Relative Price
A relative price is the price of one good or service expressed in terms of another, or of a group of others. Relative prices, rather than absolute prices, guide the allocation of resources, since they determine the trade-offs that producers and consumers face.
Definition
The relative price of a good can be expressed as the ratio of its price to a price index of all other goods, or to the price of a specific alternative. In a two-good economy, the relative price is simply the ratio of the two prices. In an economy with many goods, relative prices are typically expressed relative to a general index.
Relative prices are distinct from the general price level, which measures the average of prices. Movements in relative prices redistribute demand among goods, while movements in the general price level affect the purchasing power of money. Confusing the two is a common error in the interpretation of inflation.
The Guidance of Resource Allocation
Relative prices guide the allocation of resources by determining the profitability of different activities. A rise in the relative price of a good makes its production more profitable, attracting resources into the sector, while a fall drives resources out. The process directs capital and labour toward their most valued uses.
The allocative function of relative prices depends on their flexibility. Where prices are sticky, relative prices may not adjust to reflect changes in scarcity, and the allocation of resources may be distorted. The efficiency of the price mechanism therefore depends on the responsiveness of prices to changes in conditions.
Inflation and Relative Prices
Inflation can distort relative prices. Because not all prices adjust at the same time, inflation creates variability in relative prices, which can confuse the signals that guide resource allocation. Firms may misinterpret relative price changes as changes in the general price level, or vice versa, leading to errors in production and investment.
High and variable inflation is associated with greater relative price variability, a relationship documented empirically. The distortion of relative prices is one of the costs of inflation, additional to the costs of holding money and of the redistribution of wealth.
Terms of Trade
The relative price of exports in terms of imports, known as the terms of trade, is a key variable in international economics. An improvement in the terms of trade means that a country can obtain more imports for a given quantity of exports, raising national income. A deterioration has the opposite effect.
The terms of trade are affected by changes in world prices, by exchange rates, and by the composition of trade. Movements in the terms of trade have significant effects on the incomes of countries that export commodities and on the macroeconomic management of shocks to export prices.
Relative Prices and Real Income
Relative prices determine real income, since the purchasing power of a given nominal income depends on the prices of the goods it can buy. A change in relative prices alters the real income of individuals and of countries, redistributing purchasing power among them.
The terms of trade, the relative price of exports in terms of imports, is a key determinant of the real income of a trading country. An improvement in the terms of trade raises real income, allowing more imports for a given quantity of exports, while a deterioration has the opposite effect. The management of terms-of-trade shocks is central to macroeconomic policy in commodity-exporting economies.
Relative Prices and Taxation
The tax system interacts with relative prices. Taxes on specific goods change the relative prices of those goods, altering consumption and production patterns. The resulting distortions depend on the elasticities of demand and supply and on the substitutability among goods.
The design of tax systems must consider the effects on relative prices and the resulting distortions. Taxes on goods with inelastic demand or supply cause smaller distortions, and the optimal structure of commodity taxation balances revenue needs against efficiency costs, taking account of distributional objectives.
Relative Prices in International Trade
Relative prices determine the pattern of international trade. Countries export goods in which they have a comparative advantage, reflected in relative prices, and import others. Changes in relative prices, driven by technology, endowments, or policy, alter trade patterns and the distribution of income within countries.
The analysis of trade policy must consider the effects on relative prices. Tariffs raise the relative price of imports, protecting domestic producers while raising costs for consumers, and their effects depend on the elasticities of demand and supply for the goods affected.
Price Flexibility and Adjustment
The flexibility of relative prices affects the speed of adjustment to shocks. Where prices are flexible, changes in relative prices reallocate resources smoothly, and the economy adjusts with limited output loss. Where prices are sticky, adjustment is slower and the effects on output and employment larger.
The analysis of price flexibility informs the assessment of the adjustment mechanism and the design of policy. Institutional features, including the degree of competition and the nature of contracts, affect the flexibility of prices, and reforms that increase flexibility can improve the resilience of the economy.