Index Numbers: Laspeyres, Paasche, and Fisher Price and Quantity

Indexes
In defining an index number, always start with a ratio of sums. Each
component of each sum is a price times a quantity. The number
n
of such
price/quantity products is equal to the number of goods or services included
in the index.

=
=
=
+ + +
+ + +
n
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n
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i i
n n
n n
Q P
Q P
Q P Q P Q P
Q P Q P Q P
1

1


!

1

!

1
...
...
The next step is to insert dates for the "# mar$s.
If you want a %rice Index, ma$e sure only the prices in the numerator and
denominator correspond to different dates. &uantities have the same date'
earlier in both numerator and denominator, for a (aspeyres Index) later, for a
%aasche Index. Therefore'
(aspeyres %rice Index'

=
=
+
n
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n
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Q P
Q P
1
1
1
%aasche %rice Index'

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1
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1 1
If you want a &uantity Index, ma$e sure only the quantities in the numerator
and denominator correspond to different time periods. %rices have the same
date' earlier in both numerator and denominator, for a (aspeyres Index) later,
for a %aasche Index.
(aspeyres &uantity Index'

=
=
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n
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n
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Q P
Q P
1
1
1
%aasche &uantity Index'

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Q P
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1 1
In general, (aspeyres and %aasche %rice Indexes or Inflation *actors will
differ. Their geometric averages are called *isher Indexes +after Irving
*isher,.

Index, %rice sche Index,+%aa %rice +(aspeyres Index %rice *isher =


Index, &uantity sche Index,+%aa &uantity +(aspeyres Index &uantity *isher =
-s a measure of the inflation factor +one plus the inflation rate,, a *isher
%rice Index is the square root of the product of (aspeyres and %aasche %rice
Indexes. -s a measure of the growth factor +one plus the rate of growth,, a
*isher &uantity Index is the square root of the product of (aspeyres and
%aasche &uantity Indexes.

Question' .hy are *isher Indexes useful averages of (aspeyres and
%aasche Indexes
Answer: The advantage of the geometric averages is revealed by
considering the ratio of nominal values where /0 is the rate of change of
nominal 01%'

/0 1
1
1
1 1
+ =

=
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+ +
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Q P
Q P

2ote that both prices and quantities are different, comparing the numerator
and the denominator. If the ratio were !, for example, value has doubled +
3 144 1 ! + =
,. - doubling of nominal value might be the result of price
increases +inflation, or quantity increases +real growth, or some mixture of
inflation and growth. 5ow can the ratio of nominal values be split exactly
into an inflation factor +where

is the inflation rate, times a growth factor

+where
g
is the growth rate,

, 1 ,+ 1 +
1
1
1 1
g
Q P
Q P
n
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n
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+ + =

=
=
+ +

The split will be exact if the *isher %rice Index is used for the inflation
factor and the *isher &uantity Index is used for the growth factor. 6ust do
the substitution to confirm this claim.
7quare 8oot of the %roduct of a *isher %rice Index times a *isher &uantity
Index
9

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+
=
+ +
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+
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+
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+ +
=
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+

n
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Q P
Q P
Q P
Q P
Q P
Q P
Q P
Q P
1
1
1
1 1
1
1
1
1
1
1
1 1
1
1
1
:ring all terms under a single square root sign, cancel sums where possible
and ta$e the square root. The result is ;ust the ratio of nominal values in
ad;acent time periods.
<onclusion' *isher Index 2umbers for the inflation and growth factors are a
mathematically coherent way to average (aspeyres and %aasche Index
numbers because these averages succeed in splitting the change in nominal
value exactly into a change in prices and a change in quantities.
Example (three periods: -ssume there are only two goods in the
calculation of 01%, with prices and quantities as follows. Three periods of
data are available.
In the first period, let each price and quantity be equal to one, so that
nominal 01% is
! , 1 1 + , 1 1 +
!
1
= + =

=
=
n
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Q P
.
-ssume that the price of the first good rises for =43 to 1.= in the second
period, and then a further >>3 in the third period, i.e. from 1 to 1.= to !.4.
2ote that the second change of 4.= if a smaller percentage increase because
the price has already gone up. 7uppose the quantity of the first good
increases to !.4 in the second period +1443 increase,, and then remains at
!.4 in the third period +43 change,.
-ssume that the price of the second good rise from 1 to 1.! +!43 higher,
and then to 1.= +a further !=3, in the second and third periods, respectively)
while the quantity of the second good increase to >.4 +!443 higher, and then
to ? +a further >>3,.

