Can someone explain, in simple terms, laspeyres and paasche price index?

Question

I just need to know what it is basically. I've never taken a course on Economics so please don't get too in depth or use Economics lingo, as I will not fully understand. Thanks in advance.

Answer 1

One way to think about this to think about whether a basket of groceries has become expensive over time.  You compare prices by figuring out whether an entire basket gets more or less expensive.

You can imagine that over time some individual goods might get more expensive...consumption patterns change...so if beef got really expensive and coca-cola got expensive over time, a rational consumer would have switched to chicken and pepsi.  

So, do you compare the cost for the original market basket of goods (including beef and coca cola) at old and new prices? Or do you compare the cost of the new basket of goods (that contains chicken and pepsi) at old and new prices?

Comparing prices using the initial consumption levels is the Laspeyres index.  Comparing prices using the new consumption levels is the Paasche index.

Answer 2

Paasche and Laspeyres price indices

A price index (plural: “price indices” or “price indexes”) is a normalized average (typically a weighted average) of prices for a given class of goods or services in a given region, during a given interval of time. It is a statistic designed to help to compare how these prices, taken as a whole, differ between time periods or geographical locations.

Price indices have several potential uses. For particularly broad indices, the index can be said to measure the economy's price level or a cost of living. More narrow price indices can help producers with business plans and pricing. Sometimes, they can be useful in helping to guide investment.

The two most basic formulas used to calculate price indices are the Paasche index (after the German economist Hermann Paasche) and the Laspeyres index (after the German economist Etienne Laspeyres).

Note that the only difference in the formulas is that the former uses period n quantities, whereas the latter uses base period (period 0) quantities.

When applied to bundles of individual consumers, a Laspeyres index of 1 would state that an agent in the current period can afford to buy the same bundle as he consumed in the previous period, given that income has not changed; a Paasche index of 1 would state that an agent could have consumed the same bundle in the base period as she is consuming in the current period, given that income has not changed.

Hence, one may think of the Paasche index as the inflation rate when taking the numeraire as the bundle of goods using base year prices but current quantities. Similarly, the Laspeyres index can be thought of as the inflation rate when the numeraire is given by the bundle of goods using current prices and current quantities.

The Laspeyres index systematically overstates inflation, while the Paasche index understates it, because the indices do not account for the fact that consumers typically react to price changes by changing the quantities that they buy. For example, if prices go up for good c, then ceteris paribus, quantities of that good should go down.

Answer 3

Nope.