rate of interest for the whole economy is not easy when projects of
higher and lower capital intensity are started, and there is considerable waste
of capital in substituting capital for labour in moving things about, in the
handling of materials inside the factory, in packaging, in moving earth, in
mining, in building and construction, and their failure to develop an
appropriate technology in keeping with their factor endowments.7

Third, in the shadow rate of interest ‘double index number ambiguity’ is

present which makes its use somewhat dubious. The rate of interest is both a
stock and flow concept. The shadow rate of interest is thus not a single
measure but is concerned with relations between stock and flow. In fact, in a
developing economy there is a very large variety of stocks with different
degrees of durability. Thus the calculation of the shadow rate of interest
becomes very complicated.

7. W.A Lewis, Development Planning, 1966.

However, the appropriate formula for the calculation of the shadow rate of
interest for the economy is: where, R is the shadow rate of interest, G is the rate
of growth, Sp is the savings rate of profit receivers, Py is the share of profit in
total income, and Sw is the savings rate of the wage earners.

Assuming G = 5 per cent, Sp = 25 per cent, Py = 50 per cent, and Sw = 5 per

cent, the shadow rate of interest will be:
(b) Determination of the Price of Labour. Determination of the shadow price of
labour is a difficult problem because labourer differ in efficiency. Therefore,
shadow price of labour cannot be the same for both the unskilled and skilled
labour and for different types of skilled labour. There has to be a different
shadow price for different types of labour because labour is not like other
factors. In underdeveloped countries there is surplus labour in the rural areas
having almost zero marginal product. But its shadow price cannot be assumed
to be zero, it should be positive and provide a minimum subsistence level when
such labour is employed on construction works. “But even if the marginal
product of labour is less than the wage (or subsidized income), it does not
necessarily follow that one should use a shadow price for labour lower than
the wage. This is because wage earners tend to consume most or all the wages
which they are paid. Thus the payment of wages constitutes a real cost to the
economy, even if there is no alternative employment for labour.” Therefore,
some economists are of the view that the accounting price for labour can be
fixed anywhere above the zero marginal product of labour, and with the
increase in the marginal product of labour its accounting price can also be
raised. But, according to UN experts, assuming no surplus of skilled labour but
ample supplies of agricultural and unskilled labour the accounting prices of
different kinds of skilled labour can be based on the cost of moving workers
from villages to industrial areas, providing them with houses and other
facilities, and training them.8

8. UN. ECAFE.

(c) Determination of the Rate of Foreign Exchange. The shadow price of

foreign exchange is essential for underdeveloped countries suffering from
balance of payments difficulties. An artificial equilibrium is achieved in the
balance of payments by fixing a higher shadow rate of exchange than the
official rate of excnange. “In an optimum development plan, the accounting
price of foreign exchange would be equal both to the incremental cost of
earning foreign exchange through exports and to the incremental cost of
saving foreign exchange through import substitution. The former may be
easier to estimate in many cases because there are relatively few potential
exports, at least in the near future in underdeveloped countries.” For this,
weight is attached to the cost of foreign exchange in the project. If say, “the
accounting price of foreign exchange is 50 per cent higher than its market
value, the net effect of a project on the balance of payments should be given a
weight of .5 in addition to the effect on the national income. This is equivalent
to valuing all foreign exchange costs and earnings at a price of 1.5.”9
According to Dr. Little, Israel is the only developing country in which the
accounting price of foreign exchange is estimated in this way.10 It is not
essential that every project should be weighted equally because the foreign
exchange component of each project is different.

As an alternative, it is suggested that the demand for and the supply of foreign
exchange should be computed which should then determine the rate where the
two equilibrate. But this procedure is not practicable in developing economies
where the foreign exchange requirements differ sector-wise and project-wise.
Further, a single shadow rate of exchange cannot be applied over time. It will
have to be reviewed and raised at different points of time on the basis of the
‘black’ and ‘free’ rates of exchange, because the market for some important
international currencies like the dollar and the sterling is imperfect. Professor
Tinbergen suggests the calculation of the shadow rate of foreign exchange
based on the ‘black’ and ‘free’ rates of exchange. If the official (free) exchange
rate is Rs. 7.5 a dollar and the black rate is Rs. 15 a dollar and the conversion
of the official rate is four times as great as that at the black rate, then the
shadow rate would be the weighted average

Rs. 9 per dollar would then be the most serviceable shadow rate instead of the
official rate of Rs. 7.5.

DIFFICULTIES OF SHADOW PRICE

Apart from certain difficulties already mentioned in the determination of

shadow price for capital, labour and foreign exchange, there are other
difficulties of a general nature.
First, the calculation of shadow prices pre-supposes the availability of data.
But adequate data is not easily available in less developed countries.

Second, in order to establish the intrinsic value of a factor or product requires

the existence of full equilibrium in all market. 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.

Third, 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
social institutions in the economy. “Land prices will depend upon the system of
land tenure and on agricultural policy generally. The supply price of labour
will depend upon the motivation and education of potential workers, on
acceptability of employing women and on the attitudes to different kinds of
work. The price of capital will depend upon degrees of monopoly in the
economy.”11 Thus shadow prices are difficult to ascertain under the existing
institutional framework of underdeveloped countries.

9. Ibid.,

10. I.M.D. Little, “Project Analysis in Relation to Planning in a Mixed Economy,” in Development
Problems. OECD, Paris, 1967.

