Question

The Standard Conversion Factor (SCF) despite simple to calculate considered an arbitrary and conversion factor to calculates shadow prices Briefly mention why?

Answer 1

Let us first understand what is shadow pricing. So, shadow price is an estimated price for something that is not normally priced in the market or sold in the market. It is often used in cost-benefit accounting to value intangible assets, but can also be used to reveal the true price of a money market share. In general, and when market distortions prevail, the use of shadow prices intends to take an economy towards an optimal allocation of resources by valuing goods and factors at their social opportunity costs.

Know uderstanding the Standard Conversion Factor, it is a ratio or economic price value of all goods in the economy. at their border price equivalent values to their domestic.

It is widely believed that the shadow exchange rate should simply be the inverse of the standard conversion factor. Instead of trying to estimate accounting prices for all items involved in decomposing the social cost/benefit of some commodity, it is suggested that an average ratio of accounting prices to market prices could be used.

Economic calculations can be carried out in two ways: either by using the standard conversion factor to translate all market prices of non-tradable goods and services into border price equivalents, or by applying a shadow exchange rate for the domestic currency to internationally traded goods and services. Both methods should give similar results if carried out rigorously.

If a standard conversion factor (the marginal product conversion coefficient) is applied to factor incomes and non-tradable goods, there is no need to apply a shadow exchange rate to traded goods. The standard conversion factor translates values measured in domestic prices to their border price equivalents, making allowance for the effects of external trade distortions on domestic prices. The calculation is effectively carried out in international price units. On the other hand, the shadow exchange rate must be categorically applied to border prices when parity prices are calculated, if factor incomes and non-tradable goods are to be measured in domestic prices. Here the calculation is carried out in domestic price units.

The procedures are equivalent as a result of the following mathematical identity:

Shadow exchange rate = Official exchange rate / Standard conversion factor