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Shadow pricing is the practice of assigning a monetary value to an item, commodity, or service that is not ordinarily bought and sold in any marketplace.
Because no actual price can be assigned by trading in a market, the true value is unknown and can only be estimated. The estimation is often based on an assumption of the highest price that a company might be willing to pay to acquire the item in question.
Since a shadow price is assigned based on assumptions and estimations, its accuracy may or may not reflect the actual value of the item. Shadow pricing is frequently used by financial analysts in cost-benefit analysis to assign a monetary value to intangible assets.
Shadow pricing is used in many different areas and comes with a specific definition based on the context it is used in.
A common context where shadow pricing is applied is that of what economists refer to as societal value. In such a context, shadow prices are utilized to estimate the benefits to society that may be gained from things such as public parks or libraries.
Shadow pricing may also be used to estimate costs, as well as benefits, to society. An area where it is frequently seen now is that of climate change. Shadow pricing is used to approximate the unseen costs to society of using carbon-based energy sources.
In the world of investing, shadow pricing is used to estimate the actual value of shares in a money market fund when the nominal value of the shares does not represent their true value.
In a business context, shadow pricing is often utilized as part of the decision-making process when a company is considering making a major capital investment.
Since the actual dollar value of the company’s return on its investment may not be able to be precisely determined, it may need to assign a shadow value that represents its best estimate of the return that can be generated.
There may also be cost factors, such as weather-related delays in construction, that must be assigned a shadow price.
Company XYZ is a retailer that sells most of its merchandise online. Its current shipping practice is to deliver items sold using UPS Ground Shipping, which ordinarily takes four to five days. The company believes that it can substantially increase sales by offering a two-day delivery service on all orders.
It is impossible for the company to assign a definitive value to the increased sales revenues it can gain by changing its shipping policy. Therefore, it assigns a shadow price of $50,000 that represents its best estimate of the monetary benefit that can be obtained from the altered shipping policy.
The company then conducts a cost-benefit analysis, comparing the shadow price of the benefit to be gained from added revenue to the extra shipping cost required for a two-day delivery service.
If the extra shipping costs total significantly less than $50,000, the company would determine that changing its shipping policy would be beneficial to its bottom line.
The above is an example of how companies use shadow pricing and cost-benefit analysis in decision making. Of course, it’s important to note that the company’s cost-benefit analysis may not be correct if it errs in estimating a shadow price to the additional business it can generate from using a two-day delivery service.
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