The Construction of Price Indexes

A price index represents the average prices of a basket of goods and services, and various methods can be used to average the different prices.

A price index created by holding the composition of the consumption basket constant is called a Laspeyres index.

Simply using a fixed basket of goods and services has three serious biases:

Substitution bias – upward bias

Quality bias – upward bias

New product bias – upward bias

Many countries adjust for the quality of the products in a basket, a practice called hedonic pricing.

New products can be introduced into the basket over time.

The substitution bias can be somewhat resolved by using chained price index formula.

Fisher index: the geometric mean of the Laspeyres index and the Paasche index.

Paasche index : an index formula using the current composition of the basket.