Question

1. You are the head of a research team, and you are training your team members on the index number technique. Your task is to explain to your team members that when measuring an overall price increase (e.g., inflation), the Laspeyres index likely overestimates while the Paasche index likely underestimates it.

Answer 1

The Laspeyres Price Index is a price index used to measure the economy’s general price level and cost of living, and to calculate inflation. The index commonly uses a base year figure of 100, with periods of higher price levels shown by an index greater than 100 and periods of lower price levels by indexes lower than 100.

A key differentiator between the Laspeyres Price Index and Paasche Price Index is that it uses weights taken from a base period.

The Paasche price index is an index formula used in price statistics for measuring the price development of the basket of goods and services that is consumed in the current period. The question it answers is how much a basket that consumers buy in the current period would have cost in the base period.

The diagrama are simply a combination of the two we saw individually. They help us, however see the differences between both indices. The main downside to these indices is the fact that they do not take into effect substitution effects. When the price of something rises, we tend to consume less of it. Because the Laspeyres index uses base period quantities, it tends to overestimate inflation by assuming that individuals’ income expense is still distributed in the same way. The opposite is true of the Paasche index: because it uses current period quantities, it underestimates inflation.