Question

Assume that you live in a simple economy in which only three goods are produced and traded:

fish, fruit, and meat. Suppose that on January 1, 2010, fish sold for $3.50 per pound, meat was

$4.00 per pound, and fruit was $2.50 per pound. At the end of the year, you discover that the

catch was low and that fish prices had increased to $5.00 per pound, but fruit prices stayed at

$2.50 and meat prices had actually fallen to $2.00. Can you say what happened to the overall

"price level"? How might you construct a measure of the "change in the price level”? What

additional information might you need to construct your measure?

Answer 1

The information can be summarized as table 1:

Period 1	Price per pound	Quantity
Fish	3.50	Q1
Fruit	4	Q2
Meat	2.50	Q3

.. and table 2

Period 2	Price per pound	Quantity
Fish	5	Q4
Fruit	2.50	Q5
Meat	2	Q6

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Can you say what happened to the overall "price level"?

It is not clear what has happened to the price level, as some prices have increased and some have decreased.

If it is assumed that the quantity bought of each good is the same, then the overall prices have decreased.

However, if people bought more fish, the price level has increased. If people bought more fruits, the price level has decreased.

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How might you construct a measure of the "change in the price level”?

The procedure to construct a price index has to be followed:

• Define a basket for the typical consumer: how many pounds of each good are purchased?
• Fix this quantity at the base year, and allow for prices to change every year.
• Value of basket every year = summation of [P x Q] for each good
• Fix the base year basket value as 100
• Calculate what happens to the value of the basket every year, to find out the inflation rate.

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What additional information might you need to construct your measure?

The information on "quantity purchased by the typical consumer" is missing.

That will decide the relative weights of the goods. The price index gets affected by goods that are consumed more.