Since domestic market prices may be corrected for the various distortions and imperfections, with domestic and foreign goods made comparable using a shadow price of foreign exchange, or goods may be valued at world prices, as recommended by Little and Mirrlees. Once all values are established in terms of world prices, it does not matter what currency they are expressed in. Any exchange rate may be used because all prices are their border price (c.i.f. for imports and f.o.b. for exports).
The problem comes with the valuation of non- traded goods at world prices, such as, for example electricity supply, transport facilities and construction. To value these and other non-traded goods (including many service activities) at world prices involves estimating the marginal social cost of these goods in terms of their inputs of traded goods (measured in world prices) and non-traded goods, including the labor embodied in them (value at shadow wage, where the opportunity cost of labor itself must also be valued at world prices).
By valuing all the outputs and inputs by their foreign exchange value, projects which earn or save foreign exchange are encouraged. As we shall see later, it is through the valuation of labor, in particular, that projects using domestic as opposed to foreign inputs may be encouraged.
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