Calculating a Laspeyres Price Index

FE312 Fall 2007

Quantity of Burgers Price of Burgers($) Quantity of Milkshakes Price of Milkshakes($)
2005 100 2.00 50 1.00
2006 120 3.00 75 1.50
2007 125 4.00 25 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,
L
t
=
P
n
j=1
p
jt
q
j0
P
n
j=1
p
j0
q
j0
where the subscript j0 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:
L
base year
=
{Q
burgers
(2005) P
burgers
(2005)} + {Q
milkshakes
(2005) P
milkshakes
(2005)}
{Q
burgers
(2005) P
burgers
(2005)} + {Q
milkshakes
(2005) P
milkshakes
(2005)}
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.
L
base year
=
{100 2.00} + {50 1.00}
{100 2.00} + {50 1.00}
=
250
250
L
base 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 alue
base year
= 1 100 = 100
Calculate the Index value for 2006:
L
2006
=
{Q
burgers
(2005) P
burgers
(2006)} + {Q
milkshakes
(2005) P
milkshakes
(2006)}
{Q
burgers
(2005) P
burgers
(2005)} + {Q
milkshakes
(2005) P
milkshakes
(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.
L
2006
=
{100 3.00} + {50 1.50}
{100 2.00} + {50 1.00}
L
2006
=
300 + 75
200 + 50
=
375
250
L
2006
= 1.5
Index V alue
2006
= 1.5 100 = 150
1
Calculate the Index value for 2007:
L
2007
=
{Q
burgers
(2005) P
burgers
(2007)} + {Q
milkshakes
(2005) P
milkshakes
(2007)}
{Q
burgers
(2005) P
burgers
(2005)} + {Q
milkshakes
(2005) P
milkshakes
(2005)}
Do the same for 2007, now the prices for 2007 have been substituted into the numerator. The quantities
are still xed in 2005.
L
2007
=
{100 4.00} + {50 3.00}
{100 2.00} + {50 1.00}
L
2007
=
400 + 150
200 + 50
=
550
250
L
2007
= 2.2
Index V alue
2007
= 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:
Inflation Rate
20052006
=
150 100
100
= .5 100 = 50%
Inflation Rate
20062007
=
220 150
150
= .47 100 = 47%
Laspeyres Index Value Ination Rate
2005 100
2006 150 50%
2007 220 47%
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?
2