Explain with an example a situation in economic appraisal where shadow prices should be used even if market prices exist. Also, explain why shadow prices should be used as per the example given by using the shadow price definition.
Expert Answer
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Answer – Situation Requiring Shadow Prices in Economic Appraisal:
Consider a scenario where a company is conducting a cost-benefit analysis for a proposed project that involves the construction of a new factory. The project is expected to have environmental impacts, affecting a nearby river’s water quality. While there may be market prices for inputs like labor, materials, and land, the value of the river’s ecosystem services may not be adequately captured by these market prices.
Why Shadow Prices Should Be Used:
Definition of Shadow Prices: Shadow prices represent the economic value of resources or impacts that do not have a market-determined price. In this case, the shadow price would capture the economic value of the river’s ecosystem services, such as water purification, habitat maintenance, and recreational opportunities.
Ecosystem Services Valuation:
Ecosystem services provided by the river, like clean water, recreational opportunities, and biodiversity support, may not have market prices.
Shadow prices help in quantifying the economic value of these non-market goods and services.
Cost-Benefit Analysis:
In the economic appraisal, the company needs to weigh the costs of the factory project against its benefits, considering both market prices and the economic value of the river’s ecosystem services.
The shadow prices allow the inclusion of the river’s value, providing a more comprehensive understanding of the project’s overall impact.
Optimal Decision Making:
Using shadow prices ensures that decision-makers have a complete picture of the project’s costs and benefits, incorporating both market transactions and the economic value of non-market goods.
This helps in making informed decisions that consider the full social and environmental implications of the project.
Final Answer Summary:
In economic appraisal, shadow prices should be used when assessing projects with environmental impacts or non-market goods and services. Using the example of a factory project affecting a river, shadow prices enable the quantification of the economic value of ecosystem services not reflected in market prices. This ensures a more accurate and comprehensive cost-benefit analysis, aiding decision-makers in making optimal choices that consider both market and non-market aspects.