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

P1?Q1? + P2?Q2? + ... + Pn?Qn?

∑ Pi?Qi?
i =1
=
P1?Q1? + P2?Q2? + ... + Pn?Qn? n
∑ Pi?Qi?
i =1

The next step is to insert dates for the “?” marks.

If you want a Price Index, make sure only the prices in the numerator and
denominator correspond to different dates. Quantities have the same date:
earlier in both numerator and denominator, for a Laspeyres Index; later, for a
Paasche Index. Therefore:
n n
∑Pi t +1
Qit ∑Pit +1Qit +1
i =1 i =1
Laspeyres Price Index: n Paasche Price Index: n
∑Pit Qit ∑Pit Qit +1
i =1 i =1

If you want a Quantity Index, make sure only the quantities in the numerator
and denominator correspond to different time periods. Prices have the same
date: earlier in both numerator and denominator, for a Laspeyres Index;
later, for a Paasche Index.
n
∑Pit Qit +1
i =1
Laspeyres Quantity Index: n Paasche Quantity Index:
∑ Pi Qit
t

i =1
n
∑Pit +1Qit +1
i =1
n
∑Pit +1Qit
i =1
In general, Laspeyres and Paasche Price Indexes or Inflation Factors will
differ. Their geometric averages are called Fisher Indexes (after Irving
Fisher).

Fisher Price Index = (Laspeyres Price Index)(Paa sche Price Index)

Fisher Quantity Index = (Laspeyres Quantity Index)(Paa sche Quantity Index)

As a measure of the inflation factor (one plus the inflation rate), a Fisher
Price Index is the square root of the product of Laspeyres and Paasche Price
Indexes. As a measure of the growth factor (one plus the rate of growth), a
Fisher Quantity Index is the square root of the product of Laspeyres and
Paasche Quantity Indexes.

Question: Why are Fisher Indexes useful averages of Laspeyres and

Paasche Indexes?

Answer: The advantage of the geometric averages is revealed by

considering the ratio of nominal values where $G is the rate of change of
nominal GDP:
n
∑Pit +1Qit +1
i =1
n
= 1 + $G
∑ Pi Qit
t

i =1

Note that both prices and quantities are different, comparing the numerator
and the denominator. If the ratio were 2, for example, value has doubled (
2 = 1 + 100% ). A doubling of nominal value might be the result of price
increases (inflation) or quantity increases (real growth) or some mixture of
inflation and growth. How can the ratio of nominal values be split exactly
into an inflation factor (where π is the inflation rate) times a growth factor
(where g is the growth rate)?
n
∑ Pit +1Qit +1
i =1
n
= (1 + π )(1 + g )
∑ Pi Qit
t

i =1
The split will be exact if the Fisher Price Index is used for the inflation
factor and the Fisher Quantity Index is used for the growth factor. Just do
the substitution to confirm this claim.

Square Root of the Product of a Fisher Price Index times a Fisher Quantity
Index

n n n n
∑ Pi t +1
Qit ∑ Pi t +1
Qit +1 ∑ Pi Qit +1
t
∑ Pit +1Qit +1
i =1 i =1 i =1 i =1
= n
× n
× n
× n
∑ Pit Qit ∑ Pit Qit +1 ∑ Pit Qit ∑ Pit +1Qit
i =1 i =1 i =1 i =1

Bring all terms under a single square root sign, cancel sums where possible
and take the square root. The result is just the ratio of nominal values in
adjacent time periods.

Conclusion: Fisher Index Numbers for the inflation and growth factors are a
mathematically coherent way to average Laspeyres and Paasche 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): Assume there are only two goods in the
calculation of GDP, 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
n =2
nominal GDP is ∑ Pit Qit = (1 × 1) + (1 × 1) = 2 .
i =1

Assume that the price of the first good rises for 50% to 1.5 in the second
period, and then a further 33% in the third period, i.e. from 1 to 1.5 to 2.0.
Note that the second change of 0.5 if a smaller percentage increase because
the price has already gone up. Suppose the quantity of the first good
increases to 2.0 in the second period (100% increase), and then remains at
2.0 in the third period (0% change).
Assume that the price of the second good rise from 1 to 1.2 (20% higher)
and then to 1.5 (a further 25%) in the second and third periods, respectively;
while the quantity of the second good increase to 3.0 (200% higher) and then
to 4 (a further 33%).

