Correcting Market Distortions:

Shadow Prices and Discount Rates

Chapter 6
• Observed market prices sometimes reflect true cost to
society. In some circumstances they don’t because there are
distortions which prevent market prices from conveying true
economic values.
• When this occurs have to correct observed price to calculate
the shadow price, which better reflects the value to society.
– Types of distortions include taxes, subsidies & other forms of
gov’t intervention.
• In competitive markets D represents marginal benefits to
society and supply curve social costs. Social costs are equal
to private costs. Likewise private benefits equal social
benefits.
 A Market with a Per Unit Tax
• Suppose have a market
for good but price
observed for the good
includes a per unit tax,
here price consumers pay
is not the price the firms
keeps.
– T – is the tax

– Pc = P f + T
• Pc – price gross of tax
• Pf – price net of tax
Project Demand with a Per Unit Tax
• Suppose there’s a project
that requires the good as an
input.
– Demand for the good
increases
– leads to new equilibrium at
point C
– Output increases from Xe to Xf
– price firms retain increases
from Pf to Pf ’
– Price consumers pay increases
from Pc to Pc’
• Non-project demand for the firm falls from X e to Xc
• Note that the Government requirement of X G comes from
two sources:
– Xf - Xe – units of new supply
– Xe - Xc – units of displaced demand
• If market weren’t distorted by the tax, there would not be a
problem because consumers marginal benefit would equal
the firms marginal costs, this not the case here because of
tax (the competitive output should be at X f )
• The tax has driven a wedge between consumers’ and firms’
valuation of this input.
• The tax creates a problem for someone trying to value the input
because the market outcomes are distorted by the tax.
• What the shadow price does is try to take the distorted prices and
correct them for the distortion to get a valuation/price that is
distorted.
• In this example the shadow price takes a weighted average of the
opportunity costs of the two sources of the gov’t’s input
requirement.
– For example, Suppose the gov’t needs XG units of X to complete the project,
can calculate PG the shadow price as either: or

• Where Pf – price net of tax and Pc – is the price gross of tax (Pc = Pf +T)
• An alternative expression of the shadow price in the
previous example uses elasticities
,where is the elasticity of supply and is the elasticity of
demand
• The shadow price PG will depend critically on elasticities;
elasticities will determine how big increases are in new
demand as well as how big is displaced demand.
• Recall that the elasticity determines the slope of the
demand and supply curves.
– A more elastic demand(supply) curve will be flatter
– A more inelastic demand(supply) curve will be steeper
• → D1 is flatter than D2
• → D1 is more elastic
than D2
• Note that in general the shadow price will fall
between gross – of – tax and net – of – tax
price.
• However, there are some special cases where
the shadow price takes on specific values.
– These extreme cases occur when the demand is
prefectly elastic and inelastic and supply is
perfectly elastic and inelastic
Extreme Cases
 Distortionary Subsidies
• Analysis is basically the
same as a distortionary
tax
Choosing and Computing a Discount Rate

• Recall the NPV =, where r is the discount rate and

B and C represent benefits and costs, respectively.
• The NPV will depend on r as well as benefits and
costs.
– a smaller discount rate will lead to larger values of the
NPV, large values of the discount rate lead to smaller
values of the NPV
– a discount rate of 0 means that society weights the
future equally to the present, thought to be
“altruistic” discount rate
• Marginal rate of time preference
– Consider whether someone wants a $1 today versus
tomorrow
– Whether someone picks to have the $1 today or
tomorrow reflects their time preference, or how they
trade off between these alternatives
– For example, suppose you have the choice of $1000
today or $1200 one year from today, if you pick $1000
today then your rate of time preference is 20%; you
would have a stronger preference for having
something today.
• Can formalize the idea of time preference and
choosing between today and tomorrow with
the following model.
• Suppose individuals choose between
consumption today and tomorrow, denoted
and subject to a lifetime budget constraint.
• Assume that individuals have preferences over
consumption today and tomorrow
• The individual’s problem can be written as

