What is Shadow Pricing?
Shadow pricing can be referred to be a concept applied to some financial analysis situations (like cost-benefit analysis), of pricing an item, on the basis of 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.
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.
How Does Shadow Pricing Work?
It is a concept which significantly depends on cost-benefit analysis, applied on an item not generally traded in a market. By giving it a shadow price, the analyst gets a clear picture of 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. Entity assigns it a shadow price of $70,000 as a benefit. Therefore entity is advisable to pay $70,000 or less for overtime.
Example of Shadow Pricing
For example, when the electricity is produced using the natural resource’ coal,’ then the value of the electricity that is produced can be quantified. Still, at the same time, the amount of the negative impact on the environment due to the coal-burning cannot be quantified. Here 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.
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. In these situations, there is a need for Shadow pricing as the quantifies commodities value of 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. 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 are useful for the decision making the purpose of the business.
- Public Policy: Estimation of prices of capital, foreign exchange, etc. through shadow pricing is mandatory for the development of public sector plans.
- 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. where benefits and cost associated are compared. It proves to be an excellent tool for the assessment of any project, and decisions can be taken accordingly.
The following are some of the different advantages:
- Related Benefit: It is one of the useful tools which is 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 comparisons.
- Timely Decision: Proactive right decisions regarding the project are taken based on cost-benefit analysis.
- Appropriate: These prices are comparatively more suitable for economic calculations.
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 as well before deciding the shadow pricing for the decision-making process because there are chances that it could lead to a 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 take assumptions only based on his understanding.
- Inaccurate: There are high chances of wrong estimates in 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 which should be considered in mind 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.
Shadow Pricing is a technique through which price tag is put on those items, which are without it, i.e., whose price couldn’t be determined easily or which usually are 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 for ascertaining this price, which is then used in making certain decisions.
Be it a small project’s decision, or a decision at the International level, it helps it all. It is proof less, based on the subjective assumptions, ignores social opportunity cost in the long run, etc. These factors should also be considered in mind before making any decision based on shadow pricing.
It has been a guide to what is shadow pricing and its definition. Here we discuss examples, need, and how does shadow pricing work along with advantages and disadvantages. You may learn more about financing from the following articles –