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 be also 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 would proceed accordingly.
How Does Shadow Pricing Work?
It is a concept which greatly depends on cost-benefit analysis, applied on an item not normally traded in a market. by giving it a shadow price, the analyst gets a clear picture of how associated cost 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 using the coal can be quantified but at the same time, the value of the negative impact which is there on the environment due to the burning of the coal cannot be quantified. Here for the value of the impact or the social cost on the environment due to the burning of the coal, shadow pricing comes into the picture. It gives price-like value to unpriced coal-burning effects on the environment.
There are various qualitative aspects in an organization that plays an important role in the decision-making process of the business but they don’t have the value on the basis of 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 cost by which certain decisions of the business can be understood in a better way thereby helping in the better decision-making process of the overall business.
Importance and Uses
It plays an important role in the areas where it is difficult to determine the value of the things especially the things that are of qualitative nature 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 analysis where benefits and cost associated are compared. It proves to be a great tool for evaluation 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 in order 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 appropriate for the purpose of 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 considering the shadow pricing for the purpose of 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. This is so because the subjective assumptions may vary from person to person and the person will take assumptions only on the basis of his own 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 are normally not traded or purchased in a normal market. These prices may vary for different time periods and for 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 taking any decision on the basis of shadow pricing.
This 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 –