P Q P Q
t =1 : 1 1 t =1 : 1 1
Good 1 : Good 2 :
t =2 : 1.5 2 t =2 : 1.2 3
t =3 : 2 2 t =3 : 1.5 4

With these numbers you should be able to verify and complete the following
table of sums. Prices change as you shift right from one column to the next;
quantities change as you shift down from one row to the next. Nominal
GDP in each period is therefore read off along the downward sloping
diagonal:

 2 t =1 t =1 2 2

 ∑ Pi Qi ∑ Pit =2Qit =1 ∑ Pit =3Qit =1 
 i =1 i =1 i =1   2 2.7 3.5 
 2 t =1 t = 2 2 2   
 ∑ Pi Qi ∑ Pit =2Qit =2 ∑ Pit =3Qit =2  =  5 6.6 ? 
 i=21 i =1 i =1   ? 7.8 ? 
 P t =1Q t =3
2 2  
∑ i i ∑ Pit =2Qit =3 ∑ Pit =3Qit =3 
 i =1 i =1 i =1 

The first row holds quantities fixed at their period 1 levels. Therefore,
2.7/2.0 = 1.35 is the Laspeyres price index or inflation factor, using the first
two periods which means that the “first” period is period 1. Prices have
increased by 1.35 – 1 = 35% according to this measure.

The second row holds quantities fixed at the period 2 levels. Therefore,
6.6/5.0 is the Paasche price index or inflation factor, using the first two
periods. Prices have increased by 1.32 – 1 = 32% according to this measure.
The two measures differ because different quantities are used in the
calculation.

Now use the first and second columns, which hold prices fixed at their
period 1 and period 2 levels. Laspeyres and Paasche quantity indexes or
growth factors, comparing the first two periods, are 5.0/2.0 = 2.5 and 6.6/2.7
= 2.44, which yields growth rates of 150% and 144.4%. Remember that to
go from a “inflation factor” or a “growth factor” to a rate of inflation or a
rate of growth, just subtract 1.

Sticking with the first two periods, the Fisher Price Index is the geometric
average (1.35 )(1.32 ) =1.3349 for an inflation rate of 33.49%. Similarly,
the geometric average (2.5)( 2.44 ) =2.47 is the Fisher quantity index,
indicating real growth of about 147%. Finally, multiply the Fisher Price
Index times the Fisher Quantity Index. The result is the ratio of nominal
values, 6.6/2 = 3.3 (apart from rounding error).

Repeat the exercise by calculating the Fisher price and quantity indexes
using the second and third periods. This just means that the “first period” is
period 2 and the “second period” is period 3.

The Selected NIPA 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 Consumption and Investment.
The chain index is just a connected series of Fisher Price indexes, or Fisher
Quantity indexes. Each additional year of data corresponds to t +1 and
what was new last year becomes old or ‘initial’ period t data as time passes.
n =2
This means that the corner elements ∑ Pit =3Qit =1 = (2 ×1) + (1.5 ×1) = 3.5 and
i =1
n =2
∑Pit =1Qit =3 = ? are not used in calculating chain indexes because the prices
i =1
and quantities are separated by more than one period. They are used in
calculating “fixed weight” index numbers such as the Consumer Price 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 CPI, 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.

Calculations of Laspeyres, Paasche, and Fisher Index Numbers as measures

of inflation factors and growth factors are straightforward once you have the
above table of sums set up. Behind the calculations are more difficult
conceptual issues, in particular:
(1) What goods should be included in the index?
(2) Are 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 milk. Price indexes for services such as
medical care. A medical check up is far more expensive now that it was
twenty years ago but more informative. Would you want to purchase an
older, less informative check up at a lower price (if it were available)? So,
was there inflation in the cost of medical care or not? It’s a hard question to
answer.

Further note on price indexes.

A Laspeyres price index is equal to a share-weighted average of individual

inflation factors looking forward (new price over old price) for each good,
where the shares are for the initial period:

Pnt Qnt Pnt +1 ∑ Pi Qi

t +1 t
P1t Q1t P1t +1 P2t Q2t P2t +1
+ + ... =
∑Pit Qit P1t ∑Pit Qit P2t ∑Pit Qit Pnt ∑Pit Qit
Confirm this result by canceling a price in each term on the left and adding.

A Passche price index is equal to the reciprocal of a share-weighted average

of individual deflation factors looking backward (old price over new price),
where the shares are for the final period (say the next period):

 
 
 1  ∑Pi t +1Qit +1
 =
 P1
t +1
Q t +1
1 P1
t
+
P2
t +1
Q t +1
2 P2t
+...
Pnt +1Qnt +1 Pnt  ∑Pit Qit +1
 
 ∑Pi Qi ∑Pi t +1Qit +1 P2t +1 ∑Pi t +1Qit +1
t +1 t +1
P1t +1 Pnt +1 

Confirm this result by canceling a price in each term in the denominator on

the left, adding, and taking the reciprocal.

The main reason that economists think that the Laspeyres index for inflation
will exceed the Paasche index is that shares are likely 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.