A price index is a measure that examines the weighted average of prices of a basket of goods and services. A basket of goods is a theoretical container consisting of selected goods or services that economists can use to understand prices. Price indexes show the change in the average price (the amount of money paid to acquire a good or service) or a group of prices over time, such as one month, one quarter (every three months), or one year. Price indexes can increase or decrease. For example, a consumer may pay $2.50 for a loaf of bread one year and $2.75 the next year. A price index—such as the Consumer Price Index (CPI)—reflects this change. The Consumer Price Index is a measure that examines the average of prices of a basket of goods and services bought by consumers, weighted according to the amount of each good purchased.
Price indexes were first developed to figure out how people could earn enough money to afford the same goods and services each year, even when prices rose. By comparing price indexes year over year, economists can tell whether the price level is increasing or decreasing in an economy. For example, Lily earned $3,000 per month and spent about $500 on food. Then the price of food rose, and she was paying $575 for the same amount of food each month. This means that Lily now has $75 less to spend on other things. If the prices of too many of Lily's purchases increase, then she may not be able to afford the same things she used to buy if she still earned $3,000 per month. Cost of living refers to the average amount of money needed to afford necessary or usual goods, such as housing and food. Price indexes can indicate how much employers must increase wages (money paid by an employer in exchange for work) so people like Lily can afford the same standard of living after inflation occurs.
Consumer Price Index
The Consumer Price Index (CPI) is measure that examines the weighted average of prices of a basket of goods (commodities used to satisfy a want or need) and services bought by consumers. It includes a weighted average of the prices of commonly used goods and services from eight main groups:
- food and beverages
- housing (such as rent and furniture)
- apparel (such as clothing and jewelry)
- medical care (such as medications and hospital visits)
- transportation (such as airline tickets and fuel)
- recreation (such as televisions and pet care)
- education and communication (such as college tuition and postage stamps)
- other goods/services (such as haircuts and tobacco products)
Many people from all over the country buy these goods and services. The CPI reflects about 89% of those people—called urban consumers, or people who live in cities and metropolitan areas. This group includes professionals, the unemployed, and retired people. There are several groups of people whose purchases are not reflected in the CPI, including farm families and people in the armed forces.
Calculating the CPI begins with the fixed basket of goods and services, or the products from the eight main groups. A U.S. government agency called the Bureau of Labor Statistics surveys consumers to find out how they spend their money. The Bureau of Labor Statistics creates a sample market basket of goods based on these surveys. Each quantity is then multiplied by its price in a specific year to find out the cost of the market basket in that year. For example, suppose one shirt cost $7 in 2016. If the basket contains 10 shirts, then the total cost of shirts in the basket is $70.
For comparisons, a base year is used. A base year can be randomly chosen, but when two years are compared, the base year is the earliest one. Once a year is chosen as the base year, all prices for goods will be converted to the equivalent prices from that year. Calculating the CPI means dividing the cost of the basket of goods in a given year, GY, by the cost of the same fixed basket in the base year, BY, and then multiplying the quotient by 100.Calculating the CPI
| Year | Number of Shirts | Price of Shirts | Cost of Shirts | Number of Hats | Price of Hats | Cost of Hats | Nominal Value of Goods | CPI |
|---|---|---|---|---|---|---|---|---|
| 2005 (base year) | 10 | $4.30 | $43.00 | 5 | $2.00 | $10.00 | $53.00 | 100.0 |
| 2010 | 10 | $5.80 | $58.00 | 5 | $2.50 | $12.50 | $70.50 | 133.0 |
| 2015 | 10 | $7.00 | $70.00 | 5 | $3.25 | $16.25 | $86.25 | 162.7 |
CPI is calculated by dividing the total cost of a basket of goods in a given year by the total cost of a basket in a base year and multiplying by 100.
Consumer Price Index
Producer Price Index
The Producer Price Index (PPI) is a measure that examines the weighted average of prices at the producer level. Like the CPI, the PPI can be used to assess the overall change in prices in an economy. The PPI includes both of the following:
- goods and services bought by consumers from sellers (such as stores) or directly from producers
- goods and services bought by producers as inputs or investments, such as stock supplies for manufacturing or improvements to facilities
A commodity is a good that is bought and sold in a commercial transaction and is interchangeable with other goods of the same type, such as grains, metals, and oil. The PPI Commodity Index records average price changes for the goods in this market. Manufacturing deals with making and putting together parts for finished goods, such as making car parts to produce a car. Processing stage refers to the manufacturing phase, when products are between the raw and finished stages.
The wholesale market includes the sales of finished goods to retailers. A finished good is a good that has completed all phases of manufacturing but has not yet been sold. Suppose a company makes shirts. The company then sells the shirts to a distributor. The distributor sells the shirts to retailers for consumers to buy. In this case, the distributor is the wholesaler. Wholesalers sell large quantities of goods at low prices. Companies such as Target and Walmart are retailers that buy the wholesalers' goods in large quantities and then sell these goods to consumers. The PPI can change in many different ways. Generally, it increases based on inflation, but it can also decrease or stay the same.
The PPI includes many industries but not all of them. For example, food and energy industries are not part of the PPI. People use the PPI to examine trends (general directions in the market) for industries and markets in manufacturing, commodities, and wholesale. As for the CPI, a base year is chosen to compare PPIs from different times. The PPI and the CPI follow similar general trends; when one goes up, often the other will rise as well. The two ways of measurement are connected based on the influence of the production chain. Although related, the CPI is different from the PPI because it includes imports.