<p>Price level is the general level of prices in an economy. It is a variable that indicates what is the purchasing power of money (see Blanchard et al. Macroeconomics: a European Perspective). You can think of it as a variable that tells you what average prices are compared to some baseline.  Price level is often measured using the <a href="https://www.investopedia.com/terms/c/consumerpriceindex.asp" rel="noreferrer">consumer price index (CPI)</a>.</p>
<p>As your textbook correctly stated economic agents primarily care about real profits, wages etc. The reasoning behind this is that what matters is not what is the number of zeros on your paycheck but what you can buy with it. For example, suppose that you are offered a job that pays <span class="math-container">${\\\$}1,000,000$</span> salary per month. Is that salary high or low? Well if the average price level <span class="math-container">$(P)$</span> is so high, due to inflation, that even apple or postage stamp cost <span class="math-container">${\\\$}1,000,000,000$</span> you would probably not be willing to work for that one million per month, because it would not be enough to even buy you one apple. However, if price level would be such that stamps and apples cost only <span class="math-container">${\\\$1}$</span> that kind of salary would be great because you can purchase whole host of apples with it.</p>
<p>What really matters for decisions is how much goods and services you can buy with profit an wage you get. Consequently, in economics we often divide nominal variables by price levels in order to adjust them for any effects of inflation.</p>

CC BY-SA 4.0
2020-10-25T12:02:42.400Z
2020-10-25T12:02:42.400Z
1muflon1
<p>You should interpret <span class="math-container">$P$</span> as being the price of some bundle of goods people want to consume. Then if we have some monetary amount (in dollars, euro's or some other monetary unit of account), let's call it <span class="math-container">$M$</span>, what does <span class="math-container">$M/P$</span> mean? Note that: <span class="math-container">$P \times (M/P)=M$</span> so <span class="math-container">$M/P$</span> is the number of consumption bundles with price <span class="math-container">$P$</span> you can buy with your <span class="math-container">$M$</span> units of currency. This is why <span class="math-container">$M/P$</span> is a 'real' amount: it tells you how much your monetary wealth really buys.</p>

CC BY-SA 4.0
2020-10-25T12:08:00.530Z
2020-10-25T18:41:09.073Z
2020-10-25T18:41:09.073Z
user18214
<p>I've just started to learn macroeconomics and I think even the teachers can't get what's the price level and why we divide by it in order to find for example real economic profits.
Textbook says &quot;What firms and households care about are profits in terms of what they can
buy, that is, real economic profits. We divide the preceding expression by the price level,
P, to get real economic profits     <span class="math-container">$$Π= F(K,L) - (R/P)K - (W/P)L$$</span></p>
<p>I just cant understand the part of dividing by P, everything else is clear.
Thank you.</p>

<macroeconomics><wages><price-level><profits><capital>
What's the logic behind dividing rental price of capital and wage rate by price level?
Ali Rahimli
# What's the logic behind dividing rental price of capital and wage rate by price level?

(Asked by: username_0 on 2020-10-25)

I've just started to learn macroeconomics and I think even the teachers can't get what's the price level and why we divide by it in order to find for example real economic profits.
Textbook says "What firms and households care about are profits in terms of what they can
buy, that is, real economic profits. We divide the preceding expression by the price level,
P, to get real economic profits $$Π= F(K,L) - (R/P)K - (W/P)L$$

I just cant understand the part of dividing by P, everything else is clear.
Thank you.

**Tags:** macroeconomics, wages, price-level, profits, capital

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## 2 answers

### Answer by username_1 on 2020-10-25. Score: 6

Price level is the general level of prices in an economy. It is a variable that indicates what is the purchasing power of money (see Blanchard et al. Macroeconomics: a European Perspective). You can think of it as a variable that tells you what average prices are compared to some baseline. Price level is often measured using the [consumer price index (CPI)](https://www.investopedia.com/terms/c/consumerpriceindex.asp).

As your textbook correctly stated economic agents primarily care about real profits, wages etc. The reasoning behind this is that what matters is not what is the number of zeros on your paycheck but what you can buy with it. For example, suppose that you are offered a job that pays ${\\\$}1,000,000$ salary per month. Is that salary high or low? Well if the average price level $(P)$ is so high, due to inflation, that even apple or postage stamp cost ${\\\$}1,000,000,000$ you would probably not be willing to work for that one million per month, because it would not be enough to even buy you one apple. However, if price level would be such that stamps and apples cost only ${\\\$1}$ that kind of salary would be great because you can purchase whole host of apples with it.

What really matters for decisions is how much goods and services you can buy with profit an wage you get. Consequently, in economics we often divide nominal variables by price levels in order to adjust them for any effects of inflation.


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### Answer by username_2 on 2020-10-25. Score: 3

You should interpret $P$ as being the price of some bundle of goods people want to consume. Then if we have some monetary amount (in dollars, euro's or some other monetary unit of account), let's call it $M$, what does $M/P$ mean? Note that: $P \times (M/P)=M$ so $M/P$ is the number of consumption bundles with price $P$ you can buy with your $M$ units of currency. This is why $M/P$ is a 'real' amount: it tells you how much your monetary wealth really buys.


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