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Hi there!
I’ve watched the lecture twice. And I understand the definition of shadow prices (which is the most extra above the current price we would be prepared to pay for an extra unit of limited resource). But I’m sorry I still don’t understand why we should calculate this extra cost by finding the extra contribution (generated by having one extra unit of the limited resource).
Please help me!
The extra contribution that we calculate is the amount of the extra contribution that we would be making if the cost of the extra resource stayed at the normal price (per kg, or per hour, depending on what the limited resource is).
Suppose that the limited resource was labour and the normal cost of labour is $5 per hour. If we get one extra hour of labour and the total contribution increases by $2 as a result, then we only get an extra $2 provided that the cost remains at $5 per hour. (The contribution of $2 will have been calculated using the cost of labour as being $5 per hour).
If we have to pay (say) $5.50 per hour for the extra hour, then the extra contribution will be $0.50 lower and will only be $1.50 per hour. There is still an extra contribution and so the extra hour would be worth buying.
If, though, we had to pay $7.50 for the extra hours (i.e. $2.50 more than usual) then the extra contribution would be $2 – $2.50, which would mean that we would be losing $0.50 and so it would not be worth buying.
The most we would be prepared to pay would be $7 per hour ($2 per hour extra) because then the extra contribution would be $2 – $2 = 0 and the total contribution would stay the same.
Know I totally get it! Thank you for your kind reply John! 🙂 Wish you have a nice day!
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