Posted on

The Price Index

The price index is an arbitrary number used in comparing the output and price levels of one period with that of another. To do this, the chosen period cost is divided by the base period cost. For instance, the cost of a cup of garri in January 2001 was ₦10 while in January 2002, it went up to ₦25. The price index of garri can be calculated as follows:

The price of garri in 2001 (Base year) = ₦10
The Price of garri in 2002 (Current year) = ₦25
image

The figure 100 is the index for the base year which is calculated as follows:

image

The price index is used to discount the output and price level of garri in 2002 to that of 2001. In this case, one can erroneously conclude that output and income have therefore, increased. In actual fact, they have not. The output level of garri is still the same inspite of the fact that the price, and therefore, income of the seller has risen.

The price index is, therefore, used to discount the Gross National Product of one year with that of another. It determines whether or not the increase is due to actual increase in output, or mainly as a result of increases in the price level of goods and services.

Worked Example

Assuming the GDP for 1989 is ₦80 million at 1989 marked prices, while the GDP for 1990 is ₦160 million at 1990 market prices, it is also assumed that the increase in price was 100% between 1989 and 1990. The inflationary distortion is cancelled by using a price index to discount the 1990 GDP value to that of 1989. To discount the 1990 GDP figures at the 1989 prices the following steps are taken.

i. The base year 1989 is chosen.
ii. This is given a price index of 100.
iii. The 100% increase in price will therefore give a price index of 200 for 1990.
image

The discounting is done as follows:
₦160 million at 1990 prices = ₦160 million
image

This means that although the GDP or National Income has increased by100%, the actual output has not. The monetary increase in cost of output was only due to increase in prices.

Key Points

a. The Gross National Product (GNP) shows the speed at which the economy is operating. It shows if the economy is growing, static or declining, it shows the annual value of goods and services in monetary terms.
b. The UNP is the GNP – Depreciation.
c. GDP is the total monetary value of all the goods and services produced within a country in a specified time period, usually one year.
d. Personal Income is money earned by an individual or his properties.
e. Disposable income is the money actually paid to an individual after all direct taxes have been deducted.
f. The three methods of compiling the GNP or GDP are the income, output and expenditure approaches.
g. Inflation distorts output and income values of the GDP. Price indices are, therefore, used to eliminate this distortion.
h. To calculate the price index:
i. Choose a base year.
ii. Find the prices of goods and services for the base year.
iii. Find the prices of goods and services for the current year.
iv. Divide the prices of the current year by the prices of the base year.
v. If prices of the current year is higher than that of the base year, the index number will be greater than 100.
i. Cost of living is the cost of the goods and services required by a man to survive.
j. Standard of living is the ability, or the extent, to which a family is able to meet their
needs with ease within a particular period of time.

READ MORE