Relative price

The relative price (English relative price ) is the price of a good in terms of the price of another material. So it is the relationship between two prices. The relative prices describe the exchange ratio between goods. This is to be understood in such a way that a certain tradable good of an autarkic economy can be exchanged in a certain ratio with a good of another autarkic economy.

Definition of the relative price at exchange rates

The exchange rate allows domestic and foreign money to be compared by allowing them to be expressed in the same currency. This also enables the relative prices of goods and services in different countries to be compared. So it is possible for an American to think about how much he wants to spend on a German car and an American motorcycle. All he has to do is transfer the prices into the same currency. At an exchange rate of $ 1.50 per euro, this means that an American pays $ 60,000 for a car that costs € 40,000 in Germany. If the price of the motorcycle in America is $ 20,000, then the relative price is determined by the ratio of the two prices. In this case, the relative price is ($ 60,000 per car) / ($ 20,000 per motorcycle) = 3.00 motorcycles per car. Conversely, the same relative price applies to a German.

Relative prices depending on the exchange rate

Exchange rate ($ / €)	1.25	1.5	1.75
relative price (motorcycle / car)	2.5	3	3.5

General assumptions

Transformation curve

From the transformation curve or also the production possibility curve, one can read off which production possibilities an economy has. The relative prices play a special role here. They are used to determine what an economy actually produces. To make the whole thing a little more understandable, let's imagine an economy that we call domestic. The economy produces only two products, namely cheese and wine.

In our simplified economy, work is the only factor of production . It follows that the supply of cheese and wine is determined by the fact that workers want to work in the sector where they earn the higher wages. The graphic shows the production possibilities of our economy. As you can see here, the PF line describes the amount that the domestic can produce for a given production volume of one of the two products. In the following we assume that

• ${\displaystyle P_{C}}$and cheese and wine price, ${\displaystyle P_{W}}$
• ${\displaystyle a_{LC}}$and person hours a pound of cheese and a liter of wine, ${\displaystyle a_{LW}}$
• ${\displaystyle P_{C}/a_{LC}}$and hourly wages for the cheese and wine sector. ${\displaystyle P_{W}/a_{LW}}$

With these terms one can then derive the following relationships:

• ${\displaystyle P_{C}/P_{W}>a_{LC}/a_{LW}}$ Specializing in cheese
• ${\displaystyle P_{C}/P_{W}=a_{LC}/a_{LW}}$ Regardless of whether it is cheese or wine
• ${\displaystyle P_{C}/P_{W}<a_{LC}/a_{LW}}$ Specialization in wine

Another way to interpret these equations is to say that the economy specializes in the production of cheese when the relative price of the cheese exceeds its opportunity cost . It will specialize in the production of wine when the relative price of the cheese is below its opportunity cost.

Relative price in the one-factor model

Determination of the relative price after trade

The one-factor model describes the structures and effects of trade between two countries that each have only one production factor. The model here consists of domestic and foreign countries, each of which only has the production factor work and can produce two goods: cheese and wine. In order to be able to compare the two markets, we consider the relative supply ( RS ) and the relative demand ( RD ). We expand our assumptions by

• ${\displaystyle \operatorname {\mathit {{L}^{*}}} }$ as a worker from abroad and
• ${\displaystyle a_{LC}^{*}}$and call them the work coefficients of cheese and wine. ${\displaystyle {a}_{LW}^{*}}$

As you can see, the RS curve is an increasing function of the cheese price in relation to the wine price. The RD and RD ¹ curves have a decreasing course. The striking thing about the relative supply curve RS is its step-like course.

