Price index Totally Explained

Everything about Price Index totally explained

A price index (plural: “price indices” or “price indexes”) is a statistic designed to help to compare how the prices of some class of goods and/or services, taken as a whole, differ between time periods or geographical locations. Comparing price indices across time makes it possible to calculate the inflation rate. Comparing price indices across geographical regions makes it possible to calculate purchasing power parity measures. The class of goods covered by a price index can be quite broad: in a consumer price index, for instance, the class of goods is roughly “things bought by a typical urban consumer”. As an example of a narrower index, the United States Bureau of Labor Statistics has a price index for “steel mill products”. Sometimes an index will be very specific, as in the US Energy Information Administration index entitled “Gasoline — All Grades”.
   By design, a price index reduces all the distinct prices for the class of goods in question to a single number. On one hand, doing this has the potential to cut through the noise and make it easier to see the big picture; on the other hand, it has the risk of hiding potentially important details: a price index can potentially increase even though a sizeable minority of the prices are actually decreasing. The usefulness of a price index may therefore depend on both the nature of the particular dataset and the intended use of the index.
   Price indices have several potential uses. For particularly broad indices, the index can be said to measure the economy's price level and the extent to which there's inflation. This information is useful to central banks as they plan out monetary policy. A broad index can also be used to estimate changes in the cost of living. This can be useful in contract negotiation: one party may be more willing to accept a certain salary if it's scheduled to increase automatically as costs go up. Price indices can also be used to help to measure other economic statistics such as Gross Domestic Product.
   More narrow price indices can help producers with business plans and pricing. Sometimes, they can be useful in helping to guide investment.
   Some notable price indices include:

Introductory treatment

Unweighted price average

Perhaps the simplest way to get a general sense of the price of a class of goods would be to take the (arithmetic) average of the price of each good. For example, let's say the class of goods under consideration is apples. Here are some Seattle-area apple prices from Aug 18, 2007:

Granny Smith: $0.72 each

Red Delicious: $0.75 each

Fuji: $0.50 each

Gala (large): $0.75 each

Breaburn

: $0.90 each Then one measure of the general price apples, taken as a whole, is ť

frac

P(M)_t

is used as the price relative.
   The "link-to-show-no-change" assumes the opposite of the direct comparison method; it assumes that the entire difference between the two items is do to the change in quality. The price relative based on link-to-show-no-change is 1.
   The "deletion method" simply leaves the price relative for the changing item out of the price index. This is equivalent to using the average of other price relatives in the index as the price relative for the changing item. Similarly, "class mean" imputation uses the average price relative for items with similar characteristics (physical, geographic, economic, etc.)to M and N.

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