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What is Shadow Pricing?

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  • Written By: James Doehring
  • Edited By: Lauren Fritsky
  • Last Modified Date: 06 September 2016
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In economics, shadow pricing is assigning a monetary value to all parts of a production process, including intangible assets. The technique is used in cost-benefit analysis. It can help planners and managers understand how certain changes in a business will affect the outcome. By definition, shadow pricing involves making an educated guess as to the value of certain business assets and effects that are not typically sold on the market.

When managers try to optimize their businesses, they try to evaluate what effects would result from various changes. These changes could include hiring more workers, operating more hours per week or opening up another office. Some of these changes may involve fairly straight-forward costs, such as the hourly wage a new worker would have to be paid. Other costs, on the other hand, may be more difficult to estimate. These could include lost time for skilled workers or environmental damage resulting from increased production.

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Shadow pricing involves putting a price on all aspects of production, even the intangible ones. This task can prove to be exceedingly complicated, because many modes of production are not sold on the open market, which is what determines many costs of business. For example, if additional unskilled workers are being considered for hire, the market rate for labor may be easy to determine. The cost of committing an experienced manager to help open up a new factory may be much harder to calculate, however. There may be unpredictable events that will require the manager’s attention in the future.

The cost of these intangible assets is sometimes called the opportunity cost of a decision. An opportunity cost, as the name implies, is the cost of missed opportunities. A worker who is fully occupied on one project is not able to work on any other projects. The opportunity cost can also apply to the community at large. The opportunity cost of opening up a factory in one location includes the missed opportunity of building anything else in the same location.

Governments use shadow pricing the try and determine the comprehensive cost of a project, including the social or environmental costs. If the market price of building a road is relatively low, but the damage to the environment is quite large, the project may not be justifiable. Likewise, if the road would result in unacceptable noise near residential areas, the project could be scrapped. Shadow pricing, therefore, is the quantitative evaluation of all hidden costs of a proposed economic decision.

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umbra21
Post 2

@KoiwiGal - It's not so much making it easier to calculate, although that helps.

I hate to say it, but carbon taxes and fines for other kinds of environmental damage are punishments.

Most businesses aren't going to include environmental damage in their shadow pricing, simply because they don't have to directly wear the effects of it, at least not economically. It's a matter of them all saying someone else should do something, but not being willing to do it themselves (possibly because they feel it would be putting themselves at a disadvantage).

The current solution is to basically punish them for not doing something they ought to be doing for their own sakes, as businesses, as community members and as human beings.

KoiwiGal
Post 1

I think that people ought to use shadow cost to take the environmental and social effects of industry into account more often. In fact I think it should be a standard practice.

If you think about it, while people tend to see environmental issues as merely sucking away money from other places, in the long run a healthy environment is an asset as much as anything else.

Directly as well as indirectly.

I guess that's why there are so many carbon tax schemes and things going around at the moment. People are trying to put a price on that aspect of industry to make it easier to calculate.

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