Sometimes a business has to weigh the costs and benefits of a project when some components, such as non-compete agreements or proprietary business methodologies, don't have a market price. In order to fully analyze a project, these components must be assigned a dollar value. If the commodity doesn't have a market price because it cannot be sold in the market, the business can allocate a "shadow" or estimated price instead.
TL;DR (Too Long; Didn't Read)
A shadow price is a way of giving a price-like quality to something that can't be sold in the market. Businesses use it to calculate the costs and benefits associated with a project.
Shadow Price Explained
The shadow price is a proxy value for a product or service that doesn't have an actual market price, such as a trademark, patent or business methodology. These intangible assets clearly have a value to the business – and may be critical to its long-term success – but they can't be sold separately from the company's business operations. Businesses sometimes allocate a shadow price in order to evaluate the costs or benefits associated with a project.
Why Businesses Use Shadow Price
When businesses need to make a decision about whether they should undertake a particular project, they typically weigh the potential costs to run the project against its expected benefits. In performing a cost-benefit analysis, the business must account for intellectual property, brand recognition and other intangibles that don't have a market value, as well as utilities, raw materials and such that do. There's not much science behind these calculations. For the most part, shadow prices are guesstimates based on years of business experience.
Shadow Price Example
Imagine that a retail business is renovating one of its stores. While the cost of the physical remodel is fairly easy to quantify, the benefits of doing the renovation are harder to express in monetary terms. The business assigns a shadow price to such things as employee satisfaction, customer satisfaction, greater productivity and other expected benefits of doing the renovation. By assigning a dollar value to these perks, a business can evaluate the total value of the renovation above the costs of construction.
How to Determine a Shadow Price
Since shadow pricing is a proxy model, it typically is based around this question: What would the business be willing to give up to gain an additional unit of the good or service? This, in turn, indicates the highest price a business would pay for the resource and still give the go-ahead for the project. For businesses that don't have complex modeling tools at their disposal, the shadow price remains a guesstimate based on a range of possible "prices," some of which may be accurate and some inaccurate by substantial amounts.