Shadow pricing or proxy pricing is the process of assigning theoretical values to different metrics. The method can be used to assign values to intangible assets such as social welfare services.
Companies can use this method in several cost-benefit and project appraisal scenarios. However, this method relies heavily on estimates.
Let us consider what is shadow pricing and its common uses.
Shadow Pricing – Definition
Shadow pricing is a process of assigning a monetary value (price) to a commodity, item, or unit that does not have a readily available price otherwise.
Shadow pricing is assigning prices to commodities or services that are not commonly traded in any marketplace. In other words, it is the process to quantify the market value of items or services.
Since there does not exist an actual marketplace for these items, the shadow pricing will offer only theoretical prices. These prices can only be estimated using available information.
Shadow pricing does not always ensure correct pricing. It is a process that derives prices using estimates and analysis. Often analysts would assign shadow prices at a maximum level that a company is willing to pay for a particular unit, item, or service.
How Does Shadow Pricing Work?
Shadow pricing assigns hypothetical or “artificial” prices to units or items that do have readily available prices. The process starts with gathering information and reliable data to analyze the requirements.
Analysts make informed estimates about the prices. The most common practice is to compare shadow prices of services or items with similar units.
One of the most widely used practices of shadow pricing exists in the cost-benefit analysis. Often businesses perform cost-benefit analysis with intangible asset acquisitions, project evaluations, and quantifying services.
Analysts assign costs to certain activities against the perceived benefits. The assigned costs may not reflect actual costs. Analysts then compare the project or activity against the dollar value of benefits arising from the project.
Shadow pricing is used in assigning a dollar value to services or activities of a business that do not have cost tags otherwise. For instance, a cement manufacturing business may want to assign a dollar value to its chemical hazards for the environment.
Shadow Pricing in Different Contexts
Shadow pricing can be defined in different ways. There are no set rules to assign shadow prices to commodities, items, or services. Thus, it is a process that can be analyzed in the context of the scenario under consideration.
Let us consider a few scenarios and shadow pricing in different contexts.
Government entities and public welfare organizations may want to assign shadow pricing to their contributions to the public. For example, a government institution may want to analyze the public benefit of building a library in a particular area.
Shadow pricing can also be used in project evaluations. Particularly, companies can assign shadow prices to projects for non-commercial activities. A company can then use assigned costs against perceived benefits from the project.
In stock markets, shadow pricing is applied to assign dollar value to shares in a money market fund. It is the process of assigning amortized costs rather than the market value of a stock or security.
Companies can use shadow pricing in different scenarios for project evaluations or business activities as well. For example, a delay in a project due to unavoidable weather or economic factors can be assigned dollar values to assess additional costs.
Uses of Shadow Pricing
As discussed above, shadow pricing can be used in various contexts. Different entities can use shadow pricing for assigning dollar values to otherwise non-quantifiable items.
Here are a few common uses of shadow pricing in practice.
Public Policy
Government and other public entities assign shadow pricing to projects of public interest. Also, the process is used in the estimation of interest rate, exchange rate, and inflation rate changes and their relative impact on the economy.
Thus, shadow pricing offers a useful tool in shaping public policies for governments and public sector entities.
Cost-Benefit Analysis
Private and commercial entities use shadow pricing for cost-benefit analysis. The practice is more common when appraising intangible assets. For example, a company spending money on a particular research project can compare the costs and benefits it brings for the company.
Project Evaluations
Another important use of shadow pricing is seen with project evaluations. Businesses assign artificial pricing and costs to a particular project before undertaking it. They can estimate the net present value of a project through this process. It can help them in deciding between mutually exclusive projects.
Quantifying Data
Government entities can use the practice of shadow pricing to quantify data where reliable information is unavailable. In many cases, undocumented economies present such challenges where registered and documented data is scarce.
It is a useful tool to assign theoretical prices to different metrics. It can help government entities to overcome data shortage challenges.
Accounting Practices
In many cases, companies can use proxy prices and shadow pricing in their accounting practices. It happens when there is no documented data available in the market.
It is common practice with large companies to evaluate their negative externalities such as carbon footprint and impact on nature from their business activities.
Why Shadow Pricing is Needed?
It is hard to believe that businesses and other types of entities would use shadow pricing when data and information are abundant. However, in many situations, the lack of data compels users to follow this practice.
Let’s briefly discuss some key reasons why shadow pricing is needed and in which situations.
Inefficient Market Mechanism
Inefficient markets mean undocumented economies. These are the markets where data is not documented properly. For example, in developing countries, there is a common practice to adopt low wage rates than announced by governments.
Similarly, many businesses do not file tax returns properly. Government and other entities need shadow pricing when there is a small data sample size in the market.
Unreliable Data
A similar reason to the one stated above is unreliable data. For companies and economies alike, unreliable data may compel users to follow shadow pricing practices.
Similarly, a business adopting newer technologies may not have sufficient historic data stored. It can use proxy pricing for performance and project appraisals.
Uneven Economic Metrics
Another common issue with undocumented economies and a lack of data is the use of uneven economic metrics. For instance, currency exchange rates in the interbank market and open markets are significantly different in such economies.
It makes it harder for economists and analysts to shape policies and evaluate economic conditions. Thus, they use artificial pricing methods to compensate for the lack of data in the market.
Example
Let us consider a few scenarios where shadow pricing can be used.
Suppose a company wants to relocate into a new office. The management considers the new place a marketing hub. It estimates an increased rent and other costs of around 15% per month.
It is easier for the company to estimate new costs with the plan. However, it cannot fully estimate the benefits associated with the move. It can use the shadow pricing method to estimate future benefits including increased revenue.
If the benefits exceed the estimated 15% additional costs, the company can continue with the relocation plan. Else, it may revise the plan or abandon it altogether.
Suppose a company ABC runs a fast-food outlet. It plans to expand its delivery services by an additional 50 kilometers radius.
The management expects to generate an additional $ 5,000 profit monthly. The gross revenue estimates are around $ 25,000 additional. Using the shadow pricing method, the ABC company can pay additional staff and other expenses as long as it remains profitable with its current estimates.
Advantages of Shadow Pricing
Shadow pricing is a useful method for businesses and government entities. Both types of users can utilize this method for several advantages.
- Companies can use this method for the cost-benefit analysis for services that cannot be quantified otherwise.
- It is a useful method to assign proxy values for intangible assets.
- It can be used in project evaluations as well.
- Government entities can use this method to analyze economic policies when there is no reliable data available in the market.
- It can be used to weigh social welfare projects such as building a park or library with intangible and non-quantifiable benefits.
Disadvantages of Shadow Pricing
As with any other theoretical method, it has some disadvantages for its users as well.
- At best the practice of shadow pricing is based on estimates. It means a user cannot offer any proof as to the backing of the claims.
- Since users rely on the historic date (if any) and informed estimates, this method is prone to user bias.
- The accuracy of this method is also questionable. Most of the time the users have to rely on guesswork and estimates.
- It may not be a suitable method for project appraisals in the long term.
- Th shadow pricing method itself requires reliable input data. However, it is commonly used when there is a lack of data for a company or in an economy.