Market Prices versus Economic Costs

We now return to the main theme of this site: getting the prices right.

Once analysts have identified and measured the costs and benefits of the

project, they must price them. Financial analysts use the market price of

the goods and services paid or received by the project entity. As noted earlier,

financial analyses are conducted in the currency of the country at the

domestic price level. This means that financial costs and benefits are valued

at the prices that the project entity is expected to pay for them. Usually

these are prices set by the market, although in some cases the government

may control them. Neither market nor government-controlled prices necessarily

reflect economic costs to society.

The economic values of both inputs and outputs may differ from their

financial values because of market distortions created by either the government

or the private sector. Tariffs, export taxes and subsidies, excise

and sales taxes, production subsidies, and quantitative restrictions are

common distortions created by governments. Monopolies are a market

phenomenon that can be created by either private or public sector actions.

Some market distortions are created by the nature of the good or

service. The values to society of common public services, such as clean

water, transportation, road services, and electricity, are often significantly

greater than the financial prices people pay for them. A project that sells

electricity below its economic cost implicitly subsidizes the users of the

service. Similarly, a project that employs labor at a wage rate that is higher

than its economic cost implicitly subsidizes labor. The differences between

financial and economic prices are rents that accrue to some group in the

society and convey important information about the distribution of costs

and benefits.

Valuation of Inputs and Outputs

In economies where distortions are few, market prices provide a reasonably

good approximation of the opportunity costs of inputs and outputs.

In economies characterized by price distortions, however, market prices are a poor reflection of those costs. The financial assessment of the project

usually differs markedly from the economic assessment. An economic

analysis should assess the project’s contribution to the society’s welfare.

This evaluation requires that the analyst compensate for price distortions

by using shadow prices that reflect more closely the opportunity costs

and benefits of the project, instead of market prices. In principle, if we

adjust all prices to reflect opportunity costs, these calculations would be

extremely time-consuming and expensive. In practice, analysts undertake

few adjustments and concern themselves primarily with adjustments

of the prices of tradable goods, the exchange rate, and the wage rate.