11. W.A. Lewis, op. cit.

Fourth, another difficulty arises with regard to the time dimension. The concept
of shadow prices is static and timeless, for shadow prices are used to
overcome the difficulties involved in project evaluation and programming
when factor prices change over time. All inputs and outputs are valued at fixed
shadow prices in such cases. This is not realistic because, as Tinbergen himself
pointed out, “the realization of investment pattern will itself influence these
intrinsic values, but only after some time, since investment processes are
essentially time-consuming.”12 If accordingly, labour, capital, foreign
exchange and other products are assigned different, they may give
contradictory results in accordance with the time-period considered. Hence the
concept of shadow prices remains essentially a static one.

Fifth, if shadow prices are calculated in terms of Qayyum’s definition, they

require the calculation of marginal productivity of factors by the government
and the manipulation of the system of subsidy and taxation in such a way as to
equate the supply prices of factors to the value of their marginal productivity.
But it is not easy to calculate the marginal productivity of factors (especially of
capital and labour), and producers’ response to changes in taxes and subsidies.
Thus, the shadow prices based on marginal productivity are also indeterminate.

Sixth, another practical difficulty that arises is that of using shadow prices in
the economy where the private enterprises buy inputs and sell outputs at market
price. 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 she does not possess a monopoly.

Seventh, 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 accounting
prices of the inputs of labour, capital and foreign exchange will not only be
difficult but impossible because the decision about the construction plans of the
two projects cannot be the same.

Eighth, often prices of such services as electricity and transport are regulated
by the government, and are not fixed on the basis of social opportunity cost.
“For example, the prices of electricity used in feasibility studies of industrial
projects in many developing countries are derived as an average charge of a
two-part tariff. Since a two-part tariff charges a consumer according to his
individual demand, rather than the system peak demand, it will fail to reflect
the long-run incremental cost (hence the social opportunity cost of
electricity).”13

Conclusion. Prof. Myrdal in his “Asian Drama” regards shadow prices as

“utterly unreal and other worldly in concept, particularly in underdeveloped
countries like those in South Asia... as it is recognised that they cannot be
definitely ascertained.... This abstract and metaphysical concept cannot help to
solve the theoretical and practical problems facing South Asian planners. It
stands out as a typical example of the pseudo-knowledge, given a learned and
occasionally mathematical form, that unfortunately has formed a major part of
the contribution of Western economies to the important tasks of ascertaining
the facts in underdeveloped countries and creating a framework for policies
designed to engender and direct development.”14

12. Tinbergen. op. cit. Italics mine.

13. Ajit K. Dasgupta, op. cit., p. 92.

14. Asian Drama— An Enquiry into the Poverty of Nations, pp. 168-69. Italics mine.

USES OF SHADOW PRICES

Despite these difficulties shadow prices possess the following uses:

1. In Project Evaluation. The use of market mechanism for the determination

of product and factor prices is not a perfect and correct method because it
leads to a wrong allocation of resources. In underdeveloped countries, the
market mechanism operates imperfectly due to a number of economic and
social obstacles. Therefore, it is not possible to have project evaluation on this
basis. Even otherwise, the rise in prices being inevitable during the process of
planning, it is therefore not possible to correctly assess the costs and benefits
of a project. “Accounting prices are a convenient tool for evaluating
investment projects in different sectors of the economy....A factor that is
expected to be in short supply should have an accounting price higher than its
market price, while one that is surplus should have a valuation that is lower
than its market price.”’15

Thus shadow prices are used for evaluating the effects of a project on the
national income which are also termed as external effects. This is often done
on the basis of the profitability criterion or cost-benefit analysis where both
costs and benefits are calculated at accounting prices. Sometimes even rough
estimates of shadow prices also help. “They may, for example, show how
sensitive the priority figures of a number of projects are to changes in such
accounting prices. They may enable us to classify products in groups that are
attractive under certain specified emergency circumstances...It may
nevertheless have a rough guide for emergency cases.”16
2. In Public Policy. The success of development planning depends upon the
correct operation of public policy. Shadow prices are intrinsic prices on whose
correct determination depends the success of a plan to a considerable extent. In
a mixed economy, the public sector cannot be developed unless the prices of
labour, capital, foreign exchange and other inputs are determined in
accordance with shadow prices. Though very often shadow prices are rough
estimates, yet the state should try to bring market prices close to the shadow
prices of products and factors through fiscal, monetary and other measures for
the successful implementation of the plans.

3. In Programming. Shadow prices have the greatest importance in

programming. Programming is the working of the economy in a rational,
consistent and co ordinated manner. The main aim is to maximise the national
income through time. For this, it makes an optimum use of the amount and
composition of investment, and adopts public investment, fiscal, monetary and
commercial policies. In the context of under developed countries,
programming implies the optimum use of investment whereby there is no
difficulty in the production process. But in reality, the difficulties of supplies of
factors, rise in market prices and the scarcity of foreign exchange is apparent
in such economies. All such difficulties are overcome with the help of shadow
prices, and fiscal, monetary and other policies help in bringing the market
prices of factors, products and foreign exchange in conformity with their
shadow prices and thus make programming a success.

In the case of linear programming for a wide class of problems, the variables
in the dual solution can be interpreted as shadow prices or accounting prices,
in as much as they are the ‘correct’ input prices being consistent with the
maximum value of the primal objective function.... When these shadow prices
are imputed to the given inputs, the value of the dual objective function is
minimised. It can then be interpreted as the minimum input cost, subject to the
constraints, and to the requirement that no profits be made. These shadow
prices are, therefore, not different from the factor prices that would emerge in
perfectly competitive equilibrium in which product prices are exogenously
determined.”17

Thus the technique of shadow prices serves as a useful computational

shorthand in devising a relatively efficient system of project evaluation and
helps in achieving success in programming and public policy.
15. UN, ECAFE. op. cit.

16. J. Tinbergen, op. cit.

17. J. Mishan, op. cit. Italics mine.