MA – May 2020 – L2 – Q5b – Decision making techniques

Explain the concept of shadow price and assess the acceptability of a timber supply offer based on shadow pricing.

Question

b) A timber merchant from Takoradi made a proposal to Blasius Ltd to supply this specialized timber which is in short supply but at the cost of GH¢4.5 per square metre.

Required:

i) Explain the term shadow price. (2 marks)

ii) Identify the shadow price which should be paid per square metre and comment on the acceptability of the offer. (4 marks)

Answer

i) Shadow Price:

Shadow price, also known as the maximum price or dual price, is the maximum amount above the normal price that a company would be willing to pay to obtain one additional unit of a scarce resource. It represents the value that the company would place on the additional resource, reflecting the contribution it would make to the company’s profit. The shadow price is the price at which the purchaser makes a nil contribution from its use.

(2 marks)

ii) Shadow Price Calculation and Offer Assessment:

The present situation is that the demand for chairs and tables is fully satisfied from the existing resources, but there is some unsatisfied demand for benches. Thus, any additional timber would be used to manufacture more benches.

Based on the current input cost of GH¢2.00 per square metre, each unit of timber earns a contribution of GH¢2.33. Therefore, the shadow price can be calculated as follows:

Item	Value (GH¢)
Current timber cost	2.00
Contribution per square metre	2.33
Total shadow price	4.33

Given the shadow price of GH¢4.33 per square metre, the offer from the timber merchant at GH¢4.50 per square metre exceeds the shadow price by GH¢0.17.

Comparison	Value (GH¢)
Offer price	4.50
Shadow price	4.33
Excess	0.17

Conclusion: Since the offer price of GH¢4.50 per square metre exceeds the calculated shadow price of GH¢4.33, the offer should be rejected as it would not contribute positively to the company’s profits.

(4 marks)