What is "shadow price"

n. (context economics English) A price for a resource, good, or service which is not based on actual market exchanges, but is mathematically derived from indirect data obtained from related markets. vb. (context transitive economics English) To calculate a shadow price for.

The term "Shadow Price" or "Shadow Pricing" is used to refer to monetary values assigned to currently unknowable or difficult to calculate costs. The origin of these costs is typically due to an externalization of costs or an unwillingness to recalculate a system to account for marginal production. For example, consider a firm that already has a factory full of equipment and staff. They might estimate the shadow price for a few more units of production as simply the cost of the overtime. In this manner some goods and services have near zero shadow prices, for example information goods.

Less formally, shadow price can be thought of as the cost of decisions made at the margin without consideration for the total cost. For instance, consider a trip in your car. You might estimate the shadow price of that trip by including the cost of gas; but you are unlikely to include the wear on the tires or the cost of the money you might have borrowed to purchase the car.

In constrained optimization in economics, the shadow price is the instantaneous change, per unit of the constraint, in the objective value of the optimal solution of an optimization problem obtained by relaxing the constraint. In other words, it is the marginal utility of relaxing the constraint, or, equivalently, the marginal cost of strengthening the constraint.

In a business application, a shadow price is the maximum price that management is willing to pay for an extra unit of a given limited resource. For example, if a production line is already operating at its maximum 40-hour limit, the shadow price would be the maximum price the manager would be willing to pay for operating it for an additional hour, based on the benefits he would get from this change.

More formally, the shadow price is the value of the Lagrange multiplier at the optimal solution, which means that it is the infinitesimal change in the objective function arising from an infinitesimal change in the constraint. This follows from the fact that at the optimal solution the gradient of the objective function is a linear combination of the constraint function gradients with the weights equal to the Lagrange multipliers. Each constraint in an optimization problem has a shadow price or dual variable.

The value of the shadow price can provide decision-makers with insights into problems. For instance if a constraint limits the amount of labor available to you to 40 hours per week, the shadow price will tell you how much you should be willing to pay for an additional hour of labor. If your shadow price is $10 for the labor constraint, for instance, you should pay no more than $10 an hour for additional labor. Labor costs of less than $10/hour will increase the objective value; labor costs of more than $10/hour will decrease the objective value. Labor costs of exactly $10 will cause the objective function value to remain the same.