What is Relative Price? - Definition & Formula

What is Relative Price? - Definition & Formula
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  • 0:03 It's All Relative!
  • 1:06 Resource Allocation
  • 3:27 Non-Market Forces
  • 4:57 Lesson Summary
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Lesson Transcript
Instructor: Martin Gibbs

Martin has 16 years experience in Human Resources Information Systems and has a PhD in Information Technology Management. He is an adjunct professor of computer science and computer programming.

This lesson will define the concept of a relative price and demonstrate a relative pricing formula. We will also discuss the role of relative prices in the allocation of resources in economics.

It's All Relative!

If we told you that a bag of crisps cost $1.50, would you be able to state if this was a good price or not? Is it too high or too low? Without other information on hand, you really can't answer it. You would need to know the cost of other goods, your salary, and even the price of other crisps of varying brands.

This is how relative prices work. It means the price of a good relative to another good, or other measure. At its most basic, it's a ratio. For example, our crisps cost $1.50, but we earn $3.00 per hour. The relative price is .5 - you spent half of your wages on crisps!

To get the relative price of a good, divide it by another. Let's use another example. The price of a regular coffee is $2.00. A double-soy-latte-no-foam-extra-shot is $6.00. The relative price is:

  • $6.00 / $2.00, or 3:1

Every time you buy the fancy drink you lose out on 3 regular coffees.

Resource Allocation

When we analyze how land, capital, and labor are allocated for production purposes, we're studying resource allocation. That is, how these resources are used to produce the goods and services used by consumers.

As we mentioned before, just knowing the price of crisps doesn't offer the full picture. We need to know the relative prices across goods and services. Recall that relative price is the price of a good or service against another.

Let's say the supply costs go down and coffee drops to $1.50. The fancy drink is still the same, but the relative price has gone up. What will happen if the fancy drink has an increase in price? Demand will dip, and you may see a higher demand for regular coffee. So, what will happen to the market next?

  1. Fancy drinks increase in price
  2. People seek cheaper coffee
  3. Demand for cheap coffee goes up
  4. Shortage of cheap coffee occurs
  5. Price of cheap coffee goes up
  6. Now the relative price of the cheap coffee has gone up relative to other products
  7. More resources allocated to the production of cheap coffee

This was a simplistic example, but even considering the production of vehicles, mining, etc., the concept remains the same. As prices of a resource rise relative to another, companies may adjust production of goods; in so doing, this changes the allocation of resources for those and other goods.

Another example is within the factor markets, such as labor. If there is a shortage of computer programmers, this will result in higher wages for programmers relative to other jobs. Higher wages will encourage students to study in this field. Eventually the supply increases because the allocation of labor resources shifted to this field.

As labor costs go up, certain roles may have to be filled by non-humans. While it's a good thing for workers that wages have risen, employers may experience a much higher relative price of wages against their earnings. Resources are re-allocated away from wages to other options, for example, robots.

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