Much of applied welfare economics as it has developed over the past several decades involves the study and use of shadow prices. Since (as we will argue) shadow pricing means different things to different people, we start with a rather broad definition and spend some time talking about various alternative meanings of the term. Shadow pricing will refer to the study and use of first-order welfare impacts associated with changes in the levels of particular goods or groups of goods.

This definition accords with the common view of what a shadow price stands for. Suppose we are talking about some input to a government project. Then the shadow price ought to be opportunity cost per unit of increasing this input, and the correct way to measure this opportunity cost is by the marginal welfare foregone. Ambiguity in the definition arises over the ceteris paribus assumptions. When an input level is changed, what other things are allowed to change with it? Obviously, something must change in equilibrium or else an infeasibility develops. And it would be silly to ignore this infeasibility here since the shadow price would be zero if we do.

On the other hand, issues of feasibility frequently are ignored when economists discuss shadow pricing of outputs. We ask, for example, what would an extra unit of public good be worth if we had it? (And never mind how would we get it?) Here, shadow price becomes a hypothetical construction. Having obtained such a price, we proceed by comparing it with the least cost way of actually getting an extra unit.