UNDERSTANDING

CONSUMER PRICE INDEX

A topic in Microeconomics
by Justine Kaye
What is CPI?
 KEY TAKEAWAYS

C
• Main measure of the price changes and allows
the consumers to determine the effect of
price increases on their purchasing power.

• Measures changes in the cost of buying a

P
representative fixed basket of goods and
services and a yardstick for revising wages,
pensions, alimony, payments, etc.

•Generally accepted as a measure of inflation

I
in the country or can be used to find the
purchasing power of the dollar.
 Who and What are covered?

The CPI statistics cover professionals, self-

emplyoed, poor, unemployed and retired
people in the country. People not included in
the report are non-metro or rural
populations, farm families, armed forces,
people serving in prison and those in mental
hospitals.
The CPI represents the cost of a basket
of goods and services across the country on
a monthly basis. 
 The consumer price index or CPI is a more direct
measure than per capita GDP of the standard of
living in a country. It is based on the overall cost of
a fixed basket of goods and services bought by a
typical consumer, relative to price of the
same basket in some base year.

 Laspeyres Index is a methodology to calculate the

consumer price index by measuring the change in the
price of the basket of goods to the base year.
Fixed Basket

the amount of product purchased in year 1

measures the expenditure necessary to buy the fixed at

the prices in year 2 divided by the expenditure necessary
to purchase the same basket at the prices in year 1

Laspeyres Index
L= PF2F + PC2C
PF1F + PC1C
 YEAR INCOME PRICE OF FOOD PRICE OF
CLOTHING
1 $480 $3 $8

PF1 F+PC1 C=($3) (80) + ($6) (30)=$480

 YEAR INCOME PRICE OF FOOD PRICE OF
CLOTHING
2 ???? $6 $9

PF2 F+PC2 C=($6) (60) + ($9) (40)=$720

 YEAR INCOME PRICE OF FOOD PRICE OF
CLOTHING
2 ???? $6 $9

If the consumer
chooses
basket A, his income
should be $750, not
\

$720

PF2 F+PC2 C=($6) (80) + ($9) (30)=$750

 In principle, the CPI should measure the percentage
increase in expenditures that would be necessary for the
consumer to remain as well off as he was in year 1.

 In the example, the necessary expenditures increased

from $480 in year 1 to $720 in year 2. The ideal CPI
would be the ratio of the new expenses to the old
expenses.:
720/$480= 1.5

$480 (0.50) = $240

480+240= $720
If the consumer were given $750 with the new prices
and we were to calculate a CPI using the fixed basket A,
the ratio of the new expenses to the old expenses is:
750/$480= 1.5625 or 56.25%
(the consumer’s expenditure’s would need to increase by
56.25% to buy the fixed basket at the new price.)

$480 (0.5625) = $270

$480+270= $750