In really really simple terms, inflation means rising prices.

One very good example would be the price of McDonald’s vanilla ice-cream cone. If you were big enough to remember, a few years back, 1 cone used to cost only 50 cents. Then over time, it rose to 80 cents per cone. Now, it’s $1 per cone.

This whole ongoing process is called inflation.

But why do prices increase?

There are 2 reasons why prices increase.

1. There is too much money chasing after too few goods.
2. It gets more expensive to make those goods.

It gets more expensive to make those goods

First, we need to understand that firms are in business to make money.

How do they make money?

Let’s imagine you are in the business of selling slime. After some calculations, you realise that one container of slime costs you 50 cents to produce. But you want to make a bit of money so you decide to sell each container of slime for 60 cents. So your profit is 10 cents.

Cost = 50 cents
Revenue = 60 cents
Profit = Revenue – Cost = 60 – 50 = 10 cents

New Formula

Profit = Revenue – Cost

Now let’s say the price of glue increased and your new cost of making slime is now 60 cents (because you need glue to make slime). If you are still selling your slime at 60 cents per container. You will not be making profit at all.

Profit = Revenue – Cost = 60 – 60 = 0

So in order to make some money, you have decided to increase the price of your slime to 70 cents.

This is how prices increase due to the rise in cost.

There is too much money chasing after too few goods

Let’s say you now only have 5 containers of slime left and that you won’t be making them again for another year. But at the same time there are 20 people interested in buying your slime.

Before we proceed to solve the ‘problem’, you must understand that when firms are in the business, they are in business to make money.

Thus, if you are suggesting selling slime on a first-come first-served basis, it is not profit-maximizing. Meaning, you can’t get the most profit by doing this.

However, if you decide to increase the price of your slime from 50 cents to 70 cents, maybe 8 people would have pulled out and not want to buy your slime anymore. Now you have 20 – 8 = 12 people still interested in buying your slime.

That’s still more people than the number of slime you have.

So you decide to increase your price again until there is exactly the same number of buyers and slime. That way, you make more profit.

This is how prices increase when there is too much money chasing after too few goods.

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New Vocabulary

Goods, in economics terms, means products or items.

Firms = companies

Revenue = the amount of money you receive from making a sale

Cost = the amount of money you need to produce/make something

Profit = the amount of money you make from selling something