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Shadow Pricing

Updated on April 22, 2024
Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What is Shadow Pricing?

Shadow pricing can be referred to as a concept applied to some financial analysis situations (like cost-benefit analysis) of pricing an item based on subjective assumptions, for which there is no ready market or whose price cannot be determined easily or using the cost or the market price basis.

Explanation

Shadow Price means approximated or estimated economic price of a good for which there is no pricing done or the process of pricing such goods for which there is no pricing done or whose price cannot be determined easily. It can also be understood as a maximum price one would be willing to pay for an additional unit. If the benefit from an additional unit is more than the cost associated, the entity will proceed accordingly.

What is Shadow Pricing

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How Does Shadow Pricing Work?

It is a concept that significantly depends on cost-benefit analysis applied to an item not generally traded in a market. By giving it a shadow price, the analyst clearly understands how associated costs will affect benefits accruing.

It can be explained with an example:

An entity is considering paying its employees for overtime. By doing it, the entity may improve customer relations. However, the entity assigns it a shadow price of $70,000 as a benefit. Therefore the entity is advisable to pay $70,000 or less for overtime.

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Shadow Pricing Explained In the Video

 

Example of Shadow Pricing

For example, when the electricity is produced using the natural resource’ coal,’ then the value of the produced electricity can be quantified. Still, at the same time, the amount of the negative impact on the environment due to coal-burning cannot be quantified. Due to coal burning, the value of the impact, or the social cost on the environment, shadow pricing comes into the picture. It gives price-like value to unpriced coal-burning effects on the environment.

Need

There are various qualitative aspects of an organization that plays a vital role in the decision-making process of the business. Still, they don’t have the value based on which the decisions can be taken. There is a need for Shadow pricing in these situations as it quantifies commodities value, which would be viewed qualitatively generally. Under this, by assigning the dollar value to the commodities under consideration, a business can calculate opportunity costCalculate Opportunity CostThe difference between the chosen plan of action and the next best plan is known as the opportunity cost. It's essentially the cost of the next best alternative that has been forgiven.read more by which certain decisions can be understood in a better way, thereby helping in the better decision-making process of the overall business.

Importance and Uses

It plays a vital role in the areas where it is difficult to determine the value of the things, especially the things that are qualitative and useful for the decision-making of the purpose of the business.

  1. Public Policy: Estimation of capital prices, foreign exchange, etc., through shadow pricing is mandatory for developing public sector plans.
  2. Evaluation of Project: It is done based on cost-benefit analysisCost-benefit AnalysisCost-benefit analysis is the technique used by the companies to arrive at a critical decision after working out the potential returns of a particular action and considering its overall costs. Some of these models include Net Present Value, Benefit-Cost Ratio etc.read more where benefits and costs are compared. It proves to be an excellent tool for assessing any project, and decisions can be taken accordingly.

Advantages

The following are some of the different advantages:

  • Related Benefit: It is one of the useful tools used to know the benefit related to the opportunity cost of the use of the resource.
  • Pricing: It refrains from underpricing.
  • Economic Opportunity Cost: It considers the Economic Opportunity Cost for comparison.
  • Timely Decision: Proactively right project decisions are taken based on cost-benefit analysis.
  • Appropriate: These prices are comparatively more suitable for economic calculations.

Limitations

The following are some of the different limitations:

  • Proof-Less: It is just guesswork, based on subjective assumptions, and is completely proof-less. So, one should consider other aspects before deciding the shadow pricing for the decision-making process because there are chances that it could lead to the wrong decision-making of the company.
  • Objective: Since it is based on subjective assumptions, it is highly prone to bias. It is so because the subjective assumptions may vary from person to person, and the person will make assumptions based only on his understanding.
  • Inaccurate: There are high chances of wrong estimates in the case of determining the value using the shadow pricing, and if the estimates are wrong, it would ultimately lead to the wrong decision-making of the company.
  • Inflexible: It is a rigid belief, and this inflexibility is one of the limitations that should be considered before considering it for the decision-making process.
  • Period: It considers social opportunity cost for the short-run and ignores it in the long run.

Conclusion

Shadow Pricing is a technique through which a price tag is put on items without it, i.e., whose price couldn’t be determined easily or are usually not traded or purchased in a regular market. These prices may vary for different periods and different areas and occupations. Cost-Benefit analysis or probability is generally used to ascertain this price, which is then used to make certain decisions.

Be it a small project decision or a decision at the International level, it helps. On the other hand, it is proof less, based on subjective assumptions, ignores social opportunity cost in the long run, etc. These factors should also be considered before making any decision based on shadow pricing.

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