1 1 Slide Slides Prepared by JOHN S. LOUCKS St. Edward’s University © 2002 South-Western/Thomson Learning 

2 2 Slide Chapter 17 Index Numbers n Price Relatives n Aggregate Price Indexes n Computing an Aggregate Price Index from Price Relatives from Price Relatives n Some Important Price Indexes n Deflating a Series by Price Indexes n Price Indexes: Other Considerations n Quantity Indexes

3 3 Slide Price Relatives n Price relatives are helpful in understanding and interpreting changing economic and business conditions over time.

4 4 Slide Price Relatives n A price relative shows how the current price per unit for a given item compares to a base period price per unit for the same item. n A price relative expresses the unit price in each period as a percentage of the unit price in the base period. n A base period is a given starting point in time.

5 5 Slide Example: Besco Products n Price Relatives The prices Besco paid for newspaper and television ads in 1992 and 1997 are shown below. Using 1992 as the base year, compute a 1997 price index for newspaper and television ad prices Newspaper $14,794$29,412 Television 11,469 23,904

6 6 Slide Example: Besco Products n Price Relatives Newspaper Television Television advertising cost increased at a greater rate. Television advertising cost increased at a greater rate.

7 7 Slide Aggregate Price Indexes n An aggregate price index is developed for the specific purpose of measuring the combined change of a group of items. n An unweighted aggregate price index in period t, denoted by I t, is given by where P it = unit price for item i in period t P i 0 = unit price for item i in the base period

8 8 Slide n With a weighted aggregate index each item in the group is weighted according to its importance, which typically is the quantity of usage. n Letting Q i = quantity for item i, the weighted aggregate price index in period t is given by where the sums are over all items in the group. Aggregate Price Indexes

9 9 Slide Aggregate Price Indexes n When the fixed quantity weights are determined from the base-year usage, the index is called a Laspeyres index. n When the weights are based on period t usage the index is a Paasche index.

10 Slide Example: City of Newton n Aggregate Price Indexes Data on energy consumption and expenditures by sector for the city of Newton are given below. Construct an aggregate price index for energy expenditures in 2000 using 1985 as the base year. Quantity (BTU) Unit Price ($/BTU) Quantity (BTU) Unit Price ($/BTU) Sector Residential 9,473 8,804$2.12$10.92 Commercial 5,416 6, Industrial21,28717, Transport.15,29320,

11 Slide n Unweighted Aggregate Price Index I 2000 = (100) = n Weighted Aggregate Index (Laspeyres Method) I 2000 = 10.92(9473) (15293) (100) = (9473) (15293) 2.12(9473) (15293) n Weighted Aggregate Index (Paasche Method) I 2000 = 10.92(8804) (20262) (100) = (8804) (20262) 2.12(8804) (20262) The Paasche value being less than the Laspeyres indicates usage has increased faster in the lower- priced sectors. Example: City of Newton

12 Slide Some Important Price Indexes n Consumer Price Index (CPI) Primary measure of the cost of living in US. Primary measure of the cost of living in US. Based on 400 items including food, housing, clothing, transportation, and medical items. Based on 400 items including food, housing, clothing, transportation, and medical items. Weighted aggregate price index with fixed weights derived from a usage survey. Weighted aggregate price index with fixed weights derived from a usage survey. Published monthly by the US Bureau of Labor Statistics. Published monthly by the US Bureau of Labor Statistics. Its base period is with an index of 100. Its base period is with an index of 100.

13 Slide n Producer Price Index (PPI) Measures the monthly changes in prices in primary markets in the US. Measures the monthly changes in prices in primary markets in the US. Used as a leading indicator of the future trend of consumer prices and the cost of living. Used as a leading indicator of the future trend of consumer prices and the cost of living. Covers raw, manufactured, and processed goods at each level of processing. Covers raw, manufactured, and processed goods at each level of processing. Includes the output of manufacturing, agriculture, forestry, fishing, mining, gas and electricity, and public utilities. Includes the output of manufacturing, agriculture, forestry, fishing, mining, gas and electricity, and public utilities. Weighted average of price relatives using the Laspeyres method. Weighted average of price relatives using the Laspeyres method. Some Important Price Indexes

14 Slide n Dow Jones Averages Indexes designed to show price trends and movements on the New York Stock Exchange. Indexes designed to show price trends and movements on the New York Stock Exchange. The Dow Jones Industrial Average (DJIA) is based on common stock prices of 30 industrial firms. The Dow Jones Industrial Average (DJIA) is based on common stock prices of 30 industrial firms. The DJIA is not expressed as a percentage of base- year prices. The DJIA is not expressed as a percentage of base- year prices. Another average is computed for 20 transportation stocks, and another for 15 utility stocks. Another average is computed for 20 transportation stocks, and another for 15 utility stocks. Some Important Price Indexes

15 Slide Deflating a Series by Price Indexes n In order to correctly interpret business activity over time, when it is expressed in dollar amounts, we should adjust the data for the price-increase effect. n Removing the price-increase effect from a time series is called deflating the series. n Deflating actual hourly wages results in real wages or the purchasing power of wages.

16 Slide Example: McNeer Cleaners n Deflating a Series by Price Indexes McNeer Cleaners, with 46 branch locations, has had the total sales revenues shown on the next slide for the last five years. Deflate the sales revenue figures on the basis of constant dollars. Is the increase in sales due entirely to the price-increase effect?

17 Slide n Deflating a Series by Price Indexes YearTotal Sales ($1000)CPI , , , , , , , Example: McNeer Cleaners

18 Slide n Deflating a Series by Price Indexes DeflatedAnnual YearSales ($1000)Change(%) 1996 (8,446/156.9)(100) = 5, (9,062/160.5)(100) = 5, (9,830/163.0)(100) = 6, (10,724/166.6)(100) = 6, (10,724/166.6)(100) = 6, (11,690/172.6)(100) = 6, After adjusting revenue for the price-increase effect, revenue is still increasing at an average rate of 5.9% per year. Example: McNeer Cleaners

19 Slide n Selection of Items When the class of items is very large, a representative group (usually not a random sample) must be used. When the class of items is very large, a representative group (usually not a random sample) must be used. The group of items in the aggregate index must be periodically reviewed and revised if it is not representative of the class of items in mind. The group of items in the aggregate index must be periodically reviewed and revised if it is not representative of the class of items in mind. n Selection of a Base Period As a rule, the base period should not be too far from the current period. As a rule, the base period should not be too far from the current period. The base period for most indexes is adjusted periodically to a more recent period of time. The base period for most indexes is adjusted periodically to a more recent period of time. Price Indexes: Other Considerations

20 Slide Price Indexes: Other Considerations n Quality Changes A basic assumption of price indexes is that the prices are identified for the same items each period. A basic assumption of price indexes is that the prices are identified for the same items each period. Is a product that has undergone a major quality change the same product it was? Is a product that has undergone a major quality change the same product it was? A substantial quality improvement also may cause an increase in the price of a product. A substantial quality improvement also may cause an increase in the price of a product.

21 Slide Quantity Indexes n An index that measures changes in quantity levels over time is called a quantity index. n Probably the best known quantity index is the Index of Industrial Production. n A weighted aggregate quantity index is computed in much the same way as a weighted aggregate price index. n A weighted aggregate quantity index for period t is given by

22 Slide End of Chapter 17