What Is a Price Index?
A price index shows the average price of a group of goods or services in a certain area during a specified period of time. A price index provides information on price movements over time and variations in prices in different locations. These indexes can help people measure the economy and industries and plan investments.
An economist who wants to calculate this index first chooses a base year, then chooses the group of goods and services whose price movements he or she wants to track. The economist has to gather the prices of these goods and services in the base year and at the present. He or she then calculates a ratio of the prices at the present to the prices in the base year. The simple formula is as follows: (Current prices / Base year prices) X 100. A price index value of above 100 shows an upward movement on prices, while a value of below 100 indicates a downward movement.
For example, consider an economist who only wants to find the price movements of shirts, pants and bread from 2009 to 2010. During the considered period, the price of each shirt has risen from $20 US dollars (USD) to $25 USD, the price of each pair of pants has risen from $10 USD to $12 USD and the price of each loaf of bread has risen from $0.50 to $0.55. If the economist wants the group of goods to consist of 10 shirts, five pairs of pants and 100 loaves of bread, the price of the group of goods is $250 USD — ((10 X $10 USD) + (5 X $20 USD) + (100 X $0.50 USD)) in 2009 and $300 ((10 X $12 USD) + (5 X $25 USD) + (100 X $0.55 USD)) in 2010. The price index can be calculated as follows: ($300 USD / $250 USD) X 100 = 120. The index therefore shows the overall upward movement in prices of goods under consideration.
In reality, teh index often represents a basket of hundreds of goods and services to create a comprehensive depiction of an economy or an industry. There are several types of common price indexes, encompassing an industry or a whole economy. Consumer price index (CPI) covers the retail prices of a large group of goods and services, including food, housing, clothing and transportation, to quantify the cost of living in a particular geographical area. Economists also use the CPI to calculate inflation. Producer price index or wholesale price index measures the prices manufacturers charge for their products, while home price index shows the movements in residential property prices.
@Charred - That’s a question open for considerable debate, but I do agree that fuel impacts consumer prices. In that case you would also have to look at the commodity price index (oil is, after all, a commodity) to see where commodities are heading.
I don’t think we’ll ever see low gas prices again, even if they drop somewhat, so unfortunately the consumer price index will keep its upward trend in my opinion.
@miriam98 - You have to look at factors other than inflation which explain the rise in consumer products. You have to consider other factors which influence prices, like transportation costs.
If gasoline prices rise, it becomes more expensive to transport groceries to the local stores and so the food becomes more expensive to account for the added fuel costs.
Does it really matter which grocery store it is? No, because transportation costs are rising all across the board. Consequently if gas prices drop (hopefully a lot) then maybe your basket of goods will drop as well. The question is do we control gas prices or are we at the whim of greedy market speculators?
@allenJo - It doesn’t matter. They probably take an average of prices across a variety of retail outlets. But even if they used the discount stores for their baseline, the effect would still be the same.
If prices are rising, then prices are rising – whether you buy from Wal-Mart or Sears or wherever. The trend will be the same.
The consumer price index is therefore a very good benchmark of where we’re at in terms of inflation. If you’ve ever looked at a consumer price index chart, you cannot escape the conclusions that stuff is getting more expensive all the time.
It’s a trend that we have to live with, and hopefully your employer’s raise will at least account for that inflationary increase.
I understand the principle of the retail price index, but where does the economist get his information on his basket of goods?
Prices for shirts, bread and other consumer items can vary depending on where you buy them. If you shop at Wal-Mart you may pay less than if you shop at Sears. Don’t you think it would make a difference on what you’re using for your benchmark in your calculations?
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