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Shadow Price Definition – What is Shadow Pricing?

What Is a Shadow Price?

ShadowA Shadow Price is an assigned monetary value to an item, commodity, or service where the true value is unknown and can only be estimated.  Shadow pricing is commonly used to establish a value for something that is not ordinarily bought and sold in any marketplace.

Due to the fact that no exact price can be verified through market transactions, the genuine value is unknown.  As a result, it can only be estimated. Often, the value is based on an assumption of the highest price that a business would be willing to pay to obtain the item. A shadow price is determined using assumptions and approximations.  Therefore, its accuracy may not exactly correspond to the item’s true value. Nevertheless, financial analysts typically employ shadow pricing in cost-benefit analyses.  It helps to assign a monetary value to intangible assets – even when only using an estimate.

Shadow Price – A Deeper Look

A shadow price, in its most common sense, is an arbitrary price applied to a non-priced asset or accounting entry. Of course, certain assumptions regarding costs or value are frequently used to accurately establish a shadow price. Although it can result in a subjective and imprecise value, shadow pricing is used in a variety of contexts.  As a result, it has varying definitions depending on how and where it is utilized.

Shadow Price – Cost-benefit analysis

Businesses frequently do comparative studies of project or investment costs.  Then, they compare these costs to the predicted benefits.  Ultimately, this procedure helps to make a decision about undertaking a project or investment. When doing a cost-benefit analysis, a company must frequently account for the costs or advantages of intangible assets.  These can be difficult to give a monetary value to.  Yet, they must be monetarily quantified for the purposes of the analysis.

Shadow Pricing for Money Market Funds

In the context of money market funds, shadow pricing refers to the practice of accounting the price of securities based on amortized costs rather than their given market value.  Money market fund shares are typically assigned a nominal net asset value of $1. In reality, the actual net asset value is not accurately captured by this practice.  However, these funds are required by law to reveal the true net asset value to shareholders.  As a result, fund managers use a shadow share price to provide investors with a more accurate picture of the fund’s performance.

Shadow Pricing – Economics and social values

Shadow pricing is frequently used in the context of economists in establishing a societal value. The process is used to evaluate the societal benefits derived through items like public parks or libraries. Shadow pricing can also be used to evaluate other societal costs and benefits. For example, climate change is a growing concern.  Shadow pricing is a way of approximating the unseen societal costs as a result of using carbon-based energy sources.

Shadow Price – Advantages and Disadvantages 

Using shadow pricing allows a company to gain a better knowledge of the true value of potential projects. Therefore, it is an essential component of conducting a cost-benefit analysis.  Further, it helps management make decisions regarding a project’s strategy and scope.  In the public sector, shadow pricing can promote responsible ethical behavior.  As a result, is an important tool for accurately evaluating social benefits.  Shadow pricing is useful for incremental decisions.  For example, when management needs to know the benefit associated with the cost of extending the usage of a resource. The cost-benefit analysis can increase profitability over the long term.

However, there are several drawbacks to using shadow pricing.

  • Cannot be verified – Establishing a shadow price is inherently subjective.  This is because the assets being valued are intangible so the shadow price cannot be absolutely verified.
  • Potentially biased – Because analysts must rely on educated guesses, there is a high risk of bias. Unfortunately, this implies that there is always a possibility the shadow price is incorrect. If the mechanism utilized to calculate the shadow price is faulty, the company’s actions may be misguided and may lead to ultimate failure.
  • Short-term emphasis – Finally, some critics argue that shadow pricing places too much focus on short-term social opportunity costs while ignoring long-term corporate concerns.

When Is a Shadow Price Used?

  • Private sector – In business, when evaluating a project, shadow pricing is an extremely important tool. Even if shadow pricing is merely a rough estimate, it helps management assess the value of specific operations and attempts to assign a monetary value to the various project responsibilities. Furthermore, in order to do a cost-benefit analysis, a corporation must use shadow pricing to assign values to intangible goods.
  • Public sector – Shadow pricing is also commonly employed in public policy to determine the benefits of various public infrastructure projects.  This would include proposals like public transportation, parks, and bike lanes. Economists attempt to determine the societal value of projects such as public parks and public transportation.  Shadow pricing can highlight the benefits of certain infrastructure projects that are not generally ascribed a monetary value.

Shadow Price Examples

Upgrade office facilities

A company plans to renovate the corporate office facilities.  The cost of the renovation can easily be calculated.  As a result, an accurate dollar amount can be assigned to the project.  However, there are expected benefits that cannot be easily calculated.  In this case, shadow prices can be used to estimate the additional benefits that are not easy to quantify.  For example, possible benefits might include improved employee morale and larger working spaces resulting in greater job satisfaction.  Since it is impossible to assign a precise dollar value to such potential benefits, an estimated shadow price is assigned to set a dollar figure to compare with the actual cost figure.

Sell or donate

A company is considering relinquishing some of its excess property to the local city government.  Possible uses include a library and a park.  Alternatively, the company can sell the property to a developer.  Potential uses to the developer would be a strip mall or an office complex. To properly weigh the alternatives, the company can assign a shadow price to the value and utility that city residents will gain from a park or library.  An additional shadow value would be the increased esteem the company would gain from the community with such a generous donation.  The company could then compare the proceeds it would receive from selling the property to a developer with the increased esteem and social benefit derived from donating the property to the city.

Overtime pay

A company is considering paying its labor force overtime pay to deliver a shipment to a customer early. Early delivery of the important order may qualify the company for more business with the customer. To weigh the options, the company assigns a shadow price of $10,000 as the benefit of this improved relationship with the key customer. As a result, the company determines it is willing to pay up to $10,000 in overtime pay to make the early delivery.

Shadow Price FAQs

What Is Shadow Pricing?

Analysts and economists use shadow pricing to assign a monetary value to non-marketed products.  For example, production expenses and intangible assets. Shadow prices are required in order to do an appropriate cost-benefit analysis of a project.

Why use a Shadow Price?

Using a Shadow price gives managers a more complete picture of the costs and benefits of a project. In the public realm, shadow prices assist in deciding whether a public project is worthwhile to pursue. Shadow pricing can help save money by highlighting the best course of action to pursue.

What is a shadow price in linear programming?

In linear programming, a restriction is usually placed on the shadow price of a resource.  It is typically described as the highest price that should be paid to receive an additional unit of the resource in question. This definition, on the other hand, is vague and may lead to wrong conclusions.

What resources can be represented using a Shadow Price?

Shadow pricing not only helps to quantify production actions in a cost-benefit analysis.  A shadow price can be assigned to abstract commodities that aren’t normally given a numerical value. One common example of an abstract commodity is a public park.  A shadow price assigns a monetary value to the benefit of a park in order to decide the benefits of pursuing the project.

Up Next: What Is the Hedge Ratio?

Hedge RatioThe hedge ratio is the hedged position value divided by the total position value.  A ratio of 1 or 100% means that the position is fully hedged and a ratio of 0 means it is not hedged at all.

The ratio is the comparative value of an investor’s open position to their overall position. In other words, it compares the value of the investor’s position that is protected through hedging to the total size of the position or portfolio.

Investors are subject to varying amounts of risk.  To compensate, they can actively choose to reduce certain risks through hedging.  A hedge is a crucial component of the risk management process. Hedging a portfolio helps to mitigate risk and manage one’s exposure. But how much is sufficient?  Under-hedging leaves the position exposed. Yet, over-hedging can result in unnecessary expenses that eat into potential yields and profits.   Once you have hedged your portfolio, you might want to know what portion or percentage of your portfolio is risk protected. This is where the hedge ratio formula can shed some light.

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