Shadow Pricing: Understanding Value Assessment for Intangibles

Shadow Pricing refers to the estimated monetary value of goods or services not typically traded in financial markets. Businesses frequently rely on shadow prices to assign monetary values to such intangibles, thereby guiding informed project decisions. Despite its usefulness in evaluating non-market assets, shadow pricing is influenced by subjective assumptions, which can lead to biases and inaccuracies. Commonly applied to intangible assets and externality evaluations in both corporate and public sectors, from determining money market fund values to assessing public infrastructure like parks.

What Is Shadow Pricing?

A shadow price is the estimated cost of something that is not normally sold in the market. Businesses use shadow prices to quantify the costs and benefits associated with a project, but these estimates rely on subjective assumptions.

Shadow pricing is often used to value intangible assets or abstract commodities for cost-benefit analysis. It is also used to estimate the actual value of a money market fund, even if its stated value is $1 per share.

How Shadow Pricing Works

In money market funds, shadow pricing accounts for securities’ prices using amortized costs instead of market value. Money market fund shares have a net asset value (NAV) of $1, though the actual NAV may vary slightly.

Such funds are required by law to disclose the actual NAV—the shadow share price—to show the fund’s performance to investors more accurately. However, the use of the term “shadow price” in relation to money market funds is the less common usage of the phrase. It is more frequently applied in the process of cost-benefit analysis in business decision-making.

In its most common usage, a shadow price is an “artificial” price assigned to a non-priced asset or accounting entry. Shadow pricing is frequently guided by certain assumptions about costs or value. It is generally a subjective and inexact, or imprecise, endeavor. To make a decision regarding the undertaking of a project or investment, businesses often perform a comparative analysis of the project or investment cost against the projected benefits.

In a cost-benefit analysis, businesses must assign monetary value to intangible assets that are hard to price.

Pros and Cons of Shadow Pricing

Shadow pricing helps businesses better understand a project’s true value. It’s essential for cost-benefit analysis and aids management in decisions on project strategy and scope. Shadow pricing encourages responsible ethical behavior and is a vital tool in accurately evaluating a project.

However, shadow pricing has several limitations. Most notably, shadow pricing is inherently subjective; because the assets it attempts to value are intangible, the shadow price is proofless. Furthermore, because analysts must employ a fair amount of guesswork, there is significant room for bias. This means there is also a good chance the shadow price is not accurate. If the methodology used to create the shadow price is flawed, the business may direct its actions in a way that won’t benefit and could discredit the company.

Finally, some critics believe shadow pricing puts too much emphasis on short-term social opportunity cost while ignoring the long-term priorities of the business.

Practical Uses of Shadow Pricing

Shadow pricing is an incredibly useful tool when evaluating a project. Even though shadow pricing only provides a rough estimate, it helps management assess the value of certain operations and attempts to place a monetary value on the different tasks associated with the project. Furthermore, when a company wants to run a cost-benefit analysis, it must use shadow pricing to assign values to intangible items.

Shadow pricing is also frequently used in public policy in order to designate the value of various public infrastructure projects such as public transportation, parks, and bike lanes. Economists seeking the societal value of projects like public parks will use shadow pricing to demonstrate the benefits of certain infrastructure projects that are not typically assigned a monetary value.

Shadow Pricing: A Practical Example

An example of shadow pricing as applied to a proposed business plan to renovate a company’s office facilities might be the assignment of a dollar value to the expected benefits of doing the renovation. While the cost of the renovation can easily be assigned a dollar value, there are elements of the project’s expected benefit that must be assigned a shadow price because they are not as easy to quantify.

The possible benefits of the project include the following:

• Improved employee morale
• Lower staff recruiting costs
• A lower employee turnover rate and increased productivity

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 cost figure.