Project evaluation in economies in general disequilibrium : an application of second best analysis

It is assumed that institutional rigidities and public policies prevent the markets for foreign exchange, labor, and savings from being cleared by unconstrained competitive market prices and that this situation may be expected to persist throughout the life of the project. In addition, the level of taxation is assumed to be suboptimal. Under these conditions the use of "first best" shadow prices -- the prices that would obtain in a general competitive equilibrium -- is incorrect. The disequilibria are defined in detail and the case is made for developing second best shadow prices suitable for project evaluation in such an environment. Partial disequilibrium shadow prices are derived for foreign exchange, labor, time and investment by considering each market disequilibrium in turn. Then, in order to take account of the disequilibria existing concurrently in the various markets, the appropriate general disequilibrium shadow prices are derived. It is concluded that neither the conventional first best shadow prices nor partial disequilibrium shadow prices are satisfactory substitutes for the correct general disequilibrium shadow prices.