Shadow Pricing with Suboptimal Policy Rules

This paper aims to clarify different views on the validity of the Little-Mirrlees border price rule for project evaluation in a context where the Government chooses its controls suboptimally in a systematic fashion. The rule is shown to be valid quite generally for small public sector projects when the Government’s response restores market-clearing in markets for nontradeables and foreign exchange. It can be invalid in contexts of (a) non-market clearing or (b) private sector projects that generate profits distributed to households. In the latter case special treatment of profit effects is required, along the lines described by Little and Mirrlees.