Ian Little and James Mirrlees have argued that in an open economy the
social opportunity cost or "shadow price' of a good is the
"world price' at which it can be bought from or sold to foreigners.
This proposition is valid in a wide range of circumstances, and these
shadow prices can be used in cost benefit analyses. Difficulties arise
when shadow prices must be found for goods which are not traded
internationally, and for which there is no obvious "world price'.
Several economists have discussed this problem and have proposed methods
of calculating "foreign-exchange-equivalent factor shadow prices'.
These derivations, however, have made the technical assumption that the
number of traded goods does not exceed the number of non-traded inputs.
Bertrand has argued that this assumption is not appropriate in many
situations and that factor shadow prices cannot, in principle, be
derived in such cases.
In Discussion Paper No. 42, CEPR Programme Director Alasdair Smith
argues that Bertrand's conclusion is too pessimistic. He considers two
plausible situations in which more goods will be produced than there are
factors of production: a small open economy, in which diversification of
production is itself an objective of government policy; and a large open
or closed economy in which there is consumer demand for a wide range of
goods. Input shadow prices can be calculated in the first case, provided
that the government has applied its diversification policy consistently
and that this policy is modelled explicitly in the analysis. In the
second case, an explicit treatment of consumer demand makes possible the
calculation of shadow prices.
In both cases the economist must model explicitly the causes of product
diversification in order to calculate shadow prices. This is
straightforward in the case of the small open economy in which there are
no constraints on government policy other than a set of fixed market
distortions. As we move away from such simple cases, the calculation of
shadow prices for both goods and factors requires more detailed
information about the structure of the economy. The issue, Smith argues,
is not the existence of these shadow prices, but rather the practical
problems involved in their calculation.
Factor Shadow Prices in Distorted Open Economies
Alasdair Smith
Discussion Paper No. 42, January 1985 (IT)