ABSTRACT
In this chapter we explain the essential concepts needed to perform logically consistent and useful applied cost-benefit analyses and suggest how to implement them. We present the concepts of a shadow price and marginal social value, explain how to use them and discuss their calculation in fully determined and partially determined systems using linearized and non-linearized models. We review several important issues in shadow pricing: the choice of numeraire, shadow prices as border prices, the shadow price of foreign exchange, negative shadow prices, relationships between shadow prices, why competitive firms break even at shadow prices and when shadow prices equal producer prices. We then analyse the role of two simple cost-benefit indicators-the effective rate of protection and domestic resource cost-which have been used as cost-benefit measures by policy advisors in evaluating projects and policies, particularly in less developed countries. A major theme of the chapter is that shadow prices are sensitive to the adjustment mechanism assumed, so that any shadow-pricing exercise is worthless without a specification of the mechanisms at work in the economic model underlying the calculation.