The RS curve shows that there is no supply of cheese if the world price falls below . This means that there is no cheese production if the relative cheese price falls below . If the relative cheese price is the same , a domestic worker earns the same in cheese making as he does in wine making. If that is the case, Domestic will produce both goods. This is expressed in the constant section of the supply curve RS . Until then , foreign countries will specialize in the production of wine. The relative equilibrium price of the cheese is determined by the intersection of the two curves RD and RS . At point 1 , the relative equilibrium price of the cheese is where the two countries still have a comparative advantage before trading begins . This means that domestic focuses on cheese production and abroad on wine production. However, the relative equilibrium price could be at point 2 if we use the RD ¹ curve. Then it intersects the RS curve in a flat section where the relative cheese price equals the opportunity cost of cheese in wine. That said, Inland will make both cheese and wine. ${\displaystyle {a}_{LC}/{a}_{LW}}$ ${\displaystyle {a}_{LC}/{a}_{LW}}$ ${\displaystyle P_{C}/P_{W}}$ ${\displaystyle {a}_{LC}/{a}_{LW}}$ ${\displaystyle P_{C}/P_{W}<{a}_{LC}^{*}/{a}_{LW}^{*}}$ ${\displaystyle {a}_{LC}/{a}_{LW}}$

Determination of the relative price

In order to determine the relative price, one must use the relative demand and the relative supply. With these two quantities one can then make a general equilibrium analysis. It is used to show the relationships between two markets. The relative world supply and the relative world demand is a ratio of two goods, which are expressed as a function of the price of one good in relation to the price of the other good. The curve of relative world supply is shown by the RS line, and the curve of relative world demand is shown by the RD line.

Example for determining the relative prices

Origin of the relative price

In this example we assume that the world economy consists of only two countries, namely domestic and foreign. Domestic produces textiles and exports them to other countries. Abroad produces food and exports it in turn to the domestic market.

• ${\displaystyle \operatorname {\mathit {P_{C}}} }$and relative price of textiles and food ${\displaystyle \operatorname {\mathit {P_{F}}} }$
• ${\displaystyle \operatorname {\mathit {Q_{C}}} }$and domestically produced textiles and food ${\displaystyle \operatorname {\mathit {Q_{F}}} }$
• ${\displaystyle \operatorname {\mathit {Q_{C}^{*}}} }$and quantities of textiles and food produced from abroad ${\displaystyle \operatorname {\mathit {Q_{F}^{*}}} }$
• ${\displaystyle \operatorname {\mathit {P_{C}}} /{P_{F}}}$ Domestic exchange ratios
• ${\displaystyle \operatorname {\mathit {P_{F}}} /{P_{C}}}$ Exchange ratios from abroad

To find the relative price, we need to find the intersection of relative world demand and relative world supply for textiles. The RS curve has an upward slope because a rise in the price ratio causes domestic and foreign countries to produce more textiles and less food. As a result of this increase, the relative world demand curve RD has a decreasing course because it causes the two countries to increase their stock of food. The relative price now results from the intersection of the RS and RD curves. The intersection of the curves is the point that shows the relative equilibrium price ( terms of trade ) of the textile exporting country. ${\displaystyle P_{C}/P_{F}}$ ${\displaystyle (P_{C}/P_{F})^{1}}$

See also

• Big Mac Index

literature

• Gustav Dieckheuer: International economic relations . 5th edition. Oldenbourg, Munich / Vienna 2001, ISBN 3-486-25806-0 .
• Paul R. Krugman, Maurice Obstfeld: Theory and politics of foreign trade . 7th edition. Munich 2006, ISBN 3-8273-7199-6 .
• Joseph E. Stiglitz : Economics . 2nd Edition. Munich / Vienna 1999, ISBN 3-486-23379-3 .

Individual evidence

1. ^ P. Krugman, M. Obstfeld: Internationale Wirtschaft . 7th edition. Munich u. a. 2006, p. 44.
2. ^ P. Krugman, M. Obstfeld: Internationale Wirtschaft . 7th edition. Munich u. a. 2006, p. 403.
3. ^ P. Krugman, M. Obstfeld: Internationale Wirtschaft . 7th edition. Munich u. a. 2006, p. 62.