Relative, Not Absolute, Price Matters

It is helpful to suspend talking about absolute price in terms of dollars and cents. Absolute price is defined as “the number of dollars that can be exchanged for a specified quantity of a given good.” Instead, economists deal with relative price, defined as “the quantity of some other good that can be exchanged for a specified quantity of a given good” (Landsburg 1996: 34). This is an important distinction because in the final analysis, we live in a barter economy.

The reason economists discuss relative, as opposed to nominal, prices can be illustrated by the example of married couples with young children deciding on a night on the town, versus the same decision made by couples without children. Suppose an expensive date, including dinner and a concert, is $150, whereas a cheap date is dinner and a movie, costing $75. Each couple faces the same two options. The childless couple would have to sacrifice the enjoyment of two movies and two dinners for one expensive date ($150/$75). The married couple, because they must hire a babysitter for, say, $50, no matter which date they decide on, will most likely choose the more expensive date. Why? Because the relative price is only 1.6 cheap dates ($150+$50/$75+$50), compared to two for the childless couple. Therefore, we would expect to see married couples on more expensive nights on the town. To illustrate, a letter to the editor of BusinessWeek said that Hollywood should price new movies at $30 for home viewing, because he compares it to $75 for a night out at the movies (babysitter, popcorn, tickets). Not a bad idea and an interesting opportunity for Hollywood, one that is certainly consistent with the concept of relative, not absolute, price.

In a purely rational sense, a price difference of $400 between two products is the same no matter what the total product price is. However, that same $400 is perceived to be a much larger difference for a $1,000 purchase that it is for a $20,000 purchase. In one study, 68 percent of the respondents said they were willing to drive to another store to save $5 on a calculator selling for $15; but if the same calculator cost $125, only 29 percent of the respondents were willing to do so (Nagle and Holden 1995: 300). The tendency of buyers to engage in this type of calculation is known as the Weber-Fechner Law, which states that buyers perceive price differences in proportional terms, not absolute terms. This refers to the percentage change in price, and not to the absolute level, and indicates that there is an upper and lower threshold of price in the mind of each customer. If the price falls outside of that band, customers ignore the offering. This is precisely why your firm can be a price searcher, rather than a passive price taker.

Another facet of the distinction between absolute and relative price is another deleterious effect of hourly billing. If a firm quotes $300 per hour as their standard rate, yet the people paying the bill are earning, say, $50 per hour, the comparison is the wrong anchor to put in the customers mind. Better to quote a fixed price, focusing the customer on the nominal price, rather than making them think in relative terms.

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