How can the shadow price be determined?

The determination of shadow prices can be done through the general equilibrium or the partial equilibrium analysis.

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 are 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.

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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.

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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.

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.

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.

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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.

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.

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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.