What is the Meaning and Scope of the Paasche Index? How is it Calculated?
There are various ways to assess and compare price changes in commodities and services that have occurred over the years. One such method is the Paasche Index. It provides a realistic measure of increase or decrease in inflation using commonly bought commodities.
Financial analysts and media alike use this index to analyse economic growth, inflation and consumer spending patterns. Read on to know every crucial detail related to this index.
What Is Paasche Index?
Paasche Price Index is a consumer price index that one can use for calculating inflation. Economic experts have defined it as a methodology for evaluating the change in prices of a fixed basket of goods and services when compared to a base value in an observation year.
In simple words, it tracks the change in prices of a selection of commodities and services. By checking this index, one can assess the current price level and living costs against a base period. Financial analysts can also use it to track a country’s monetary development and inflation.
Some other names of the Paasche Index are current weighted index, fixed basket index or fixed weight index. It was developed in the 19th century by a German economist, Hermann Paasche, after whom it is named.
How to Calculate the Paasche Index?
Paasche Price Index Formula
The formula for calculating the current year’s Paasche Price Index is:
Paasche Price Index = Sum (Observation Price X Observation Quantity) / (Base Price X Observation Quantity)
Here, the observation price and observation quantity denote the price and quantity of a commodity in a period when one is calculating the index. Base price is the price of the same set of items in a base year, which one also refers to as year zero.
Given below are the steps to calculate the current weighted index.
Step 1:
Use the weighted sum method for calculating composite index number. To do this, you need to use the Paasche Index formula, dividing prices of commodities/services in the current year by that in a base year.
Step 2:
Multiply this ratio by 100 to receive the index number. Remember to consider 100 as the index value of the base year.
Step 3:
If the number you get is over 100, it denotes inflation. However, if this resultant number is below 100, it represents deflation or a drop in price levels.
Also Read: Consumer Price Index (CPI) Explained – Calculation and How Does it Work
Example of Paasche Index
Let us use an example to understand the Paasche Index better.
Given below is information about the change in prices and quantities of individual items in an economy. First, let us calculate the Paasche Price Index for year 0, year 1 and year 2. Here, Year 0 is the base year.
| Items | Year 0 | Year 1 | Year 2 |
| Item A | Rs. 100 | Rs. 110 | Rs. 120 |
| Item B | Rs. 150 | Rs. 160 | Rs. 170 |
| Item C | Rs. 200 | Rs. 210 | Rs. 220 |
The next table shows the quantity of goods bought in year 0, year 1 and year 2.
| Items | Year 0 | Year 1 | Year 2 |
| Item A | 10 | 15 | 20 |
| Item B | 25 | 30 | 35 |
| Item C | 40 | 45 | 50 |
Now, let us use the formula for Paasche Price and calculate:
Paasche Price Index in Year 0
= [{(Rs. 100×10)+(Rs. 150×25)+(Rs. 200×40)} / {(Rs. 100×10)+(Rs. 150×25)+(Rs. 200×40)}] x 100
= {(12,750 / 12,750) x 100}
= 100
Paasche Price Index in Year 1
= [{(Rs. 110×15)+(Rs. 160×30)+(Rs. 210×45)} / {(Rs. 100×15)+(Rs. 150×30)+(Rs. 200×45)}] x 100
= {(15,900 / 15,000) x 100}
= 106
Paasche Price Index in Year 2
= [{(Rs. 120×20)+(Rs. 170×35)+(Rs. 220×50)} / {(Rs. 100×20)+(Rs. 150×35)+(Rs. 200×50)}] x 100
= {(19,350 / 17,250) x 100}
= 112.17
The price index that we received after using the Paasche Price Index formula is as follows:
- Year 0 (Base Year) = 100
- Year 1 = 106
- Year 2 = 112.17
Please note from the above-illustrated example that in the Paasche Price Index, only the prices vary. We compared the current year’s prices, i.e., the observation year’s prices, to the base year’s prices while keeping the quantities the same.
Advantages of the Paasche Index
The various advantages of the Paasche Price Index are as follows:
- It helps economists and financial analysts to evaluate the cost of living and general price levels in an economy.
- This price index takes into account the current quantities of commodities available and focuses on people’s consumption habits and patterns.
- Furthermore, it helps experts understand and assess monetary developments in the country with respect to inflation.
- Governments can use the Paasche Price Index to formulate monetary and fiscal policies and control inflation.
- It assesses the whole basket of goods and services. It takes into account both high-cost and low-cost goods.
- The Paasche Price Index issues warning signals to higher authorities about the rising cost of living and prices because it may hamper a country’s economic growth.
- This particular price index also helps one understand the effect of governmental policies on items and services people consume regularly.
Disadvantages of the Paasche Index
Listed below are some of the limitations of the Paasche Price Index:
- This index does not take into consideration the changes in people’s tastes and preferences over years and their subsequent effects.
- There could be many goods and services that did not exist in the base year or past years, or their prices may have been introductory ones. So, it might be challenging to get their exact prices.
- The Paasche Price Index understates the changes in prices. This is because it focuses on changes in consumer behaviour caused by increased prices.
- Furthermore, the Paasche method does not consider the economic growth that took place between two years.
- This index uses current data. But it might not be easy to extract accurate, current data from various websites.
Points to Know about Paasche Index
Given below are important points to note regarding Paasche Price Index:
- High growth in the index might prove to be harmful to ordinary people. This is because they might be unable to buy essential goods due to the high prices.
- If a significant change occurs in the Paasche Price Index, it indicates that authorities need to take necessary actions to address its sudden increase or sudden fall.
Also Read: What is Market Penetration? How to Calculate and Increase it?
Final Word
This blog has provided important details regarding Paasche Index, including its formula, calculation, benefits, limitations, etc. Moreover, steps to calculate have been listed along with a detailed example. You can use these details to understand the current price levels in the economy and make informed financial decisions.
FAQs
Ans: The Paasche Price Index has a higher potential downward bias compared to other indices due to its usage of fixed weights in the current period. These depict the current purchasing patterns that occur after substitution.
Moreover, fixed weights place importance on items that have undergone relatively minor price changes and are bought in larger quantities than in the base period.
Ans: Paasche Price Index is an index formula. It is also referred to as a composite index number of prices that one arrives at through the weighted sum method. Economic experts use the Paasche Index to assess price development in a basket of goods and services one consumes in the current period.
Ans: Laspeyres Index is another method of calculating the consumer price index. It does so by measuring and evaluating price changes in a basket of goods in an observation year compared to the base year.
Ans: Both Laspeyres and Paasche Indexes are used for calculating price level changes over time. They use the prices of goods and services in a base year and an observation year to calculate changes in price levels.
Laspeyres and Paasche Indexes have a lot of similarities. However, the main difference and a distinct feature of the Laspeyres Index is that it uses base year quantities as weights. The Paasche Index instead makes use of current year quantities as weights.
Ans: The Paasche Index does not take into consideration the substitution of choices that people make due to rising inflation. For example, if housing costs are increasing compared to income, Paasche Index will allow the substitution of a smaller house over a larger one. By doing this, it ensures affordability in the absence of fixed standard quality. However, this also leads to the Paasche Index understate inflation.
Disclaimer
This article is solely for educational purposes. Navi doesn't take any responsibility for the information or claims made in the blog.