where is the interest rate and T is the present

value of income over the individual’s lifetime
(periods 1 and 2 in this example).
We’ll discuss the solution to this problem in
graphical terms,
• Absolute value of slope of the indifference curve
measures the rate at which individuals are indifferent
between substituting current consumption for future
consumption, i.e., the MRS between consumption
this year and consumption next year, where and is
the marginal rate of time preference.
• An equilibrium for this problem is where the rate at
which people are willing to trade consumption today
and tomorrow equals the price of moving
consumption allocations, i.e., the interest rate
• An equilibrium, will occur when the
indifference curve is tangent to the budget
line, i.e., where
• If you can freely borrow then you can shift
consumption to the future until the MRTP falls
to the interest rate you must pay
– If then save and reduce consumption today
– If then borrow and increase consumption today
• In a prefect capital market
• Investment demand
- Looks at firms making
investment decisions
- Assumes perfect capital
markets
- A firm has a variety of
investment projects to
select from which have
different rates of return
associated with them.
• supply of funds for
investment is provided
by individual saving
• if rate of interest > rate
of time preference then
save
• represented by
Aggregate savings
schedule
• Market equilibrium
occurs where supply of
savings schedule equals
the demand for
investment funds,
where rate of return
equals the rate of time
preference; the
equilibrium point is the
market interest rate
• The previous equilibrium is based on the
assumption of prefect capital markets.
• Generally, the real world is not comprised of
perfect capital markets since there are
distortions, e.g., taxes, risk, gov’t borrowing,
which all drives wedges between market and
social outcomes, and, consequently, society
can end up with under investment.
Market Equilibrium with Distortions
• On previous slide and represent investment demand
and supply of funds without taxes
• Introduction of taxes (both corporate and personal)
shifts back the investment demand and supply of
funds curves, denoted by and
• With taxes the market clearing interest rate would be
– The marginal return on investment before taxes would
be , the opportunity cost of forgone investment
– The marginal rate of return on savings after taxes would
be
• Suppose the government undertakes a new
project/program that it funds by borrowing.
– This would shift out the demand for funds, shifts
out to’
– Private sector investment falls by crowding out
effect
 Considerations for social discount rate
• Individuals tend to prefer to consume a given amount of
benefits immediately, rather than in the future.
• Individuals also face an opportunity cost of forgone interest
if they postpone receiving a given amount of funds until
later because they could potentially invest these funds
once they are received.
• These two considerations of importance to individual
decisions -- the marginal rate of time preference and the
marginal rate of return on private investment -- provide a
basis for deciding how costs and benefits realized by
society in the future should be discounted so that they are
comparable to costs and benefits realized by society today.
• Arnold Harberger using this framework
suggests the following estimate of the social
discount rate (SDR):

• Some empirical evidence suggests that savings

is not very sensitive to interest rates, which
implies that the savings schedule would be
relatively inelastic (i.e., vertical), so that and
and , which implies that
• Another approximation to social discount rate would
be
• Some argue in favour of as an approximation to
social discount rate because social discount rate
should be rate at which individuals should be willing
to postpone a small amount of consumption for
future consumption.
• Could also use the opportunity cost of forgone
investment (return on investment)
• As with shadow prices, the marginal rate of
time preference and the rate of return on
capital can be distorted.
• The distortions can include taxes, inflation and
risk (default or bankruptcy)
• Like shadow prices, we can take observed
interested rates and correct them for the
various distortions.
Estimating the social discount rate
• There are a few different ways we can use to
estimate the social discount rate
• Looking at the diagram for the market for savings and
investment our options would include

• Of course we can also use also use a combination of

these three (e.g., as Harberger did and another
alternative, which we will shortly)
 Computing
• proxies for a rate of return on low risk private
sector investments before taxes but after
correcting for inflation
– Suggests that we can take an observed interest and
correct/adjust it to get an estimate of
– Want to use a low risk corporate bond, so it would have
a lower default risk and adjust it for taxes and inflation
• Two steps in computation, assume that corporate
bond rate is 6.86%, corporate tax rate is 35% and
inflation rate is 3.92%:
 Computing : An Example
1. Figure out before return

