Relative price

The relative price (English relative price ) is the price of a good, expressed in the price of another good. He is therefore to each other the ratio of two prices. The relative prices describe the exchange ratio of goods among themselves. This is to be understood that a particular tradable good a self-sufficient economy can be exchanged in a given relationship with a good of another self-sufficient economy.

Definition of the relative price of foreign exchange rates

The exchange rate allows the comparison of domestic and foreign funds by allowing its expression in the same currency. This allows the relative prices of goods and services in different countries compare. So it is possible that an American about how much he wants to spend on a German car and an American motorcycle. To this end, he only needs to transmit the prices in the same currency. This means at an exchange rate of $ 1.50 per euro, that an American pays for a car that costs in Germany € 40,000, $ 60,000. If the price of the bike in America is $ 20,000, then determined the relative price from the ratio of the two prices. In this case, the relative price ( $ 60,000 per car) / ($ 20,000 per motorcycle) = is 3.00 motorcycles per car. Vice versa for a German applies the same relative price.

General assumptions

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

In our simplified economy labor is the only factor of production. It follows that the selection of cheese and wine is determined from the fact that workers want to work in the sector where they earn a higher wage. The graph shows the production of our economy. As you can see here, the PF- line describes the amount that can manufacture the domestic production for a given amount of the two products. We assume in the following that

• And cheese and wine price,
• And person-hours a pound of cheese and a liter of wine,
• And labor for cheese and wine sector.

These names can then derive the following relations:

• Specialization in cheese
• Whether cheese or wine
• Specialization in wine

These equations can also be interpreted by saying that the economy specializes in the production of cheese if the relative price of cheese exceeds its opportunity cost. They will specialize in the production of wine, if the relative price of cheese is less than its opportunity cost.

Relative price in the one-factor model

The one-factor model describes the structures and effects of trade between two countries, which have only one factor of production, respectively. The model here consists of domestic and abroad, each only have the production factor labor and can produce two goods: wine and cheese. To be able to compare both markets, we consider the relative supply (RS) and the relative demand (RD ). We are expanding our assumptions, by

• As a worker from abroad and
• And call the labor coefficients of cheese and wine.

As you can see, the RS curve is an increasing function of the price of cheese relative to wine price. The RD and RD1 - curves have a decreasing gradient. The Striking of the relative supply curve RS is her step-like course.

From the RS curve shows that there is no offer of cheese when the world price falls below. Thus, there is no cheese production if the relative price of cheese falls under. If the relative price of cheese is equal to a worker earns in Germany the same in the cheese-making as in wine making. If this is the case, then domestic will produce both goods. This can be seen in the constant portion of the supply curve RS. As long as that abroad will specialize in the production of wine. The equilibrium relative price of cheese is determined by the intersection of the two curves RD and RS. At point 1, the equilibrium relative price of cheese is located where the two countries still have a comparative advantage before the opening of trading. This means that domestic focused on the production of cheese and abroad to wine production. However, the equilibrium relative price might be in point 2, if we use the RD1 curve. Then she cuts the RS curve in a flat section where the relative price of cheese is equal to the opportunity cost of cheese in terms of wine. That is, both domestic will produce cheese and wine.

Determining the Relative Price

To determine the relative price, you have to use the relative demand and relative supply. With these two variables can then create a general equilibrium analysis. It serves to illustrate the relationships between two markets. The world relative supply and relative world demand is a ratio of two goods that a good in relation expressed at the price of other goods as a function of the price of. The curve of the relative global range is represented by the RS- line, and the curve of the relative global demand represented by the RD line.

Example for determining the relative prices

We assume in this example that the world economy consists of only two countries, domestic and foreign. Domestically produced textiles and exports them to other countries. The international food is produced and exported in turn to the domestic market.

• And relative price of cloth and food
• And of domestic produced textiles and food quantities
• And foreign -produced textiles and food quantities
• Exchange ratios of domestic
• Exchange ratios of foreign

To determine the relative price, we need to determine the intersection of the relative world demand and the relative world supply of textiles. The RS- curve has an upward slope because an increase in the price ratio, the domestic and foreign causes to produce more cloth and less food. Due to this increase the world relative demand curve RD has a downward sloping because it caused the two countries to increase their stock of food. The relative price is now obtained from the intersection of RS and RD curve. The intersection of the curves is the point of showing the equilibrium relative price ( terms of trade ), the country's textile export here.