A general price index is an economic measurement that assesses the change in prices for goods and services. This index often measures the inflation in a market that artificially increases prices for goods and services at both the wholesale and consumer level. Common price indexes include the price deflator, consumer price, and wholesale price index. Examples of formulas used to compute a general price index include Laspeyres, Paasche, and the Fisher Ideal. Each of these methods tells a different story in terms of price changes in a market in regards to a single item.
The Laspeyres Price Index compares a single item’s price currently to a base period. The question to answer here is the sales price today compared to a product with similar quality in an identified base year. The base year represents 100 percent, with current values ranging above or below. Below the base year indicates decreasing prices, while values over 100 percent tend to indicate increasing prices. This can either occur from deflation or inflation, respectively; it is possible to overstate the effects of inflation with this general price index, however.
A Paasche price index measurement compares the current price for a product today to the same product in the base year. In most cases, the base year for this index can be the same as the one for the Laspeyres Price Index. While this index does provide some useful information, it may not be among the most published in an economy. The biggest drawback here is that consumer preferences typically change over time. Therefore, comparing the general price index today to that of the base year distorts the fact that the same product may not have been as valuable in the base year.
Computing the Fisher Ideal index attempts to remove any bias from the previous two formulas. It compares the price index for a product today in constant dollars. The formula naturally removes inflation from the equation and therefore eliminates any overstatement of this figure. Unfortunately, the Fisher Ideal index also prevents individuals from measuring the price change in a good or service. Another problem in the formula is how complex it is to remove the effects of the previous two measurements in terms of a general price index.
Economists can use any variety of general price indices to assess the health of an economy. The purpose is to measure the strength of an overall economy and various industries within. Monthly or quarterly computations are common, so individuals can determine a trend of rising or decreasing prices.