Shadow Pricing

From CEOpedia | Management online

Shadow Pricing also called Shadow Price, is a term which is used mainly in reference to the monetary values which are assigned to the currently difficult to calculate or unknowable costs. The basis for this assumption is commonly associated with the unwillingness or an externalisation of costs due to recalculate a system to check for marginal production. When the absence of the market price occurs, the most relevant measure is based on the amount of money people are willing to pay in order to get the particular product[1].

When the Shadow Prices are used?

Shadow Prices are used usually on occasion when a particular market does not exist or in situations when market failure leads to the variance between marginal social cost and the market price[2]. In this case the shadow pricing analysts attempt to retrieve an estimate of how the market price could look like if the relevant goods were sold in the ideal market. It is also crucial to underline that these price assumptions may be different in various time periods and they may vary in the different geographic areas. The method of shadow pricing is often used on the assumption related to the new product which is planned to be introduced to the market. Moreover, this calculation and the collection of the data due to process the establishment of the shadow pricing can provide the full image of the product in terms of the market needs as well as the frequency of sale. Furthermore, in some case, the shadow pricing may reflect the equilibrium of the market. Shadow pricing is also commonly used in terms of cost-benefit analysis. During this analysis, some of the elements cannot be quantified by the two main points such as references to a cost and market price.

What are the commonly used parameters of Shadow Pricing?

During the analysis process when the price is estimated according to a predetermined formula planned to mimic the effect of the trade, the below-listed parameters are commonly used:

  • the demand for the product,
  • the coverage of the particular area,
  • the prices range,
  • the wages,
  • the rations, etc[3].

The area of usage of the Shadow Pricing

Shadow pricing is a commonly used convenient tool which easily founds its purpose in the areas such as:

  • the public policy issues,
  • the computer programming,
  • the project evaluations of economic sectors.

What are the limitations of Shadow Pricing?

Shadow pricing has a few very important limitations such as:

  • has no universality,
  • is mainly based on the assumptions,
  • lack of adequate data,
  • cannot be available at the adequate and reliable data,
  • it is a timeless and static concept,
  • it is an indeterminable concept.

Examples of Shadow Pricing

  • Environmental Externalities: It is a type of shadow pricing which is used to measure the cost of environmental degradation which is difficult to calculate. This type of pricing is used to measure the monetary value of the resources which are consumed to produce a product and the damage which is done to the environment during the same process. The cost of such externalities is assigned to the products which are produced, so that producers are aware of the damage they are causing to the environment.
  • Non-Market Goods: Non-market goods are those goods which do not have a market price, as they are not traded in the market. For example, natural resources such as water, air or soil are non-market goods. Shadow pricing is used to assign a monetary value to these non-market goods, so that the cost of their consumption can be taken into account.
  • Opportunity Cost: Opportunity cost is the cost of forgoing an alternative course of action. It is used to measure the cost of making a decision which has a long-term impact. For example, if a company decides to invest in a new technology, the opportunity cost would be the cost of not investing in other projects which could have been more profitable. Shadow pricing is used to assign a monetary value to the opportunity cost so that it can be taken into account when making decisions.
  • Human Capital: Human capital is the knowledge, skills and abilities of workers which can be used to generate economic value. Shadow pricing is used to assign a monetary value to the human capital of workers, so that their contribution to the production process can be taken into account. This is important in order to ensure that workers are compensated fairly for their work.

Advantages of Shadow Pricing

Shadow Pricing has a number of advantages:

  • It is an important tool to allow the efficient allocation of resources in an economy. It allows for pricing decisions to be made based on the availability of resources, rather than the market price of the product.
  • Shadow Pricing is used to determine the social costs of production, as it takes into account the full cost of production, including all externalities such as environmental and social costs. This is beneficial for governments and businesses, as it ensures that the full cost of production is taken into account when pricing decisions are made.
  • Shadow Pricing can also help to ensure that resources are used in an efficient manner. By calculating the full cost of a product, businesses can determine the most cost-effective way of producing it. This is beneficial for businesses, as it helps to ensure that resources are used in the most efficient way possible.
  • Finally, Shadow Pricing can be used to help determine the price of a product, in cases where the market price is not available. This can be beneficial for businesses, as it allows them to set a price which is based on the full cost of production, rather than the market price of the product.

Other approaches related to Shadow Pricing

  • Cost-benefit Analysis: Cost-benefit analysis is a method for assessing the potential benefits or costs of a given project or opportunity. It considers both the direct and indirect costs associated with the project, including the cost of labour, materials, equipment, and other costs. It is used to help make decisions on whether to pursue a project and how to allocate resources.
  • Contingent Valuation: Contingent valuation is a method of estimating the value of an intangible good or service that cannot be measured in the traditional market. It typically uses surveys to determine an individual’s willingness to pay for a certain good or service.
  • Opportunity Cost Method: The opportunity cost method is a calculation of the potential earnings that are lost when a certain resource is used in one project instead of another. It is usually used to compare the costs and benefits of different projects and to make decisions on which to pursue.

In summary, Shadow Pricing is a method used to assign monetary values to difficult to calculate or unknowable costs. Other methods related to shadow pricing include cost-benefit analysis, contingent valuation, and the opportunity cost method. These methods are used to help make decisions on which projects or opportunities to pursue and how to allocate resources.


Shadow Pricing — recommended articles
Cost per unit — Step cost — Differential cost — Cost model — Contingent valuation — Differential costing — Hidden cost — Irrelevant cost — Weighted average method

References

Footnotes

  1. ↑ Dreze J. and Stern N.(1990).pp.2-6
  2. ↑ Layard R. and Glaister S.(2012).pp.15.
  3. ↑ Dreze J. and Stern N.(1990).pp.2-6

Author: Magdalena Czajka

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