. © 1999-2003
Douglas A. Ruby

Equilibrium Analysis

Production and Production Possibilities

A Consumer Optimum

A Producer Optimum


Overview of Economics

Macroeconomic Principles

Microeconomic Principles

Macroeconomic Theory

Microeconomic Theory
The Role of Relative Prices
in Market-based Economies

Microeconomics, as one branch of economic theory, is defined as the study of the behavior of individual economic agents. These agents are divided up into producers (business firms) and consumers (households) and thus microeconomics is the study of how these agents react to changes in relative prices. In any market economy, these relative prices act as signals about surpluses or shortages that may exist in individual markets and will guide in the allocation of resources to their best use.

A relative price may be expressed in terms of a ratio between any two prices or the ratio between the price of one particular good and a weighted average of all other goods (aog) available in the market.

PR = (Px / Py) or (Px / Paog).

For example given the price of two goods --  houses and apartments, where we may observe that the price of houses are increasing relative to apartment rents.

(Phouses / Papartments) = PR ,

This may be the result of increased desire (preferences) for detached housing. A developer would react to this signal by allocating resources (land, labor, materials) to the construction of houses. These scarce resources would be pulled-away from alternative uses -- apartment construction. The result is the construction of more houses and fewer apartments.

Suppose that in contrast we find that the rental rate of apartments is decreasing:

(Phouses / Papartments ) = PR

This outcome may be the result of an oversupply of apartment units. Developers would react by building fewer apartments thus releasing scarce resources for alternative uses -- housing. The result is the same: more houses are built and fewer apartments constructed. More importantly, we find that more houses are built even though the price of houses has not changed.

Relative Prices
	are the magnet that draw goods from one place to another.

In general, we would expect that if a relative price increases (the price in the numerator is larger or the price in the denominator is smaller),  resources will be reallocated towards that good in the numerator. If, however, a relative price decreases  (a smaller numerator or larger denominator), resources will be reallocated towards that good in the denominator.

Relative prices with respect to final goods and services (i.e., Px/PY) address the economic question of what to produce?. These ratios can also aid in the understanding how factor inputs are used in the production of these final goods; that is, the question of how to produce?.

In a country where capital is relatively scarce we might find that capital is expensive relative to other factors of production -- i.e., labor. This country might engage in labor intensive production relying on workers rather than machines to produce different goods. In other countries we might find that labor is relatively scarce and thus relatively expensive. Production in these countries might rely more on capital intensive production. In each case similar goods are produced. However, the methods used might differ -- not because one type of production is better than another but because these methods reflect the relative price of the factor inputs.

For example, we might find that:

In country-A:
  • Wage Rate (w) = $20.00/hour
  • Rental Cost of Capital (r) = $50.00/hr
In country-B:
  • Wage Rate (w) = $5.00/hour
  • Rental Cost of Capital (r) = $20.00/hr
To focus just on the price of capital, one might conclude that country-B might engage in capital intensive production given that capital is cheaper in dollar-terms. However, when expressed as relative prices:
(w/r)country-A > (w/r)country-B
Country-A will rely on capital intensive production and Country-B will rely more on labor intensive production.

Understanding relative prices helps us understand how inflation can cause problems for a market economy. In an inflationary environment, all prices are rising although often at different rates. It may be that the price of housing is increasing by 5% per year and the price of food is increasing by 8% per year. The overall rate of inflation would be some average of these two values combined with prices of other consumer goods. For individual producers and consumers, it becomes difficult to distinguish between a change in relative prices (such that one good is more valuable relative to other goods) and a change in all prices due to the inflation. In this inflationary environment,  individual producers may often confuse a change in the price of  her/his particular good as a relative change with the reaction that s/he allocates more resources towards production of that good. A reallocation of resources mistakenly takes place. Thus, inflation can cause inefficiencies in the marketplace in that it distorts the signals necessary for the proper allocation of resources.

Concepts for Review:
  • Capital Intensive Production
  • Consumers
  • Inflation
  • Labor Intensive Production
  • Producers
  • Relative Prices
  • Resource Allocation