What is shadow price? Definition and meaning
Shadow price, or shadow pricing, is the real economic price of projects, activities, goods, and services that have no market price. It also includes projects, etc. for which prices are difficult to estimate. The shadow price is the opportunity cost, i.e., what somebody had to give up when they made a choice.
The shadow price is the proxy value of a good or project. We often define it by what somebody has to give up to gain an extra unit of that good.
However, the impact resulting from a project or the value of a good when measured using the shadow price may differ from its value when measured using market prices.
This is because the market has not properly priced it in the first place.
The shadow price can also mean the highest price that a company would be willing to pay. Specifically, the highest price it would pay for one extra unit of something.
Shadow pricing involves determining whether doing something will bring in greater benefits than the costs incurred. When we have estimated the shadow price, we subsequently decide whether to go ahead with a plan. If we decide to go ahead, we also decide how much we are willing to spend on it.
For example, let suppose we’re calculating whether it’s worth paying workers for an extra hour’s overtime. If the shadow price is greater than the cost of one hour’s overtime, we decide to go ahead.
In other words, we go ahead if the benefit is greater than the cost.
In this case, the shadow price is how much the company would lose if it didn’t continue producing for another hour.
Shadow price – some examples
Labor 1
The shadow wage is lower than the market wage when there is unemployment. This is because there is no loss in output elsewhere when a worker gains employment.
Therefore, the marginal social cost of hiring the worker is lower than the market wage.
Labor 2
A company is considering paying one of its delivery workers overtime to transport a shipment to a customer early.
If it does this, it has a good chance of getting much more business from the customer.
The company assigns a shadow price of $10,000. In other words, that is the benefit of having an improved business relationship with the buyer.
Therefore, management will pay up to $10,000 to the dispatcher to make the delivery.
Steel
The shadow price is higher than the market price. This is because the producer has not accounted for the marginal social cost of pollution in steel’s production costs.
Capital
The shadow interest rate exceeds the market interest rate when rationing exists in capital markets.
This is because the expected return is higher than the interest rate as companies wish to borrow more at a given interest rate than they can. The opportunity cost of funds is larger than the interest rate.
Shadow price in accounting
Before there is proper market pricing or adequate regulation for some commodity items, conservative companies, and other entities will place a value they believe to be an accurate reflection of the value of those items to their business on their balance sheets.
Most companies with a large carbon or water footprint do this.
For example, Microsoft Corporation placed a $27/ton price on its carbon emissions. This was then billed to the P&L (profit & loss) of each business unit.
It subsequently used the money to fund the corporation’s renewable energy and efficiency programs.
In an article published in Climate Money Policy – Carbon Shadow Pricing – Brian Reynolds wrote:
“118: There are 118 buildings on the Microsoft campus (15M sq ft). Each with different requirements for heating, cooling, lighting, and energy. Each with different potential needs and strategies for efficiency. And each with different capital needs.”
“30,000: There are thirty thousand different pieces of mechanical equipment and seven different and unique building management systems housed in those 118 buildings. None of them designed to speak with one another.”
“$1.5M: in savings Year-1: That’s the bottom line number Microsoft realized following the adoption of carbon shadow pricing.”
Shadow pricing – pros and cons
When a company has to make incremental decisions, determining the shadow price is useful.
Before deciding whether to go ahead with a plan, you have to weigh costs against benefits. Specifically, the cost of extending the usage of a resource against the potential benefit for your business.
Shadow pricing is often no more than calculated guesswork, especially when dealing with intangible goods.
What should you do when you are not sure how accurate your guesstimates are? You should use a range of estimates, and then link them to the most likely benefits.
Regarding the disadvantages of using a shadow price approach, AccountingTools.com writes:
“Even using a range analysis, there is a good chance that any estimates proposed will be incorrect, and possibly by substantial amounts. Shadow pricing is a limited concept that should only be applied to very specific financial analysis situations. ”
A financial analysis is an assessment of a project’s or business’ viability, profitability, stability, and solvency.
We may derive shadow prices from anything. From products and services, for example, to resources.
While economists tend to use the markets when making valuations, their research is still valid when there is no market price for something.
Video – Shadow cost of carbon
In this Energy & Mines video, Frank Roberto talks about how his company is implementing a shadow cost of carbon. Roberto is Chief Metallurgist at Newmont Mining Corporation in Colorado.