Session 2: Shadow Pricing and Externalities in ICT Investments

Learning Outcome
Identify the social pricing and externalities of the public projects.

Important Learning Terms

• Shadow pricing
• Externalities

In most public investments, the norminal value (actual cost or benefit) of an investment may not reflect the real investment costs or benefits to be able to assess the real investment costs of benefits occurring to the society, there is need to determine the shadow cost or price.

Shadow Pricing
Basic Issues to be considered:

a) Choice Numeraire
Numeraire is the unit of account in which the value of inputs or outputs is expressed.
One of the basic issues of shadow pricing is to determine the unit of account.
Basic questions to cover this might include:

• What unit of currency? Domestic or foreign currency? Should be used to express cost?
• Should costs and benefits be measured in current or constant values?
• What consumption or investment will be made of the income from the project?
• Should the income of the project be measured in terms of consumption or investment?

b) Concept of tradability
Key issue in shadow pricing is whether a good is tradable or not.
For a good that is tradable, the international price is a measure of its opportunity cost to the country because it is possible to substitute imports for domestic production and vice versa. Similarly it is possible to substitute export for domestic consumption and vice versa.

Using imports and exports UNIDO suggest three sources of shadow pricing. These depend on the impact of the project to a national economy.
As project it uses and produces resources for any given input or output.

1. Increase or decrease the total consumption in the economy.
2. Decrease or increase production in the economy.
3. Decrease imports or increase imports
4. Increase exports or decrease exports.

c) Taxes
Taxes usually pose difficulties in computation of shadow prices.
Guidelines by UNIDO

• Include Taxes, when a project results in diversion of non-traded inputs, which are fixed in supply from other producers or addition to non-traded consumer goods.
• Exclude Taxes, when a project augments domestic production by other producers.
• Ignore Taxes, for fully traded goods

Shadow Pricing of Specific Resources

a) Tradable Inputs and Outputs
For fully traded goods, the shadow price is the border price, translated in domestic currency at the market exchange rate.

A good is fully traded when an increase in its consumption results in a corresponding increase in import or decrease in export or when an increase in its production results in a corresponding increase in export or decrease in import.

This means fully traded implies that domestic changes in demand or supply affect just the level of import or exports.

b) Non-tradable Inputs and outputs conditions for non-treaded good.
The conditions for a good to be non-tradable

• Import price (CIF) is greater than its domestic cost of production.
• Export price (FOB) is less than its domestic cost of production.

For non traded good, its value should be measured in terms of what domestic consumes are willing to pay, if the output of the project add, to its domestic supplies or the requirement of the project causes reductions of its consumption by others.

Externalities

An external effect may be positive or negative examples of externalities have been articulated in module 1.1 and module 3.3.

Characteristics of externality

• It is not deliberately created by the project sponsor but is an incidental outcome of legitimate economic activity.
• It is beyond the control of the persons who affected by it, for better or for worse.
• It is not traded in the market place.

Review Questions

1. Explain in short what are social costs and benefits resulting from carrying project
2. From your experiences give examples of projects which are:
   • Financially viable but socially not viable
   • Financially not viable but socially viable
3. Explain in brief how you understand the concept of Shadow Pricing