CBA values consequences at their social opportunity cost — what society truly gives up. In a perfect market, the market price equals that opportunity cost, and you can use observed prices directly. But real economies, especially developing ones, are riddled with distortions — taxes, tariffs, minimum wages, unemployment, overvalued exchange rates — that drive market prices away from social value. Shadow prices are the corrected prices that restore social opportunity cost, and computing them is the technical heart of project appraisal in distorted economies.
Why market prices lie
- Taxes and subsidies — a tariff makes an imported input cost more than its true (world) opportunity cost; a subsidised input costs less. The market price includes the distortion.
- Unemployment and surplus labour — where labour is unemployed or underemployed, hiring a worker for a project costs society less than the wage, because little or no other output is forgone.
- Foreign-exchange distortions — an overvalued, rationed official exchange rate understates the true scarcity value of foreign currency, mispricing all imports and exports.
- Market power and externalities — monopoly prices exceed marginal cost; polluting activities have costs not in their price. The market price misstates social cost.
The shadow wage
Labour in a surplus-labour economy
The financial cost of labour to a project is the wage it pays. The economic (shadow) cost is the output society forgoes by moving that worker to the project — its opportunity cost. In an economy with abundant surplus or underemployed labour (much of rural Africa, the Lewis model of the Development course), a worker drawn into a project was producing little at the margin, so the output forgone — and thus the shadow wage — is well below the market wage, sometimes close to zero. Using the market wage would overstate the project's true labour cost and wrongly reject labour-intensive projects that are socially cheap. (Caveats: the worker may have been doing valuable seasonal or household work, and pulling labour can have general-equilibrium effects, so the shadow wage is rarely literally zero — but it is typically below the market wage.) The shadow wage is the classic illustration that financial and economic cost differ.
Border prices: the Little-Mirrlees method
Value tradeables at world prices
Ian Little and James Mirrlees (1974) gave developing-country appraisal its central technique: value tradeable goods at border (world) prices rather than distorted domestic prices. The logic: for anything the country can import or export, the true opportunity cost is the world price (what the country forgoes in foreign exchange by consuming it domestically rather than exporting, or pays to import it), not the domestic price inflated by tariffs and taxes. So a project's tradeable inputs and outputs are revalued at their CIF (import) or FOB (export) border prices, stripping out trade distortions. Non-tradeables (whose value cannot be read off a world price — local construction, transport, services) are decomposed into their tradeable and labour content, or valued using a conversion factor. The Little-Mirrlees method makes world prices the numeraire of social value — a profound simplification for an open economy riddled with domestic distortions.
The shadow exchange rate and conversion factors
Foreign exchange is itself often mispriced. Where the official exchange rate is overvalued (the local currency is officially worth more than its true scarcity value, common under FX controls), it understates the real value of the foreign exchange a project earns or uses. The shadow exchange rate (SER) corrects this — typically the official rate adjusted upward by a factor reflecting trade distortions — and is applied to value foreign-currency costs and benefits at their true domestic worth. More generally, appraisal uses conversion factors: ratios that translate a distorted market price into its shadow price (a standard conversion factor for general non-tradeables, specific conversion factors for particular items, the shadow wage rate factor for labour). The appraiser's practical job is to take a project's financial cash flows and convert each line — labour at the shadow wage, tradeables at border prices, foreign exchange at the SER, non-tradeables via conversion factors — into economic flows that reflect true social opportunity cost, then compute NPV on those.
Two systems, one logic
There are two classic shadow-pricing systems — Little-Mirrlees (world prices as numeraire, the 'border-price' approach used by the World Bank via Squire-van der Tak) and the UNIDO approach (domestic consumption as numeraire, Dasgupta-Marglin-Sen). They differ in the unit of account and in presentation but, applied consistently, give the same ranking — both correct market prices to social opportunity cost; they just measure it in different numeraires (foreign exchange vs domestic consumption). Do not be confused by the two languages: the underlying logic — replace distorted prices with opportunity costs — is one.
Exercise
An appraiser is evaluating a labour-intensive rural irrigation scheme in a country with high rural underemployment, a 25% tariff on imported cement and steel (key inputs), and an overvalued official exchange rate. The financial appraisal uses market prices throughout and shows a marginally negative NPV. (1) Explain why the financial appraisal likely understates the project's true social value, going input by input. (2) Show how to shadow-price the labour, the imported materials, and the foreign-exchange component. (3) Explain how these corrections could turn the NPV positive. (4) State one caution against assuming the shadow wage is zero.