Short note on the need for the use of shadow 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-organised 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 the 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 factors 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.”

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.”

But the government is supplying only OQ₂ quantity of water from the irrigation project at OP, 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 OP 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 OP as the shadow price which is the equilibrium price when OQ of irrigation water is supplied and demanded.