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Hello John,
I got stuck at the Shadow Price question in the MCQ Test, where the question asks ‘what’s the most per kg that the company should be prepared to pay for an extra kg of material.
The shadow cost is given at $3.70 and the current price of the material at $3.00. Is it the time difference, when the material can cost almost double the amount, the reason we calculate the current price + the shadow price?
Because in the lecture, in your example, you told us that if the current price is $10 and the contribution is $1.125, the maximum we are ready to pay =/> $11.125 and then it will be worth paying for it. In the example above, if the current price obviously we don’t have given contribution, thus I am not sure why we have to sum both amounts.
Thank you in advance,
ElenaA shadow price associated with a resource tells you how much more profit you would get by increasing the amount of that resource by one unit.
An easy way to think about it is ……. Well how much you would be willing to pay for an additional resource?
For exampleA company uses linear programming to decide on the production and sales budget that will maximise total contribution and profit for a financial period. The optimal solution involves using all available direct labour hours, for which the shadow price is $4.50 per hour, and machine hours, for which the shadow price is $3 per machine hour. Direct labour is paid $8 per hour.
If the objective of the company is to maximise total contribution and profit in each period, how much should the company be willing to pay per hour to obtain additional direct labour hours of production capacity?A .Up to but not including $4.5
B. Up to but not including $9.5
C. Up to but not including $12.5 ******This means that the company would increase contribution by paying up to $(8 + 4.50) = $12.50 see below for an explanation
D. Up to but not including $15.5If they could buy one extra hour at the ‘normal’ price of $8 then we would make the ‘normal’ contribution which would mean an extra $4.50. But given that extra hours will cost more than $8 per hour (otherwise the hours would not be limited), for each extra $1 they cost the extra contribution will be reduced by $1.
If the extra cost was $4.50 per hour then the extra contribution would be $0 and so the most extra they will be prepared to pay above the normal cost is $4.50.
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