Unit 1
Unit 2
The Australian Economic System
Relative Prices
Although we have been looking at markets as if they are all independent, the truth is that they are all interconnected. Activity in one market will have consequences that ripple through the rest of the economy.
At a simple level, consider what might happen in the market for apples based on relative prices. There are many different varieties of apples, but we will imagine that there are only two – Fuji apples and Granny Smith apples. Most of the time the prices of these two products will be similar. Now imagine that something unexpected happens in the market for Granny Smith apples, and the price increases significantly. What would happen as a result?
The answer is that some people would choose to stop buying Granny Smith apples because of the increase in price. Some of these people might decide that they will buy Fuji apples instead, because this product will satisfy the same need or want (ie it is a substitute product). In this way they will increase the demand for Fuji apples. As you have already seen, an increase in demand will result in an increase in price. Via this mechanism, we can expect to see the price for these two products to end up being relatively close to each other once again. This is why similar products like apples or newspapers usually end up with very similar prices.
But the impact of a change in the price of Granny Smith apples will move well beyond this one market. For example, some people might decide not to buy apples at all because of the increase in price. If they shift their spending to pears or bananas, then it is likely that demand for these items will increase as well. Once again, the price of substitute items is likely to increase. On the other hand, many people use Granny Smith apples to make apple pies. When the price increases, they will not make as many pies, and so the demand for puff pastry, sugar and other products that they would need to make the pie will also fall. A change in the price of just one item can affect the demand for products all over the supermarket!
It doesn’t take much to see that this can quickly spread beyond the walls of the supermarket. People who own shares in companies that make products that can be substituted for Granny Smith apples might find that their companies are now able to make higher profits. An increase in profits will mean that the dividend payable is likely to increase, which should result in an increase in demand for the shares. At this time, we can conclude that people with these shares will see an increase in their wealth. They might choose to sell their shares and buy something else, or perhaps borrow against their new found wealth and put an extension on their home.
At this stage it might be tempting for you to start exploring the relationship between markets all over the country. This can be done, but it is dangerous to take this process too far. While the relationships certainly exist, even a small change in price can act as a signal to market participants. In this case, when the price of Granny Smith apples increased it is very likely that the sellers will quickly notice any drop off in demand. To overcome this problem they might choose to increase production (ie increase supply), sell lower quality products, or just lower the price and absorb the change in profit margin. If this happens quickly enough, the market will return to equilibrium.
In the Australian economy, market participants are able to act independently to try and increase their own standard of living. As this process is happening every day, we tend to see that relative prices are finely balanced in a way that “works”. Sudden swings in prices are rare, and when they do occur they are often due to short term factors. For example, after a cyclone hit the banana growing areas of Queensland the price increased ten-fold. However, once the crops had been re-established prices returned to normal.
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