Shadow price
Empirical methods Prescriptive and policy A shadow price is the monetary value assigned to an abstract or intangible commodity which is not traded in the marketplace.
[2] Shadow prices are the real economic prices given to goods and services after they have been appropriately adjusted by removing distortionary market instruments and incorporating the societal impact of the respective good or service.
[3] A shadow price is often calculated based on a group of assumptions and estimates because it lacks reliable data, so it is subjective and somewhat inaccurate.
[4] The need for shadow prices arises as a result of “externalities” and the presence of distortionary market instruments.
An externality is defined as a cost or benefit incurred by a third party as a result of production or consumption of a good or services.
These inaccuracies and skewed results produce an imperfect market mechanism which inefficiently allocates resources.
[5] Specifically, the presence of a monopoly or monopsony, in which firms do not behave in a perfect competition, government intervention through taxes and subsidies, public goods, information asymmetry, and restrictions on labour markets are distortionary effects on the market.
[6] Shadow prices are often utilised in cost-benefit analyses by economic and financial analysts when evaluating the merits of public policy & government projects, when externalities or distortionary market instruments are present.
[8] By conducting analysis with shadow prices it allows analysts to determining whether doing the project will provide greater benefits than the costs incurred in totality.
[9] This trend can be seen with the commitments made by most multinational corporations to reducing their CO2 emissions and acknowledging the impact their business activities have on society.
An example of this is vaccinations, they provide a benefit to other people in society because after receiving one you no longer spread infectious diseases.
An example of this is pollution, discarding toxic waste chemicals into waterways have a negative effect on fish stocks in the region, reducing local fisherman's income.
Shadow pricing is frequently used to figure out the monetary values of intangibles which are hard to quantify factors during cost-benefit analyses.
This is because public goods are very rarely exchanged in the market, making it difficult to determine its price.
Take the example of a government determining whether it wants to undertake a freeway project that would save commuters 500,000 hours a year, save 5 lives a year, and reduce air pollution due to decreased congestion but with a present value cost of $250 million.
[13] Contingent valuation estimates the value a person places on a good by asking him or her directly.
[18] Revealed preferences are based on observations on real world behaviors to determine how much individuals place on non-monetary outcomes.
[21] In the freeway project example, where contingent valuation may fall short in determining how much individuals value lives, revealed preferences may be better suited.
For instance, policymakers can look at how much more individuals need to be paid to take on riskier jobs that increase the probability of fatality.
However, the drawbacks with revealed preferences also arise – in this case, if the riskier jobs increase the probability of not only death but also injury, or are also unpleasant in other respects, the higher wages may incorporate the other factors, misrepresenting the result.
Hedonic pricing is a model that uses regression analysis to isolate the value of a specific intangible cost or benefit.
It is most often used to calculate variances in housing prices that reflect the value of local environmental factors.
The model is based on widely-available and relatively accurate market data, making this method uncontroversial and inexpensive to use.
It also assumes that individuals have the freedom and power to select the preferred combination given their income but in actuality, this may not be the case as the market may be influenced by changes in taxes and interest rates.
[24] In the freeway project example, hedonic pricing may be useful to value the benefits of reduced air pollution.
It can run a regression of home values on proximity to work with a similar set of control variables.
, then we have from the multivariate chain rule: Now we may conclude that This again gives the obvious interpretation, one extra unit of optimal expenditure will lead to
[27] The first one puts an emphasis on individual travel costs, number of visits a year, and other variables.
[26] Also, the method does not consider multi-purpose journeys,[citation needed] marginal costs, and only estimates the value of the site as a whole.
In optimal control theory, the concept of shadow price is reformulated as costate equations, and one solves the problem by minimization of the associated Hamiltonian via Pontryagin's minimum principle.
