A relative price is a price of a product or service measured in comparison to the price of the reference product. It helps companies adjust the production and allocate resources in the right way.
Why is a relative price important?
You can feel the changes in relative price in everyday life as they cause changes in standard price indexes that indicate how prices change over time. These fluctuations arise when individual prices adjust to the ebb and flow of the product supply and demand. Movements in relative price inform about the scarcity of specific products or services.
If a relative price increases, it shows that demand exceeds supply (or that supply lags behind demand) whereas if a relative price decreases it indicates the opposite. The increasing relative price encourages consumers to save money on expensive products and search for their substitutes. On the other hand, producers try to bring more products to the market to gain profit.
Relative prices concerning final goods and services help companies decide what to produce. With the help of the ratio, you know how to produce. This ratio shows how to allocate land, capital, and labor to produce products and services. Knowing about a rise in relative prices allows your company to accurately adjust the production of goods.
Every company and individual needs to be aware of relative prices because of several reasons mentioned above. Now let’s review the difference between absolute and relative price.
Absolute Price vs Relative Price
There are two essential aspects to understand: absolute and relative price necessary when discussing economic decisions. Let’s find out how decisions are made based on absolute and relative prices.
An absolute price is a market price of a product or service. For example, on average a car costs $40,000 and a house $600,000. These are the absolute prices of these goods. Yet many decisions aren’t based on this price. The majority of companies consider the relative price.
A relative price is a price of a product or service compared to another. To obtain a relative price you need a ratio. Let’s imagine that you decided to buy Vintage Narcissus oolong tea as a gift for your friend which costs $3,250 per pound. At the same time, there’s a cheaper alternative to oolong tea called Tieguanyin Tea which costs $1,500 per pound.
The relative price would be $3,250/$1,500. This means that you could buy two pounds of Tieguanyin Tea instead of one pound of Vintage Narcissus tea or pay for one pound of tea half the price.
Now that you know the distinctive features of absolute and relative price on an example, it’s the right time to get to know how to calculate a relative price.
How to Calculate a Relative Price
As you already know, relative price is the price of a product compared to another product. So it’s expressed as a ratio between the prices of two products or services. To obtain a relative price of a product, divide the price of one product by another. Let’s take coffee, for example. The price of a tall cup of cappuccino costs $5 while one cup of coffee with almond milk costs $10.
$10 / $5 = 2:1
This ratio indicates that instead of buying a cup of coffee for $10 you could buy two tall cups of cappuccino.
Here is a formula to calculate a relative price for the goods you need:
Pr = Px / Py
Pr is a relative price;
Px is the price of a first product;
Py is the price of a second product.
Let’s take another example where the two goods will be houses and apartments. For instance, there’s an increase in the price of houses compared to apartment rents. This might indicate that houses are in great demand now (there is an increased demand). To meet the demand and obtain the highest profit, a developer would withdraw funds from the apartment construction and relocate them to the building of houses. As a result, there will be more houses than apartments.
Let’s imagine that the price for apartments is declining. It might be the outcome of an oversupply of apartment units. As a result, developers would build fewer apartments and consider allocating resources to building houses.
To sum it up, a relative price is a crucial concept as it helps companies allocate resources in the right way and receive the highest revenue. Besides, it allows you to compare the prices and set preferences about specific products.
Last Updated: 25.02.2021