Shadow costs are the estimated value placed on intangible costs in a project.
A shadow cost is an estimated price for an outcome that is not normally sold or given accounting value. For example, if a firm is deciding whether to build a new factory, the actual costs of material and labour will be easy to quantify, but shadow costs could involve, a negative impact on the environment, impact on firms’ reputation and the uncertainty of how long it will take to build.
Clearly the shadow costs such as the impact on the environment are subjective, and it can be difficult to agree on an agreed level.
How to calculate shadow costs?
Contingent valuation – estimates the value a person places on a good by asking them directly. How much would you pay to not have new road built near you? As individuals will give different values, a contingent valuation will be an average of individual responses.
Revealed preferences. This uses real-world behaviours to determine how much value can be placed on an outcome. For example, if individuals would pay a 10% premium to live in a quiet area – away from a busy road, then this suggests there is a shadow cost of 10% house price values from living near a busy road. Revealed preferences cannot be used for all shadow costs though, for example, the value of houses depends on many things other than environmental factors.
Problems of using shadow costs/ shadow pricing
- It is inherently subjective as it requires relying on data such as personal opinions about what people might be willing to pay. In answering surveys, individuals may not be truly honest as they give a greater weighting to public goods due to peer pressure.
- Room for bias. Because it relies on subjective data and guesswork there is room for bias, where firms can skew results to be more favourable to their desired outcome. For example, a firm building a new stadium in a residential area can highlight the impact on jobs, and relegate issues such as noise and crowd trouble.
- Outdated methodology. When pursuing a cost-benefit analysis it depends on knowing what questions to ask and which shadow costs to include. For example, in deciding whether to build nuclear reactors, we have incomplete information about the future performance of nuclear waste and whether we can safely manage these outcomes.
- Uncertainty. A further complication is when shadow costs have a degree of uncertainty. For example, a nuclear reactor may have very low external costs, but there is a small probability of a disastrous outcome. Taking low probabilities into account can be difficult as we tend to have a bias to ignore the prospect of something really bad happening.
Benefits of using shadow costs
- Important for improving the quality of cost-benefit analysis
- Can help take external costs on the rest of society/environment into account.
- Helps businesses take a more holistic approach beyond the accounting costs which only give a partial view of the outcome.
- It can enable more public goods to be supported because the real benefit of public goods (parks, flood defences, beautiful buildings) rely on non-monetary benefits. This can increase overall economic and social welfare as opposed to just focusing on GDP maximisation.
- It can be good for workers who will have their quality of workplace environment taking into account rather than just the bottom line for the company.
- It can lead to a better use of public money.
The shadow price is this estimated value placed on intangible assets, costs and outcomes. It helps give a broader picture of the social benefits/costs of a project.