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.
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.
