## What is Price Index Analysis?

A price index is used to measure inflation in most countries and is focused on a collection of products and services significant to a particular economic segment. It is a measure of changing prices over some time. The price index is a scale or a valuable device to measure changes in price levels. The economists randomly choose a certain year as the base year to convert the amount spent on a basket into a price index.

## The Basket of Goods

A basket of goods is a predetermined set of consumer goods and services, the price of which is regularly evaluated. This evaluation happens each month or often annually. Economists use the basket to track inflation in a particular country or market. Therefore, if the price of the basket increases by 5% in a year, then inflation stands at 5% too. The basket goods are indicative of the expansive economy and are adjusted from time to time to account for the evolving consumer habits.

The market basket comprises the things that are bought by an individual or an organization. Once a basket of goods is made, the prices of the things are identified and a weighted average of the prices is created. When individuals pay a large part of their income for a particular thing, any change in the price of this item will matter more than things that are bought with a smaller amount of the income. For example, a price hike of 10% in the rental rates will matter to the consumer more than a 10% hike in tomato prices. While calculating the price level, a weighted average of the price of things in the basket is worked out. The weights refer to the actual quantity of products or services bought by the individuals. A basket of goods is used to calculate the consumer price index.

## What is Consumer Price Index (CPI)?

CPI is a measure to evaluate the weighted average of prices of services and consumer goods in a basket, like, food, healthcare, and transportation. To calculate it, a change in the price of each item from the fixed basket of goods is taken and averaged out. It assesses changes in prices related to the cost of living. It is a frequently used statistic to identify inflation or deflation periods.

Understanding Consumer Price Index (CPI)

CPI endeavors to quantify the economy’s aggregate price level to measure a country’s purchasing power in terms of its unit of currency. The weighted average of an individual’s consumption pattern in terms of prices of goods and services chosen helps calculate it. A trimmed mean is often used as a part of the calculations. The trimmed mean is a method of averaging that is used to report economic data more realistically.

Bureau of Labor Statistics (BLS)

The U.S. Bureau of Labor Statistics (BLS) collects and disseminates data on the U.S. labor market and economy. BLS is an American federal agency and has calculated it as far back as the year 1913. BLS does a monthly reporting of the CPI and bases it on an index average from the period 1982-84.

## Who and What does CPI Cover?

The CPI statistics cover data for self-employed, professionals, unemployed, retired, and poor people in the country. People from rural settlements, non-metro, farms, armed forces, and inmates from mental institutions and prisons are not included in the report. The reports the monthly cost for a country’s basket of goods. These goods & services are divided into eight categories- Housing, apparel, education & communication, transportation, other goods & services, medical care, recreation, and food & beverages.

Comparison of PPI and CPI

PPI stands for producer price index while CPI stands for consumer price index. Though both indices calculate the change in prices of products and services, they are different in two ways. PPI is a very broad index. It not only includes goods & services purchased by the producers but also goods & services purchased by consumers from retailers and producers. CPI on the other hand only includes goods & services bought by the urban residents from the U.S. for their consumption. The CPI incorporates imports while the PPI doesn’t. The second difference being, sales, and taxes are not included in PPI for the producer’s returns. While CPI includes taxes and sales as these directly affect the consumers as they end up paying more for their purchases.

These differences are because the indices are meant to demonstrate separate aspects of economic activity. PPI adjusts inflated revenue sources to measure real growth and CPI adjusts revenue & expense sources to measure the changes in the cost of living.

Calculating CPI

The BLS calls and visits retail stores and service establishments like airlines, doctor’s clinics, cable providers among others to record around 80,000 articles per month from across the country. To calculate for a single article -

CPI = Cost of the market basket in a given year divided by the cost of the market basket in base year X 100

Note: BLS determines the base year.

Example

The basket of goods comprises of shoes, bags, and a pack of crisps. The prices and quantities for 2018 and 2015 (taken as the base year) are as follows –

Market Basket Values for 2015 and 2018 –

Market Basket for 2015 = (10 X \$10) + (5 X \$15) + (100 X \$0.50) = \$225

Market Basket for 2018 = (10 x \$15) + (5 X \$20) + (100 X \$0.75) = \$325

To calculate Price Index -

Price Index for 2018 = market basket 2018 divided by market basted 2015 X 100

Therefore,

Price Index for 2018 = 325/225 X 100 = 144.4

Please note, to calculate the price index for the base year, the market basket of 2015 will be divided by itself and so will always give a value of 100

Price Index for 2015 = 225/225 X 100 = 100

## Summarizing for Price Index Analysis

Personal Consumption Expenditure (PCE) – Released by the Bureau of Economic Analysis (BEA), personal consumption expenditures (PCEs) are the household expenditures incurred for some time. The U.S. Federal Reserve uses the PCE price index as the primary inflation index to make a monetary policy decision. It can be compared to CPI as they both focus on consumer prices. The economists use different measures of inflation like PPI and GDP Price Index.

GDP Price Index – The gross domestic product price index is a measure for price changes of goods & services produced in the U.S. This also includes the goods exported to other countries, purchases made by foreigners; however, the import prices are excluded. Both CPI and GDP price indices measure the U.S. economy's inflation.

Paasche Price Index – Developed by Hermann Paasche, a German economist, this is a CPI used as a measure of the price and quantity change of a basket of goods. The measurements are based on the base year price and the quantity of the observation year.

Laspeyres Price Index – Also called the base year quantity weighted method, this CPI was developed by Etienne Laspeyres, another German economist. The CPI measures the price change of a basket of goods based on a specified base period weighting.

## Common Mistake

Students sometimes get confused between the Laspeyres Price Index and Paasche Price Index. The difference between these indices is the fact that the Paasche index uses current period quantity weightings while the Laspeyres index uses the base period quantity weightings.

## Context and Applications

This topic is significant in the professional exams for both graduate and undergraduate courses –

• BA Economics
• BA Economics Honors
• MA Economics
• Master of Finance
• Master of Business Analytics

Related Courses

• Accountancy
• Human Resources
• Economics of Money and Banking
• Strategic Business Management

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