MICROECONOMICS:

INFLATION + PRICE INDICIES

THE IDEAL MEASURE OF INFLATION
 The ideal measure of Inflation would be to measure the
change in the ‘cost of living’.
 One could do that via seeing the percentage change in
people’s expenditure functions, with regards to a
reference (constant) level of utility (U).
 Thus:
 Inflation: New Expenditure function/Old Expenditure
Function x100.
 E(p1’,p2’,p3’,...,U) / E(p1,p2,p3,..., U) x100
 This is a similar concept to that of Hicksian ‘compensated’
demand.
 However, we often lack the requisite information on
preferences.
THE BEST ALTERNATIVE MEASURE
 Instead of a reference level of utility, we can instead
consider a reference Basket of Goods, which is
observable.
 Hence, we can compare the cost of living in two
different periods:
 Period 1: p1x1 + p2x2 + ... + pnxn
 Period 2: p1’x1 + p2’x2 + ... + pn’xn
 This is a similar notion to that of Slutsky’s ‘constant
purchasing power’ demand.
 And the % change is the measure of inflation.
PRICE INDICES
 When many prices change at one time, we can use a
price index to measure how much the cost of living,
roughly approximated, has risen.
 An Index Number measures the RELATIVE change in
PRICE/QUANTITY/other relevant variable.
 A Simple Index Number only considers ONE variable.

 In order to represent the change of prices of a number of

goods as a single number, we must use a weighting to
make a percentage.
 Two different weightings available:
 Laspeyres Price Index
 Paasche Price Index
LASPEYRES & PAASCHE PRICE INDICES
 The Laspeyres P.I holds the quantity purchased in the
‘base’ (reference) period constant, and calculates the
change:

p1 x0
L.P.I :
p0 x0
 The Paasche P.I holds the new quantity constant,
however:
p1 x1
P.P.I :
p0 x1
MONEY INDEX
 The Money Index is simply the change in income between the
two periods:

p1 x1
M .I :
p0 x0
 If M.I > L.P.I:
 P1x1 > P1x0
 Hence, x1 > x0 ; X1 has been revealed Preferred to X0.
 Consumer is better off in the current period
 If M.I > P.P.I:
 P0x0 > P0x1
 X0 has been revealed preferred to X1.
 Consumer is better off in the base year.
PROBLEMS WITH PRICE INDICES
 Common problem of both indices is that they assume a constant
consumption pattern.
 This is unlikely; as prices rise, there will be a substitution effect
towards cheaper goods.
 The final bundles will be dependent, therefore, on the price changes
that take place, which neither index indicates.
 Hence:
 L.P.I  Tends to overstate increases in the (true) cost of living.
 P.P.I  Tends to understate increases in the (true) cost of living.
 In addition, when price indices are carried out for groups of
consumers, we cannot directly imply the effect of a change of prices
on ALL the consumers in the group.
 It may be the case that M.I > L.P.I; however, we can’t state that all
members of the group are better off in the current period.