Improving pricing efficiency

An economy is considered production efficient if the supply of any good (or service) cannot be increased without reducing the supply of some other good. One important way in which economies can make goods available is by exporting some goods in exchange for others; thus production efficiency also implies that a country has made best use of its foreign trade possibilities. If a country cannot affect prices in the rest of the world (a reasonable assumption for most developing countries), its foreign trade possibilities are defined by the relative border prices of exports and imports.

This definition in turn helps determine opportunity costs. The opportunity cost of any good or service is the value of forgone alternatives. If the alternative to using a good were to export it, for example, the opportunity cost would be measured by the border price of the good and the resulting foreign exchange that could have been used to purchase some other import or to replace some other export. The scarcity value measures what the good is worth to the economy-calculated, for example, by the value of the extra exports the good enables to be produced. If the economy is producing efficiently, scarcity values must be equal to opportunity costs, and their common value is the efficiency price-which, for imports and exports, will then be identical to the border price. For non-traded goods, efficiency prices can be measured by the opportunity cost of their production when the alternative would be to produce traded goods, or by their scarcity value in displacing traded goods.

An economy is efficient, as opposed to just production efficient, if it is impossible to make anyone better off without making someone else worse off. In addition to producing efficiently, the final consumers must have exhausted all possibilities of mutually beneficial exchange. This in turn requires that they all face the same market prices, and that these are equal to efficiency prices. However, an economy may be efficient and yet produce a distribution of income and wealth that is deemed unacceptable. The government may then impose taxes and subsidies or intervene in other ways to improve the distribution of income and wealth. Such intervention may make consumer prices deviate significantly from efficiency prices. But by preserving production efficiency, the largest possible quantity of goods and services will be made available for distribution among consumers. Hence the concepts of production efficiency and efficiency prices remain important for producer prices (for example, before indirect taxes are added) even when market prices (consumer prices) are distorted.

Shadow prices, also known as accounting prices' are the same as efficiency prices if society is concerned exclusively with efficiency in the sense here defined. Typically, however, societies are interested in other objectives – a more equitable distribution of income, for example – as well as efficiency. In this event, shadow prices are measures of social costs and benefits that reflect concern with these other objectives.

The case for removing distortions and moving market prices closer to efficiency prices rests on the argument that prices influence production decisions, and the reform will increase production efficiency. Since choices between alternatives depend on relative prices, it may not be enough to eliminate a few distortions, since this could move relative market prices even further from relative efficiency prices. In some cases, however, it may not be desirable to eliminate distortions (such as carefully targeted food subsidies or indirect taxes), since this will prejudice other social objectives; but in many cases these social objectives are best served by other instruments or by more carefully chosen taxes and subsidies. Thus, it is often possible to confront producers with efficiency prices while keeping indirect taxes and subsidies for distributive purposes. From a policy-maker's viewpoint, the appropriate prices are those that best achieve these broader social objectives. Choosing appropriate prices is therefore equivalent to choosing the best set of taxes and subsidies, a choice central to the design of public policy.