A shadow price is the monetary value assigned to an abstract or intangible commodity which is not traded in the marketplace. This often takes the form of an externality. Shadow prices are also known as the recalculation of known market prices in order to account for the presence of distortionary market instruments (e.g. quotas, tariffs, taxes or subsidies). 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. 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.

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. Where the external effect is not being accounted for in the final cost-benefit analysis of its production. These inaccuracies and skewed results produce an imperfect market mechanism which inefficiently allocates resources.

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. The utilisation of shadow prices in these types of public policy decisions is extremely important given the societal impacts of those decisions. After incorporating shadow prices into the analysis, the impacts resulting from the policy or project may differ from the value obtained using market prices. This is an indication that the market has not properly priced the costs or benefits in the first place, or the market hasn’t priced them at all. 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. Not just the private or referent group benefits.

Although traditionally shadow prices have been used in government led research, the use of shadow prices in the private sector is becoming increasingly more common, as companies try to evaluate the social impacts of their decisions. As the desire for Environmental, Social and Governance (ESG) investing has grown so has the need for companies and investors to evaluate the societal impacts of their production and investment decisions. 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.

The figures below illustrate how shadow prices can effect efficient allocation of resources. Figure 1 illustrates a positive shadow price where the social marginal cost is less than the private marginal cost. 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. The Private Marginal Cost (PMC) is simply the cost of producing the vaccines whereas the Social Marginal Cost (SMC) is the PMC less the net social benefit of getting vaccinated.

Figure 2 illustrates a negative shadow price where the social marginal cost is greater than the private marginal cost. 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. In this instance Private Marginal Cost (PMC) is simply the cost of producing the chemicals whereas the Social Marginal Cost (SMC) is the PMC less the net social cost of discarding toxic waste chemicals.