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Shadow pricing of economic inputs and outputs is used in project analysis when some idealized assumptions of neoclassical economics are violated in the real world. Conceptually, one may capture all the key economic relationships in a comprehensive “general equilibrium” model of the economy. In such a model, the overall national development goal might be embodied in an objective function such as aggregate consumption. Usually, analysts seek to maximize this consumption subject to constraints, including limits on scarce resources (like capital, labor and environmental assets), structural distortions in the economy, and so on – see the optimality-based approach in Chapter 2. Then, the shadow price of a scarce economic resource is the change in value of the objective function, caused by a marginal change in the availability of that resource. In a mathematical programming macroeconomic model, the optimal values of the dual variables (corresponding to the binding resource availability constraints in the primal problem) have dimensions of price, and could be interpreted as shadow prices. While the general equilibrium approach is conceptually important, it is too cumbersome and data intensive to use. In practice, partial equilibrium methods are used to evaluate shadow prices of key economic resources in a few sectors or areas.
Efficiency and Social Shadow Prices
Two basic types of shadow prices exist, depending on how sensitive society is to income distribution considerations. Consider the national goal of maximizing the present value of aggregate consumption over a long period. If the consumption of different individuals is added directly regardless of their income levels, then the resulting shadow prices are efficiency prices because they reflect the pure efficiency of resource allocation. Alternatively, if consumption of low-income groups need to be raised, shadow prices may be adjusted by income group to give greater weight to the poor in aggregate consumption. Such prices are called social prices. In practice, such formal weighting schemes are seldom used in project evaluation. Instead, distributional and other social issues are addressed by direct targeting of beneficiaries and similar ad hoc methods.
In brief, efficiency shadow prices try to establish the economic values of inputs and outputs, while social shadow prices take account of the fact that the income distribution between different societal groups or regions may be distorted in terms of overall national objectives. Our analysis will place primary emphasis on efficiency shadow pricing.
Common Property Resources and Externalities
Non-priced inputs and outputs like common property resources and externalities (especially those arising from environmental impacts) must be shadow priced to reflect their economic opportunity costs. Access to common property resources is unrestricted, and thus exploitation tends to occur on a first come, first served basis, often resulting in (unsustainable) overuse. Public goods are environmental resources (e.g., scenic view) that are freely accessible and indivisible (i.e., enjoyment by one individual does not preclude enjoyment by others). These properties lead to “free riding” – a situation in which one user, (either knowingly or unknowingly), uses the resource at a price less than the it’s efficient cost, and thereby takes advantage of greater contributions by others. For example, wastewater discharge taxes may be paid by users of a transnational water source in one nation, while the benefits of cleaner water are shared with users in another country who draw from the same source, but do not pay such taxes. The JDB international symposium involving leading economists highlighted and analyzed such problems affecting both local and global commons.
Externalities are defined as beneficial or adverse effects imposed on others for which the originator of these effects cannot charge or be charged. If a (damaging) externality can be economically valued or shadow priced, then a charge or tax may be levied on the perpetrator, to compensate for and limit the damage. This is the so called “Pigouvian” or “price control” approach to environmental regulation. The basic concepts and techniques for economic valuation of environmental impacts underlying this approach are discussed later.
Unfortunately, many externalities are difficult to measure not only in physical terms but also in monetary equivalents (i.e., willingness to pay). Quite often therefore, the “quantity control” approach is taken, by imposing regulations and standards, expressed in physical measurements only that try to eliminate the perceived external damages (e.g., safe minimum standards for pollution). Especially when environmental pollution is severe and obvious, setting standards could serve as a useful first step to raise consciousness and limit excessive environmental damage, until more accurate valuation studies can be carried out. In such cases, the initial emphasis is on cost effectiveness (i.e., achieving pollution targets at the lowest cost), rather than valuing the benefits of control measures. For example, quantity controls on air pollution that limit the aggregate emission level may be combined with an initial allocation of emission rights among existing and potential polluters (which collectively do not exceed the total emission limit). This is analogous to defining property rights to an open access resource – in this case, the air shed over a particular region. Next, it would be logical to encourage schemes like marketable pollution permits (which may be competitively traded among polluters), to achieve an economically efficient redistribution of “pollution rights” within the overall emission limit. However, minimum quantity controls may not be an efficient long term solution, if no attempt is made to compare the marginal costs of compliance with the real benefits provided (i.e., marginal damages avoided) — especially as environmental conditions improve over time).
In practice, it is often prudent to use a variable mix of both price and quantity controls to protect the environment. A mixed system allows the various policy instruments to be flexibly adjusted depending on marginal cleanup costs. In this way, an optimal outcome can be approached even without full information concerning control costs.
Shadow prices are location and time specific, and their computation may be tedious. Key elements such as the numeraire, border priced conversion factors, shadow wage rates, accounting rate of interest (or discount rate), social shadow prices and distribution weights may be taken into consideration.
- ^Luenberger, David G., 1973. “An Approach to Nonlinear Programming,” Journal of Optimization Theory and Applications, 11:3 (1973) 219–227.
- ^Squire, L. and H. Van der Tak, 1975. Economic analysis of Projects, Johns Hopkins Univ. Press, Baltimore MD.
- ^Samuelson 1954.
- ^Arrow, K.J., Dasgupta, P., Jorgensen, D.W., Kuroda, M., Maler, K.G., Munasinghe, M., Nordhaus, W.D., Uzawa, H. and Weitzman, M., 1996. Symposium on the Environment and Sustainable Development, Research Centre on Global Warming, Japan Development Bank, Tokyo, Japan.
- ^Coase, R. H., 1960. ‘The Problem of Social Cost’, Journal of Law and Economics 3 (October), pp. 1–44.
- ^Pearce, D.W., and K. Turner, 1990. Economics of Natural Resources and Environment, Harvester Wheatsheaf, Hemmel Hempstead, UK.
- ^Baumol, W.J. and W.E. Oates, 1988. The Theory of Environmental Policy. Cambridge University Press, Cambridge, UK
This is a chapter from Making Development More Sustainable: Sustainomics Framework and Applications (e-book).
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