Calculating a Laspeyres Price Index FE312 Fall 2007

2005 2006 2007

Quantity of Burgers 100 120 125

Price of Burgers($) 2.00 3.00 4.00

Quantity of Milkshakes 50 75 25

Price of Milkshakes($) 1.00 1.50 3.00

Calculating a Laspeyres Index

A Laspeyres Index is known as a base-weighted or xed-weighted index because the price increases are weighted by the quantities in the base period. The Consumer Price Index is an example of a Laspeyres Index. In this example, 2005 will serve as the base year. Formally, the calculation is written, Pn j =1 pjt qj 0 Lt = Pn j =1 pj 0 qj 0 where the subscript j 0 refers to the base year value for good j , and t, refers to the current year. Below shows how to calcualte the Laspeyres index in practice.

Calculate the Base Year value of the Index:

Lbase
year

Notice that when calculating the index value for the base year, the value will simply equal 1. In practice, you dont need to go through the calculationits shown here for the sake of being thorough. Lbase
year

{Qburgers (2005) Pburgers (2005)} + {Qmilkshakes (2005) Pmilkshakes (2005)} {Qburgers (2005) Pburgers (2005)} + {Qmilkshakes (2005) Pmilkshakes (2005)}

{100 2.00} + {50 1.00} 250 = {100 2.00} + {50 1.00} 250 Lbase
year

=1

Then, typically, the value is multiplied by 100. So the base year value of the index will always be equal to 100. Index V aluebase
year

= 1 100 = 100

Calculate the Index value for 2006:

L2006 = {Qburgers (2005) Pburgers (2006)} + {Qmilkshakes (2005) Pmilkshakes (2006)} {Qburgers (2005) Pburgers (2005)} + {Qmilkshakes (2005) Pmilkshakes (2005)}

Notice in the formula, now the prices for 2006 have been substituted into the numerator. The quantities are xed (we assume they never change) in the base year. L2006 = {100 3.00} + {50 1.50} {100 2.00} + {50 1.00} 300 + 75 375 = 200 + 50 250

L2006 =

L2006 = 1.5 Index V alue2006 = 1.5 100 = 150

Calculate the Index value for 2007:

L2007 = {Qburgers (2005) Pburgers (2007)} + {Qmilkshakes (2005) Pmilkshakes (2007)} {Qburgers (2005) Pburgers (2005)} + {Qmilkshakes (2005) Pmilkshakes (2005)}

Do the same for 2007, now the prices for 2007 have been substituted into the numerator. The quantities are still xed in 2005. L2007 = {100 4.00} + {50 3.00} {100 2.00} + {50 1.00} 400 + 150 550 = 200 + 50 250

L2007 =

L2007 = 2.2 Index V alue2007 = 2.2 100 = 220

Using the Index to calculate the rate of Ination

To calculate the rate of ination between any two years, simply calculate the percentage change between the index values: Inf lation Rate20052006 = Inf lation Rate20062007 = 2005 2006 2007 150 100 = .5 100 = 50% 100 220 150 = .47 100 = 47% 150 Ination Rate 50% 47%

Laspeyres Index Value 100 150 220

Ination is dened as an increase in the price level. When the price level increases from one year to the next, this is Ination. Notice that according to the table ination slowed a bit between 2006 and 2007. When the rate of ination has decreased, this is known as Disination. The price level has increased, so the rate of ination is still positive. However, the price level has increased at a slower rate than the previous year. So disination has occured between 2006 and 2007. If the ination rate is actually negative, then Deation has occured. If the index value fell to 190 in 2008, for example (if we added that year to the table), then the ination rate between 2007 and 2008 would be negative and that would be a deation.

Study Questions
1. Explain why a Laspeyres index overstates the increase in the price level. Explain by describing the sources of bias inherent in the Laspeyres calculation (there are at least four).

2. Why is the bias in the Consumer Price Index, which is a Laspeyres index, a policy concern?

3. Why is the GDP deator a more comprehensive measure of price changes than the CPI? What is the advantage to using the CPI to judge the increase in the price level over the GDP deator?