What are the uses of shadow prices?

Shadow prices possess the following uses:

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.”

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.”

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.

In Programming:

Shadow prices have the greatest importance in programming. Programming is the working of the economy in a rational, consistent and coordinated 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 underdeveloped 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, no different from the factor prices that would emerge in perfectly competitive equilibrium in which product prices are exogenously determined.

Thus the technique of shadow prices serves as useful computational shorthand in devising a relatively efficient system of project evaluation and helps in achieving success in programming and public policy.