1. What is a shadow price and how can business managers use it to make decisions
ID: 1205958 • Letter: 1
Question
1. What is a shadow price and how can business managers use it to make decisions?
2. Formulate and write out the following linear programming problem. You do not need to solve this just specify the objective function, decision variables, and relevant constraints. A company makes three wood products (Western, English and American) using two different woods – oak and ash. Each product must be measured and cut. The profits per unit of the three products are $5, $12, and $10 respectively. There are 600 units of oak and 350 units of ash available to make the products. Western takes 4 units of oak and 1 unit of ash, English takes 6 units of oak and 5 units of ash, and American takes 3 units of oak and 3 units of ash. The company has 90 hours of measuring labor available and each product takes 1.5 hours to measure. Cutting labor availability is 110 hours; Western takes 1 hour to cut, English 1.5 hours, and American 1.25 hours to cut.
Explanation / Answer
Answer 1:
It is generally seen that price mechanism operates inefficiently in UDCs for project evaluation and programming. Market prices do not correcly reflect relative scarcities , benefits and costs as perfect competition is entirely absent.
Shadow prices reflect the intrinsic or true value of a factor of production or products. These prices may be different for different time periods as well as geographically separate areas and various occupations.They may deviate from the market price.
These can be determined by general equilibrium approach which requires existence of full equlibrium situation for entire economy which is difficult. In the case of partial equilibrium approach, the shadow prices of capital, labor and foreign exchange are detewrmined separately.
These are used by managers in project evaluation and its effects on national income. The success of a plan or public policy depends to a large extent on thecorrect determination of shadow prices. The greatest importance is in programming which implies optimum use of the investment.
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