Valuation Tools - Shadow Prices

As mentioned above market prices do not represent true economic value of a product due to market failure and policy failure. Market failure means the inability of the market mechanism, under certain circumstances, to reflect accurately the value of the environmental goods and services. Policy failure occurs when a particular government policy has unintended side effects or cause inefficient resource use.

For example, some of the state governments in India in the past have followed a policy of subsidizing minor irrigation through tube wells in order to increase food grains production. The concessions offered to farmers in terms of lower interest rate and cash subsidies provided the right incentives for farmers to go for more and more number of deep tube wells which increased irrigation facility. The unintended environmental impact, however, was the change in cropping pattern in favour of water-intensive crops, the excessive depletion of underground water resources, and the lowering of water table, which dried up shallow tube wells and resulted in overall water shortage.

A limitation of the use of market prices is that although it reflects the cost of production of the goods or services to the individuals (that is, private cost), it does not take into account social cost. For example, the pricing of cement takes into account the production cost to the producer only. It does not consider the increased health cost of residents in the locality. Use of shadow prices rectifies this shortfall by taking into account the societal impact of the production of the commodity or service.

A limitation of the shadow prices method is that it may be biased, as the estimation procedure may be imperfect. Moreover, it may suffer from personal bias of the researcher or the decision-maker.