Skip to content 
A major reason behind the failure of many public projects is the reliance on inappropriate pricing, which distorts the perceived costs and benefits of the investment. This often leads policymakers, investors, and financiers to make misguided decisions. In cost-benefit analysis (CBA), choosing the right prices is therefore critical. When market prices do not reflect true economic value—especially in distorted or incomplete markets—analysts turn to shadow prices.
Why Market Prices Fall Short
Market prices are not always ideal for public investment appraisal. In competitive markets where prices reflect supply and demand without interference, market prices may be acceptable. However, in many real-world situations, prices are affected by taxes, subsidies, monopolies, or trade restrictions, leading to divergence between market prices and opportunity costs—the real cost of resource use to society.
For instance, using the market wage to value unskilled labour may overstate the true cost if those workers were previously unemployed. In such a case, the shadow wage rate would be far lower, since the project does not deprive the economy of alternative production. Therefore, while a financial analysis might show high labour costs, economic analysis would reflect minimal opportunity cost.
Distinguishing Transfers from Inputs
Some financial flows in projects, like taxes, subsidies, and welfare transfers, are not associated with the use of real resources and do not carry opportunity costs. These are treated as transfers and are excluded from economic analysis. On the other hand, physical inputs such as oil, machinery, or land must be evaluated based on what is forgone nationally when those resources are used.
Take oil, for example. Even if it is abundant domestically, using it in a project means the country loses potential foreign exchange earnings from exports. Unlike unskilled labour, oil has a substantial opportunity cost, which must be captured through shadow pricing.
The Theory Behind Shadow Prices
Shadow prices are grounded in the principle of opportunity cost. In competitive and undistorted markets, market prices may be used. However, if a project is large enough to affect market prices—such as a national hydroelectric scheme—then new equilibrium prices must be used in analysis. When markets are distorted, shadow prices become essential for accurate evaluation.
Sources of Price Distortion
Several factors cause divergence between market prices and opportunity costs:
- Taxes and subsidies distort prices and obscure the real cost or value of goods and services.
- Externalities, both positive and negative, are often unpriced but have real impacts.
- Tariffs, quotas, and other trade restrictions limit market efficiency.
- Monopolistic practices inflate prices and reduce output and employment.
- Underemployment reduces the true cost of labour, making market wages an overestimate.
Conclusion
Shadow pricing allows analysts to move beyond misleading market signals and uncover the true economic value of a public investment. By incorporating opportunity cost and adjusting for distortions, shadow prices ensure that decisions are based on accurate, comprehensive evaluations. In public policy analysis, especially for national development projects, shadow pricing is an indispensable tool for ensuring value for money and maximizing social welfare.