2. Adjust for inflation

 Computing
• proxies for a rate of time preference after correcting
for inflation and taxes
– Suggests that we can take an observed interest and
correct/adjust it to get an estimate of
– Want to use a government bond, and a higher level of
government, e.g., Federal first, provincial second, and
lastly local, so it would have a lower default risk and
adjust it for taxes and inflation
• Two steps in computation assume that interest on
government bond is 6.77%, personal tax rate is 30%
and inflation rate is 3.92%
 Computing : An Example
1. Figure out after tax return
0.0474
2. Adjust for inflation
 Computing
• reflects the rate the government borrows at
• Only one step is need to compute . (Figures
continue from previous example)
1. Adjust for Inflation
74
• Note: there is no adjustment for taxes because
the government doesn’t pay taxes to itself.
 Criticisms
• tends to produce large discount rate
estimates; computations are based on using
corporate bond, which may have a risk
premium (e.g. firm may go bankrupt, investors
want a higher return to cover this)
• produces discount rate that are too low;
individuals may not properly account for the
long run effects of infrastructure programs on
future generations
Weighted Social Opportunity Cost of Capital
(WSOC)
• An alternative approach for computing the
social discount rate.
• Takes the perspective the discount rate should
reflect social opportunity cost of the resources
required for a project, with weights based
based on the relative contributions of the
different sources of resources
 WSOC: formula
• The weighted social opportunity cost of capital
can be computed as, where a is the proportion
of the projects resources that displace private
investment, b is the proportion of resources
that are financed by borrowing from
foreigners, (1-a-b) is the proportion of
resources displacing domestic consumption,
and is the government's real long-term
borrowing rate
 WSOC
• Since
• We already know how to compute and , but
not ; However, is relatively straightforward to
compute.
• Recall that is the government’s real long term
borrowing rate, so all we need to do is adjust a
nominal return government bond for inflation
to obtain
 WSOC: Picking the weights a & b
• are relatively easy to compute based on
available interest rate data
• The weights, i.e., a, b and (1-a-b) are harder to
determine
• In a Canadian context, Jenkins suggested using
the following values: a=0.75 and b=0.20,which
suggest that
WSOC=0.75(0.0638)+0.2(0.0274)+0.05(0.0073
)=0.0537 or about 5.4%
 WSOC: Picking the weights a & b
• On the other hand, Burgess suggests that for
Canada a is likely to be between 0.26 and
0.32, b is between 0.55 and 0.64 and (1-a-b) is
likely to be between 0.1 and 0.13. Picking the
smaller value of a and the bigger value of b
produces a smaller value of WSOC; e.g.,
WSOC=0.26(0.0638)+0.64(0.0274)+0.1(0.0073
)=0.0349 or 3.5%
 WSOC: Picking the weights a & b
• As another example, Suppose have a project that is
financed exclusively with taxes, then b=0. The
weight a should represent the proportion of taxes
that reduce investment and 1-a-b should represent
the proportion of taxes that reduce consumption.
One can obtain an estimate of a with the ratio of
gross fixed investment to real GDP. Recently, this
ratio was computed as 16.8%, so that
WSOC=0.168(0.0638)+0.0(0.0274)+0.832(0.0073)=
0.0168 or 1.7%
 Discount Rates Rules of Thumb:
United States
• What do policy makers use in practice?
– In the United States the Office of Budget Management
used a real discount rate of 10 percent during the 1970s,
but had lowered this estimate to about 7 percent by 1992.
Recently, the Congressional Budget Office and the General
Accounting Office have used the approach to get a
discount rate of about 2 percent.
– Municipalities in the United States tend to use discount
rates of 3 percent with sensitivity analysis between 0 and 7
percent.
Discount Rates Rules of Thumb: Canada
• The Federal Treasury Board Secretariat has recommended
from about 1976 to the late-1990s, a discount rate of 10
percent, with a sensitivity analysis at 5 and 15 percent.
• More recently, the Treasury Board Secretariat
(recommends) a discount rate of about 7 percent, with a
sensitivity analysis of 2 and 12 percent.
• But they recommend much lower discount rates for health
or environmental cost benefit analysis (0 to 3 percent).
• The Treasury Board Secretariat also estimates the social
rate of time preference of about 3 percent.