Monetary (Nominal) Prices
Opportunity costs may be only loosely related to monetary (absolute) prices.
Nominal prices are prices in terms of some monetary unit.
Prices in the United States are commonly stated in dollars and cents, but these nominal prices could also be stated in francs, pesos, or yen. For example, if dollars and yen were equally acceptable for purchases and $1 could be exchanged for 125 yen, just divide any price stated in yen by 125 to figure the dollar price. Tourists and international traders quickly master such mental gymnastics and become indifferent about which currency is used to state nominal prices.
Opportunity costs as measured by relative prices shape most decisions—how many hot fudge sundaes must be sacrificed for a new CD? For a ski vacation? Answers to such questions entail comparisons of monetary prices.
Relative prices are the prices of goods or resources in terms of each other, and are computed by dividing their absolute prices by one another.
Rational decisionmaking relies on relative prices, which summarize information about sacrificed alternatives. If hot fudge sundaes are $4 while CDs are $16 and ski vacations are $640, then a CD costs 4 sundaes and skiing costs 160 sundaes or 40 CDs. (16/4= 4; 640/4= 160; 640/16= 40).
Monetary (absolute) prices bear little on rational decisions until, perhaps unconsciously, we convert them to relative prices. Relative prices are unaffected if all absolute prices change on a one-time, proportional basis. Try this mental experiment: How would you react if your income, assets, liabilities, and all prices for goods and resources doubled, once and for all time? Answer: You would handle twice as many dollars, but otherwise your behavior would not change.
Conclusion: Relative prices guide decisions; changes in absolute prices ultimately affect most decisions only to the extent that relative prices are distorted. Changes in absolute prices can, however, pose problems during inflation, which is harmful primarily because it increases uncertainty and distorts relative prices—some absolute prices zoom up in an inflationary period, while others are somewhat “sticky.” Thus, inflation garbles the quality of information about relative scarcity.
Prices as Information
Relative prices compress immense amounts of information about buyers' desires and sellers' costs. For example, farmers aware that grapes consistently sell for $2 per pound while limes sell for $1 per pound also know (perhaps unconsciously) that consumers value more grapes roughly twice as much as they want more limes. And consumers know that extra grapes cost roughly twice as much as additional limes to produce.
Information embedded in relative prices spurs action. A tour of a shopping mall can provide thousands of prices to guide your purchases. Low-paying job openings are passed over when a skilled job seeker scans the want ads, while more attractive wage offers are circled for follow-up. And entrepreneurs are steered by expected prices and costs into the product lines where they perceive the greatest profit opportunities.
Prices as Incentives
Relative prices signal opportunities for pleasure and prospects of pain. Most people seek pleasure and avoid pain, but life is a series of trade-offs. Renting a trashy B-movie on DVD, for example, absorbs funds you could use to rent a culturally-rich foreign film hailed by all the critics. A child's dawdling on family chores may be overcome by either a reward (an allowance) or a punishment (no TV tonight). Grades can be thought of as prices. Prospects of an A may induce you to forgo a game of pool for 2 hours of study, while only fear of failing drives your roommate to study.
Sellers view relatively high prices for goods (relative to their production costs) as incentives that stimulate production, while low prices are disincentives that push resources into alternative types of production. High wage rates, for example, reward work, but an offer of only a low wage may cause a worker to opt for little work and much leisure.
Prices as Rationing Devices
Especially scarce goods will ideally be reserved for their more important possible uses and, where feasible, people will tend to rely more heavily on abundant goods and resources. For example, daubing black shoe polish on a pair of pumps with designer silk scarves would be wasteful; using cotton rags instead seems to make sense. Relatively higher prices for goods or resources signal greater relative scarcity and discourage lower-valued uses of goods. Thus, prices act as rationing devices. Buyers are pressured to use lower-priced goods more and higher-priced goods less.
The information conveyed by relative prices and their incentive and rationing effects are central to understanding supply and demand (Chapters 3 and 4), and explain why private transactions are often called the price system. Societies everywhere increasingly rely on the price system. A major virtue of the price system is that it helps allocate goods and resources into economically efficient patterns.