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Shadow pricing assigns a monetary value to all aspects of production, including intangible assets, to help managers understand the impact of changes on the bottom line. This includes estimating the cost of intangible assets, such as lost time for skilled workers or environmental damage. Governments also use shadow pricing to determine the full cost of a project, including social and environmental costs.
In economics, shadow pricing assigns 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 bottom line. By definition, parallel pricing involves making an educated guess about the value of certain business assets and items that are not generally sold on the market.
When managers try to optimize their businesses, they try to assess what effects would result from various changes. These changes could include hiring more workers, operating more hours per week, or opening another office. Some of these changes may involve fairly simple costs, such as the hourly wage that a new worker would have to pay. Other costs, on the other hand, may be more difficult to estimate. This could include lost time for skilled workers or environmental damage as a result of increased production.
The shadow price implies putting a price on all aspects of production, even the intangibles. This task can be extremely difficult, since many modes of production are not sold on the open market, which is what determines many trade costs. For example, if additional unskilled workers are being considered, the labor market rate may be easy to determine. However, the cost of hiring an experienced manager to help open a new factory can be much more difficult to calculate. There may be unforeseeable 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 lost opportunities. A worker who is fully engaged on one project cannot work on any other project. Opportunity cost can also apply to the community at large. The opportunity cost of opening a factory in one location includes the lost opportunity to build something else in the same location.
Governments use intent parallel pricing and determine the full cost of a project, including any social or environmental costs. If the market price of building a road is relatively low, but the damage to the environment is large enough, the project may not be justifiable. Similarly, if the highway generated unacceptable noise near residential areas, the project could be scrapped. The shadow price, therefore, is the quantitative evaluation of all the hidden costs of a proposed economic decision.
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