Shadow price


The shadow price is the value that a certain good presents, taking into account that there is no defined price for said good in the market. Although it does not present a specific price, it is attributed based on the cost that said good would have in a perfectly competitive market, including the associated costs.

In other words, the shadow price represents the opportunity cost of producing or consuming a given good or service. Well, since it does not present a market cost, the valuation must be made through cost-benefit analysis, including all associated costs, both social and private.

In other words, it is the meaning of the Lagrange multiplier, which represents the variation of a given objective when there is an additional unit of a certain limited resource.

Tobin's Q, to get an idea, is a shadow price.

The shadow price, in the same way, is one of the most important derivations of the linear programming method.

What is the shadow price for?

Being a mathematical term, it can sometimes seem like a very convoluted concept. However, below is an example to better understand this concept.

Imagine, therefore, that we have a company that wants to minimize the cost of a production function. To do this, he knows the prices of the factors of production, but he does not know the price of the product that he is going to launch on the market.

To do this, the company tries to assign a value to said production through what we call “shadow prices”, calculating the opportunity cost of producing these goods, and not other different ones.

In this way, the shadow price indicates how the maximum or minimum value of the function responds to a unit change in the restriction or condition.

Tags:  famous-phrases derivatives Business 

Interesting Articles