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The shadow price is a figure that derives from a production process that is currently working as efficiently and productively as possible. It measures the extra value that would come from increasing the most relevant production resource by one unit. In turn, this indicates the highest price the producer can pay for that added resource without becoming worse off overall.
This price is primarily a theoretical value used in economic calculations and problems, but it is most easily illustrated by a practical example. People can imagine a business that employs 50 people to make widgets. The shadow price is the amount of extra widgets that could be produced by employing one extra person. The figure also tells people how much the business can afford to pay that person before adding them will actually cost them money overall.
In most situations, this figure can apply to a variety of factors. For example, in the widget factory involved, the 50 staff may work a 35 hour week, but a separate shadow price can be calculated for increasing this to 36 hours. Such calculations will only take into account an increase in one particular factor.
It’s important to note that this only applies to situations where the production process is working to full capacity and efficiency. That is to say, there is no way to produce extra output without increasing a factor such as staff or working. Similarly, there is no way of producing the current output levels while reducing one of these factors. This means that the figure, in its purest form, usually only exists in theory, as there are nearly always reasons why a real-life production process is not at maximum efficiency.
Working out the shadow price can be an extremely complicated process, as it has to take into account many factors beyond the one being measured. In the example of the widget factory adding a 51st staff member, the factory may only have 50 machines. As the calculation only allows for the added worker and not any extra equipment, the calculation has to take account the fact that there may be restrictions on how much the worker can do. For example, the person may only be able to work for three hours a day while other workers are taking staggered lunch breaks.
Economists also use the term to refer to the opportunity cost of an activity. This is a way of measuring the true cost of producing something or supplying a service, particularly when it is not on a commercial basis. For example, building a government office has a financial cost, but the opportunity cost includes the fact that the land can no longer be used for other purposes and that the bricks cannot be used elsewhere. The shadow price is an attempt to put a monetary value on these lost opportunities.