Shadow Price
Opportunity cost of an activity or project to a society, computed where the actual price is not known or, if known, d oes not reflect the real sacrifice made.
Maximum price that management is willing to pay for an extra unit of a given limited resource. Management may wish to know whether it pays to add capacity in a particular department. It would be interested in the monetary value to the firm of adding, say, an hour per week of assembly time. This monetary value is usually the additional contribution margin (cm) that could be earned. This amount is the shadow price. A shadow price is, in a way, an opportunity cost -the CM that would be lost by not adding an additional hour of capacity. To justify a decision in favor of a short-term capacity decision, the decision maker must be sure that the shadow price exceeds the actual price of that expansion. For example, suppose that the shadow price of an hour of the assembly capacity is $8.75 while the actual market price is $9.50. That means it does not pay to obtain an additional hour of the assembly capacity. Read more: http://www.answers.com/topic/shadow-price#ixzz1bZutrKS1
A Brief Introduction to Social Cost Benefit Analysis SCBA also called economic analysis is a methodology developed for evaluating investment projects from the point of view of the society (or economy) as a whole. It aids in evaluating individual projects within the planning framework which spells out national income objectives and broad allocation of resources to various sectors. The main objective of cost benefit analysis is to choose the best alternative option in a consistent manner to maximize the net benefit to the economy. There are some major issues involved in cost benefit analysis, of which the most important are valuation of costs and benefits, shadow pricing, discounting, income distribution, the treatment of uncertainty and the measurement of externalities (e.g. environmental impact study). Economic analysis is similar to financial analysis except that in the place of (nominal) market prices one uses (real) "shadow prices" or "opportunity costs." One of the central concerns is the analysis of shadow pricing where economic values of costs and benefits are important issues that need to be specifically measured. This method is required to adjust the distortions in markets created by the divergence of the market prices from their economic values. And this is done through the estimation of shadow prices. Shadow prices as true prices provide a better guide to a more effective allocation of scarce resources.
Shadow pricing of labourWhen a project hires labour, it could have three possible impacts on the rest of the economy ± y
It may take labour away from other employments.
y
It may induce the production of new workers.
y
And it may involve impact of workers.
In the first case, the shadow price of labour is equal to what other users of labour are willing to pay for this labour. The social cost associated with inducing additional production of workers consist of the following ± y
The marginal product of the worker in the previous employment.
The value assigned by the worker on the leisure that he may have to forego as a result of employment in the project. y
y
The additional consumption of food when a worker is fully employed.
Etc. The social cost associated with the import of foreign workers is the wage they command. In their case, however, a premium should be added on account of the foreign exchange remitted abroad by these workers from their savings.
Shadow wage rateThe shadow wage rate is an important but difficult to determine element in SCBA. It¶s a function of several factors as1. The marginal productivity of labour. 2.
The cost associated with urbanisation.
3. The cost of having an additional amount committed to consumption when it increases as a result of the higher income he enjoys in urban employment. L-M has suggest the following formula for calculating the shadow wage rateSWR = c`-1/s(c-m)
Where, SWR - Shadow wage rate c`
- additional resources devoted to consumption
1/s
- value of a unit of committed resource
c
- Consumption of the wage earner
m
- Marginal product of the wage earner
The above formula may also be written as SWR = m+(c`-c) + (1-1/s) (c-m) where, (c`- c) - cost of urbanisation (1-1/s) (c ± m) - cost of having an additional amount (c-m) committed to consumption
(It may be noted that 1 is the value of a unit of uncommitted resource and 1/s is the value of a unit of committed resource.)
Illustrative Example- Calculating the Shadow Wage Rate for Unskilled Labor in a Government Rural Project Consider the case of a government corporation that is undertaking a labor-intensive sugar project in a rural area. The project requires unskilled workers on a temporary basis and pays a gross-of-tax wage that varies by the month. This amount will be subject to a 5 percent income tax. The following schedule shows in column (3), the after tax monthly wage rate for landless labor working in several alternative formal sector activities in the area, and, in column (4), the projects monthly requirements for person-months. To estimate the economic cost of the unskilled labor to the project, we first need to calculate the monthly share of the annual person-months required by the project. This is obtained in column (5), above, by dividing the number of person-months for a particular month by the total yearly person-months.
Table- Shadow Wage Rate for Unskilled Labor Month
Wage Employer Before Tax
to Wage Employee After Tax
to Person- Monthly Months Share of Annual Personmonths
(1)
(2)
(3)
(4)
(5)
January
126.3
120
1,800
0.2
February
105.3
100
1,800
0.2
March
189.5
180
1,800
0.2
April
189.5
180
900
0.1
May
105.3
100
900
0.1
June
157.9
150
0
0.0
July
189.5
180
0
0.0
August
126.3
120
0
0.0
September 157.9
150
900
0.1
October
115.8
110
0
0.1
November 157.9
150
900
0.1
December 189.5
180
900
0.1
9,000
1.0
Total
The weighted average monthly wage for casual labor is then calculated as 120 * 0.2 + 100 * 0.2 + . . . + 150 * 0.1 + 180 * 0.1 Average monthly wage after tax = 141 rupees per month, and Average monthly wage before tax = 148 rupees per month Shadow wage rate = (141 + 148) / 2 = 144.5
The Shadow Wage Rate Factor The shadow wage rate factor (SWRF) for a certain type of labor is the ratio between its shadow wage rate and its price. If project labor is paid a wage of 200 rupees per month, then the SWRF is calculated as: 144.5/200 = 0.723 in domestic prices. Where the world price numeraire is being used, this SWRF has to be revalued again using a standard conversion factor or a specific conversion factor for the output of this type of casual labor.
