Meaning of Price Index

There are different factors or phenomena in an economy that change with time. Such change in these factors or phenomena is measured with the help of index numbers. An index number is a statistical device developed to measure the relative change in the level of a phenomenon, variables, or a group of variables concerning time or other factors. Among these factors, price is also an important one. The index used to measure the price change is simply known as the price index.

The price index is directed towards the measurement of average relative change in the price of a particular commodity or a group of commodities for the current year in comparison to the base year. In an economy, there could be either wholesale price or retail price. Thus, the price index in an economy can be measured in terms of wholesale or retail prices. Thus, the price index in an economy could be in the form of a wholesale price index or retail price index. Whatever might be the form of price index, it could be either weighted or unweighted comparing the current year’s price with the base year’s price.

Types of Price Index

Price index measures prices of different commodities or groups of commodities for a orver period. It has different dimensions with which prices are associated. Thus, there are different types of a price indexes. These price indexes have been explained below:

1. Consumer Price Index (CPI): It refers to the index number computed to illustrate the change in prices of finally consumed goods and services. Since it is calculated based on the retail price charged to final consumers, it is called the retail price index. As it is paid by the consumers for their living, it is also referred to as the cost of living index. It is also used for indexing dearness allowances to employees for an increase in prices.
2. Wholesale Price Index (WPI): It is concerned with the measurement of changes in prices in the wholesale market. The wholesale market is the place where a large or bulk volume of goods is sold for further sales. The wholesale price index shows how much has the wholesale prices changed over the period.
3. Producers Price Index (PPI): It includes producer or output prices which are the prices of the first commercial transaction of goods and services or the transaction at the point of the first sale. During the 1970s and the 1980s, most of the countries around the world replaced the wholesale price index with the producer price index. The PPI usually considers the manufacturing and industrial sectors as well as public utilities. However, services like agriculture, mining, transportation and business are also included by some countries under PPI.
4. The GDP Deflator: GDP (Gross Domestic Product) refers to the total value of goods and services produced in a country during a particular year. The GDP is measured in either nominal or real terms. Nominal GDP refers to change in total output and prices of goods and services produced in an economy. On the other hand, real GDP is the value calculated by taking the output of the year under consideration but multiplied by y the price of a base year. Hence, GDP Deflator = (Nominal GDP x 100)/Real GDP; The GDP deflator shows the change in prices of all goods and services over a particular period.

Uses of Price Index

Price indexes have different uses. Its use depends upon the issue to be addressed and the preference of the user. Some of the important uses of the price index have been mentioned below:

• Facilitates comparison of price change from time to time or place to place
• Price index helps in forecasting future tendencies of price based on relative change taken place in the past
• The price index acts as a guide to formulate different economic policies
• Price index can be used in deflation or adjusting the value by transforming nominal ones into real ones
• Formulation of business strategies and policies
• Comparing the economic status of different countries internationally

Limitations of Price Index

We now understand how users are price index for economic and research perspectives. We must know, there are certain limitations attached to it as well. Some limitations of the price index have been listed below:

• Accuracy is difficult to ascertain as the price index measures the approximate change in prices only
• Since it is computed based on samples, there is a likelihood of it not representing the exact economic scenario
• Selection of base year free from abnormality is not
• As price index is averaged value, it faces the same limitations as in the case of average
• Different methods of computing price index give different results
• The price index fails to consider the change in qualities of different items consumed