Price Indexes (3) Level or Change

Economists are interested in measuring the overall price level. Unfortunately, measuring the price level in an economy is impossible. This is an important point that underlies the design of all price indexes. The prices of a pint of milk and a Ford V8 cannot be averaged because the units are different. However, we can measure the change in the price level, by converting the prices to price relatives, that all have same units. The assumption behind this practice is that variability in price change will be less than the variability in absolute prices. Lower variability reduces the sampling error.

The basic method for calculating a price index is to choose a representative basket of goods and services. The prices of all the goods and services in this basket are measured in the current period and a previous period. This is referred to as a “matched sample”. The change in prices recorded for this matched sample is used to calculate the price index.

With a matched sample there is a standard unit. The current price for each good or service is divided by the previous price. This ratio is called a price relative. If there is no price change, the price relative equals unity. So there is a common measurement rod, as all changes are measured relative to unity. The price index shows price change relative to unity (or a base of 100 or 1000 to show more significant figures).