Basic of Price Index

In this article we are going to create a price index of an economy in which we will consider only 3 commodities. A ceiling fan, one Kg wheat, and one litre diesel.

In 2010 (2010 is our base year):
Price of fan = 100 rs
Price of 1 kg wheat = 20 rs
Price of 1 litre diesel = 50 rs

Price level (2010 or base year):
100 * 1 unit (Ceiling fan) + 20 * 1 kg (Wheat) + 50 * 1 litre (diesel)

“100*1 + 20*1 + 50*1 /  100*1 + 20*1 + 50*1 = 170/170 = 1.” 

This suggest Price level for base year will always be 1. Or 1-1/100*100 = 0% inflation.

In 2015, price of these commodities:
Fan = 200 rs
Wheat = 40 rs
diesel = 100 rs
Price level (2015) = 200 * 1 (Same quantity) + 40 * 1 kg (Same quantity) + 50 * 1 (Same quantity) = 340.

“200*1 + 40*1 + 100*1 / 100*1 + 20*1 + 50*1 = 340/170 or 2.”

If we get price level = 2, it suggests prices just doubled in 2015 as compared to 2010 or 100% inflation (2-1/100*100 = 100%).

There are various method to make price index, one famous method is Laspeyres, in which quantity at base period is “fixed”. That means, in 2015 you have to consider the same quantity as in 2010. Say, 1 litre diesel, 1 kg wheat, 1 unit ceiling fan.
Another is Paasche index, in which we consider quantity of the current period. For 2015, say 2 fan are used and 3 litre diesel.

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