Explain how price(cost of living) index are computed. Illustrate your answer. 

Procedure taken

• Define the objectives of calculating the price index e.g. wage determination.
• Choose an area where the data is to be collected
• Get the price for each good in a basket  ( A basket of commodities are a sample of goods consumed by most people)
• Choose a base year (a year when prices were relatively stable)
• Simple index of the base year should be given unit 100
• Attach weights to each good in the basket
• Obtain prices in the current year
• Calculation of price relative/for simple price index for each commodity in the basket using the formula

• Compute  the average simple price index from the formula

• Calculate weighted price index from the formula

 

Weighted price index = simple price x weight

• Compute average weighted price index from the formula

A hypothetical table is shown below

Commodity	Base year prices	Base year simple index	Current year prices (4years later)	weight
A B C D E	200 150 500 100 700	100 100 100 100 100	700 500 1000 300 1200	5 4 3 2 1

Simple calculation/illustration

For A: (700/200) x 100 = 350

For B: (500/150) x 100 = 333.3

For C: (1000/500) x 100 = 200

For D: (300/100) x 100 = 300

For E: (1200/700) x 100 = 171.4

=(350 + 333.3 + 200 + 300 + 171.4)/5

= 1354.73/5

= 271

• Weighted price index = simple price x weight

A: 350 x 5 = 1750

B: 333.3 x 4 = 1333.2

C: 200 x3 = 600

D: 300 x 2 = 600

E: 171.4 x 1 = 171.4

= (1750 + 1333.2 + 600 + 600 + 171.4)/(5 + 4 + 3 + 2 + 1)

=4454.6 / 15

= 297

Conclusion

There was overall increase in general price level by 29%