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Mini Lecture 10: The Price Level versus Relative Prices
The Price Level and Inflation
The price level (PL) is the overall level of money prices in the economy. It is completely different from a
relative price since it does not represent the opportunity cost of buying one good in terms of another
good. The price level is measured by a price index which uses a weighted average of money prices.
There are a variety of price indices, but the one most commonly used is the consumer price index (CPI).
When you hear the inflation rate in the news, they are almost always referring to inflation as measured
by the CPI. No price index is perfect, and the CPI is no exception. The main problem with the CPI is that
it overstates inflation by at least one percentage point. So when you hear in the news that inflation is a
certain level, remember to subtract 1% to get the true inflation rate for the average household.
Inflation is just the growth rate of the price level so it can be positive or negative, although since the
middle of the twentieth century it is almost always positive. For most of history, though, inflation has
been negative as often as it has been positive. A declining price level is called deflation. The formula for
inflation is,
𝑃𝐿𝑡 −𝑃𝐿𝑡−1
) 100.
𝑃𝐿𝑡−1
𝜋𝑡 = (
Relative Prices
A relative price is the price that is determined by the supply and demand curve in each market. It
reflects the scarcity of the good. Although we often express this price in terms of dollars, it can also be
expressed in terms of other goods and services (i.e. the price of a gallon of gasoline is two
cheeseburgers). When the supply or demand curve in an individual market changes, this will change the
relative price of that good.
Example
Consider the following three goods: pizza, nachos and smoothies. Each has the following money prices.
Pizza
Nachos
Smoothies
$10
$2
$5
The relative price for pizza can also be expressed as 5 nachos ($10/$2=5) or as 2 smoothies ($10/$5=2).
Suppose the price level increases by 10%. Each money price will also increase by 10%.
Pizza
Nachos
Smoothies
$11.00
$2.20
$5.50
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Notice that inflation has no effect on relative prices. Pizza is still worth 5 nachos (11/2.2=5) or 2
smoothies (11/5.5=2). In other words, there has been no change in supply or demand in the pizza
market—or the nacho market or the smoothie market.
Inflation and changes in the price level have no impact on real variables such as the real wage and the
standard of living. For the average household, wages and salaries are increasing at the same rate as the
cost of living, so there is no change in the real wage. In general, there is no change in the opportunity
cost of buying specific goods and services or, in the case of the real wage, of enjoying leisure (i.e. the
opportunity cost of leisure is the goods and service that once can consume from earning the real wage).
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