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A shadow price is a monetary value 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, a shadow price can be thought of as the cost of decisions made at the margin without consideration for the total cost.
In constrained optimization in economics, the shadow price is the change, per infinitesimal unit of the constraint, in the optimal value of the objective function of an optimization problem obtained by relaxing the constraint. If the objective function is utility, it is the marginal utility of relaxing the constraint. If the objective function is cost, it is 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.
In advance of adequate regulation or market pricing for some commodity items conservative organizations will place on their balance sheets a value they believe to be an accurate reflection of the value of those items to their operations. This is common for companies with a large carbon footprint or water footprint. As an example Microsoft has placed a $27/ton price on its carbon emissions which is then billed to the P&L of its individual business units and used to fund the company's renewable energy and efficiency programs.
Suppose a consumer with utility function faces prices and is endowed with income Then the consumer's problem is: . Forming the Lagrangian auxiliary function , taking first order conditions and solving for its saddle point we obtain which satisfy:
This gives us a clear interpretation of the Lagrange multiplier in the context of consumer maximization. If the consumer is given an extra dollar (the budget constraint is relaxed) at the optimal consumption level where the marginal utility per dollar for each good is equal to as above, then the change in maximal utility per dollar of additional income will be equal to since at the optimum the consumer gets the same amount of marginal utility per dollar from spending his additional income on either good.
Holding prices fixed, if we define the indirect utility function as
then we have the identity
where are the demand functions, i.e.
Now define the optimal expenditure function
Assume differentiability and that is the solution at , then we have from the multivariate chain rule:
Now we may conclude that
This again gives the obvious interpretation, one extra dollar of optimal expenditure will lead to units of optimal utility.
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.