Shadow Price

The shadow price is the change in the objective value of the optimal solution of an optimization problem obtained by relaxing the constraint by one unit. 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, what is the price of keeping a production line operational for an additional hour if the production line is already operated at its maximum 40 hour limit? That price is the shadow price. More formally, each constraint in an optimization problem has a shadow price or dual variable.

The value of the shadow price can provide decision makers powerful insight into problems. For instance if you have a constraint that limits the amount of labor available to 40 hours per week, the shadow price will tell you how much you would 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.

© Copyright 2016 Behin-Cara-Pajoh. All rights reserved.
Privacy Policy | Terms & Conditions