! ! ' >
! = . 1 ' !
1 1 ' 1
' 1 0ood
=
=
=
t
t
t
Q P

? = . 1 ' >
> ! . 1 ' !
1 1 ' 1
' ! 0ood
=
=
=
t
t
t
Q P
.ith these numbers you should be able to verify and complete the following
table of sums. %rices change as you shift right from one column to the next)
quantities change as you shift down from one row to the next. 2ominal
01% in each period is therefore read off along the downward sloping
diagonal'

=
= =
=
= =
=
= =
=
= =
=
= =
=
= =
=
= =
=
= =
=
= =
@ . A
B . B =
= . > A . ! !
!
1
> >
!
1
> !
!
1
> 1
!
1
! >
!
1
! !
!
1
! 1
!
1
1 >
!
1
1 !
!
1
1 1
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Q P Q P Q P
Q P Q P Q P
Q P Q P Q P
The first row holds quantities fixed at their period 1 levels. Therefore,
!.A/!.4 9 1.>= is the (aspeyres price index or inflation factor, using the first
two periods which means that the "first# period is period 1. %rices have
increased by 1.>= C 1 9 >=3 according to this measure.
The second row holds quantities fixed at the period ! levels. Therefore,
B.B/=.4 is the %aasche price index or inflation factor, using the first two
periods. %rices have increased by 1.>! C 1 9 >!3 according to this measure.
The two measures differ because different quantities are used in the
calculation.
2ow use the first and second columns, which hold prices fixed at their
period 1 and period ! levels. (aspeyres and %aasche quantity indexes or
growth factors, comparing the first two periods, are =.4/!.4 9 !.= and B.B/!.A
9 !.??, which yields growth rates of 1=43 and 1??.?3. 8emember that to
go from a "inflation factor# or a "growth factor# to a rate of inflation or a
rate of growth, ;ust subtract 1.
7tic$ing with the first two periods, the *isher %rice Index is the geometric
average
>>?D . 1 , >! . 1 ,+ >= . 1 + =
for an inflation rate of >>.?D3. 7imilarly,
the geometric average
?A . ! , ?? . ! ,+ = . ! + =
is the *isher quantity index,
indicating real growth of about 1?A3. *inally, multiply the *isher %rice
Index times the *isher &uantity Index. The result is the ratio of nominal
values, B.B/! 9 >.> +apart from rounding error,.
8epeat the exercise by calculating the *isher price and quantity indexes
using the second and third periods. This ;ust means that the "first period# is
period ! and the "second period# is period >.
The 7elected 2I%- Tables from www.bea.gov include references to
"chain weighted# indexes for levels of output and prices corresponding to
different components of expenditure, such as <onsumption and Investment.
The chain index is ;ust a connected series of *isher %rice indexes, or *isher
&uantity indexes. Each additional year of data corresponds to
1 + t
and what
was new last year becomes old or EinitialF period
t
data as time passes. This
means that the corner elements
= . > , 1 = . 1 + , 1 ! +
!
1
1 >
= + =

=
=
= =
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and

!
1
> 1
=

=
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= =
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are not used in calculating chain indexes because the prices
and quantities are separated by more than one period. They are used in
calculating "fixed weight# index numbers such as the <onsumer %rice Index,
which holds quantities constant for a number of years before updating them.
It can be argued that fixed weight price indices, such as the <%I, overstate
inflation by ignoring the fact that consumers will try to substitute goods that
have risen in price by smaller percentages for goods that risen in price by
larger percentages.
<alculations of (aspeyres, %aasche, and *isher Index 2umbers as measures
of inflation factors and growth factors are straightforward once you have the
above table of sums set up. :ehind the calculations are more difficult
conceptual issues, in particular'
+1, .hat goods should be included in the index
+!, -re the goods really the same as time passes or do they change in quality
and therefore usefulness If the goods in the index are of better quality as
time passes, the "true# price will increase less +or decrease more, than the
actual price. This applies to computers and automobiles and many other
high tech goods, but not to bread or mil$. %rice indexes for services such as
medical care. - medical chec$ up is far more expensive now that it was
twenty years ago but more informative. .ould you want to purchase an
older, less informative chec$ up at a lower price +if it were available, 7o,
was there inflation in the cost of medical care or not ItFs a hard question to
answer.
*urther note on price indexes.
- (aspeyres price index is equal to a shareGweighted average of individual
inflation factors loo$ing forward +new price over old price, for each good,
where the shares are for the initial period'

+ + + +
= + +
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Q P
Q P
P
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Q P
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Q P
Q P
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P
Q P
Q P
1 1
!
1
! ! !
1
1
1 1 1
...
<onfirm this result by canceling a price in each term on the left and adding.
- %assche price index is equal to the reciprocal of a shareGweighted average
of individual deflation factors loo$ing bac$ward +old price over new price,,
where the shares are for the final period +say the next period,'

+
+ +
+ + +
+ +
+ + +
+ +
+ + +
+ +
=

+ +
1
1 1
1 1 1
1 1
1
!
!
1 1
1
!
1
!
1
1
1
1 1
1
1
1
1
...
1
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Q P
Q P
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Q P
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Q P
Q P
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Q P
Q P
<onfirm this result by canceling a price in each term in the denominator on
the left, adding, and ta$ing the reciprocal.
The main reason that economists thin$ that the (aspeyres index for inflation
will exceed the %aasche index is that shares are li$ely to change in a
systematic way, rising for goods whose prices have increased the least and
falling for goods whose prices have increased the most. This happens to the
extent that consumers are willing to substitute away from goods that have
gone up in price the most and towards goods that have gone up in price the
least, including those whose prices have actually gone down.