Shadow Prices with Variable Factor Supply and Distortion

Abstract

Trade distorting policies in a small open economy often create a difference between a product's domestic price and its price in the international market. In this situation, the cost-benefit analysis for project appraisal is conducted on the basis of the world price valuation rule as suggested by Little and Mirrlees [8]. The opportunity cost for project output is determined by the value of the alternative outputs lost elsewhere in the economy; the valuation being made at the respective world prices. This Little-Mirrlees rule for project evaluation, however, has a practical difficulty. Often it is both difficult and expensive to identify the alternative output losses, when these are widely distributed over the economy. In this situation, a direct valuation of the cost of domestic resources employed in the project can provide a more convenient and less expensive method of estimating opportunity cost. In the absence of any distortion in the economy, the cost of domestic resources could be evaluated at their market prices. But since the market prices of the products are distorted in the economy because of the trade restricting policies, the corresponding factor prices are also distorted. The valuation of the domestic resources must then be based on their shadow prices. A shadow price evaluation technique using standard trade theoretic tools has been formulated in Findlay and Wellisz [5, 543-52], Srinivasan and Bhagwati [11, 97-116] and Bhagwati and Wan [4, 261-73]. This technique derives the shadow prices in the presence of trade distortions under the assumption of perfectly inelastic factor supplies.' These shadow prices are the actual