CONCEPT OF A PRICE INDEX
There are many situations where there may be a need to compare two (or more) sets of price observations. For example, a household might want to compare the prices of groceries bought today with the prices of the same groceries bought last year; a manufacturer may want to compare movements in the prices of its outputs with movements in its production costs between two points in time; or an employer might be interested in comparing prices of labour inputs today compared with those of five years ago.
In some situations the price comparisons might only involve a single commodity. Here it is simply a matter of directly comparing the two price observations. For example, a household might want to assess how the price of bread today compares with the price at some previous point in time.
In other circumstances the required comparison may be of prices across a range of commodities. For example, a comparison might be required of clothing prices. There is a wide range of clothing types and prices (e.g. women’s coats, girls' pyjamas, boys’ shorts, men’s suits, etc.) to be considered. While comparisons can readily be made for individual or identical clothing items, this is unlikely to enable a satisfactory result for all clothing in aggregate. A method is required for combining the prices across this diverse range of items allowing for the fact that they have many different units or quantities of measurement. This is where price indexes play an extremely useful role.
A price index is a measure of changes in a set of prices over time. Price indexes allow the comparison of two sets of prices for a common item or group of items. In order to compare the sets of prices over time, it is necessary to designate one set the ‘reference’ set and the other the ‘comparison’ set. In the Australian Bureau of Statistics (ABS), the reference set is used as the base period for constructing the index and by convention is given an index value of 100.0. The value of the price index for the comparison set provides a direct measure of price difference between the two sets of prices. For example, if the price of the comparison set had increased by 35% since the base period, then the price index would be 135.0. Similarly, if the price had fallen by 5% since the base year, the index would stand at 95.0.
It is important to note that a price index measures price movements (i.e. percentage changes) and not actual price levels (dollar amounts). For example, if the Consumer Price Index for breakfast cereals in a certain period is 143.4 and the index for bread in the same period is 186.5, it does not mean that bread is more expensive than breakfast cereals. It simply means that the price of bread has increased at about twice the rate of the price of breakfast cereals since the base period.
It should also be noted that price indexes do not measure changes in the quantities of goods or services that underpin the value weights in each price index. These quantities are held constant. The relative value weights of items will change over time in response to changes in relative prices. Presentation of weights in value terms reflects the fact that it is simply not possible to present quantity weights in a meaningful way. In the CPI, for instance, the weight associated with each particular class of items is expressed as a proportion of the total expenditure of all Australian households. Hence the weights in the CPI are often referred to as "expenditure shares". This weight represents a specific "quantity by price" of that particular class of items at the beginning of a series. As the price associated with each particular class of items changes, their relative expenditure shares can change as a proportion of the total.