Pricing inputs and outputs: Market prices versus shadow prices, market power, and welfare analysis

Abstract

Our chapter surveys the literature on why market prices may provide distorted signals, i.e., diverge from socially efficient prices. There are a number of reasons for this to occur, such as price controls, externalities, imperfect competition, taxes, trade controls, etc. Broadly, market failure may occur due to the structure (characteristics) of the market or due to government intervention. In the presence of market failures, it would be sensible to identify the shadow value (efficient value) of relevant outputs or inputs. To this end, it is essential to understand the relationship between market prices and shadow prices. We begin in a setting wherein no distortions exist, and thus, market prices and shadow prices coincide. We then broaden our analysis to the cases in which market prices and shadow prices diverge, for the reasons we have given above. We also summarize some of the widely used methods to value non-market goods, services, or bad outputs, such as pollution, as well as approaches for projects that can accommodate not only allocative efficiency but also provide insights into their impact on the growth and redistribution of income.