1. Rohit Rohan
134, PGP-19
MICA

3. • Demand is defined as the quantity of a good or service that
consumers are willing and able to buy at a given price in a given time
period.
• The Theory of Demand
• Other factors remaining constant (ceteris paribus) there is
an inverse relationship between the price of a good and demand.
• As prices fall, we see an expansion of demand
• If price rises, there will be a contraction of demand.
THEORY OF DEMAND AND PRICE INDEX

5. • an index that traces the relative changes in the price of an individual
good (or a market basket of goods) over time.
• a price index is a normalized average of prices for a given class of
goods or services in a given region, during a given interval of time. It
is a statistic designed to help to compare how these prices, taken as
a whole, differ between time periods or geographical locations.
• index that tracks inflation by measuring price changes.
WHAT IS PRICE INDEX?

7. • Allowances are an important component in the pay-package of the
organised sector
• The amount of allowances is linked to a price index agreed
mutually between the employer and the employee
• It is basically in place to protect the consumer from the adverse
effect of price rise
• It is basically a type of welfare provided by the employer to the
employee
• Different types of price index can be formulated based on the
consumers’ welfare over time
WHY DO WE NEED IT?

9. • For fixing the price index, we have to make certain assumptions to
simplify the process
• The tastes and preferences of the consumer remain unchanged over a
period of time
• The preferences of the entire body of individuals can be averaged out
and be represented as one
• For simplicity, we assume that there are only two goods available in the
market
ASSUMPTIONS MADE FOR FIXING THE PRICE INDEX

11. • Let us assume that there are only two goods available to be
consumed – X and Y
• These goods will be consumed over two time periods, T0 and T1
• The following table gives a pattern of consumption of X and Y
consumed at the prevailing prices at the given time periods
Time
Px
X
Py
Y
∑PtQt
∑PoQt
∑P1Qt
To
10
10
20
15
400
400
555
T1
18
17
25
12
606
410
606
• It can be seen that the price of both the goods has increased in
time
• Consumption of ‘X’ has increased but that of ‘Y’ has fallen
HOW DOES IT WORK?

12. Time
Px
X
Py
Y
∑PtQt
∑PoQt
∑P1Qt
To
10
10
20
15
400
400
555
T1
18
17
25
12
606
410
606
• Had the quantity of Y also increased, it would have obvious that its
utility level has also increased
• The total expenditure in period 1 is higher than in period 0 – this
could be due to increased prices
• It is necessary that the expenditures relating to price rise be
adjusted in order to arrive at real income or expenditure of
consumers
• This is why we need price index to derive the welfare for employees
HOW DOES IT WORK?

14. Time
Px
X
Py
Y
∑PtQt
∑PoQt
∑P1Qt
To
10
10
20
15
400
400
555
T1
18
17
25
12
606
410
606
• The cost of the quantities consumed in the base of the period of
terminal period is greater – 606 > 555
• 606 = ∑P1Q1
>
555= ∑P1Q0
• This means that the cost of goods consumed by the consumer in
the termination period is higher than the cost of the goods in the
base period
• Thus Q0 is available to the customer in period 1 but he still chooses
Q1 in period 1
• This is because the customer chooses the combination of goods
which maximises his satisfaction – thus his combination is giving
more utility
CALCULATION OF THE PRICE INDEX

15. • Thus we have this generalisation
• ∑P1Q1
≥
∑P1Q0 which implies U1 > U0
• To derive index numbers we divide both sides by the basal ∑P0Q0
• ∑P1Q1/∑P0Q0
≥
∑P1Q0/∑P0Q0 which implies U1 > U0
• ∑P1Q1/∑P0Q0 x 100 = Index of income at current prices
• (∑P1Q0/∑P0Q0 x 100 = Laspeyer’s Price Index)
CALCULATION OF THE PRICE INDEX

17. • The tables and data so far have been shown to depict an
improvement in welfare.
• A similar approach can be used for situations where a detoriation
in welfare is estimated
• ∑P1Q1/∑P0Q0 x 100 = Index of income at current prices
• ∑P1Q0/∑P0Q0 x 100 = Laspeyre’s Price Index
• ∑P1Q1/∑P1Q0 x 100 = Paasche’s Price Index
• Both the indices should be used together and can be used to
provide a consistency check
LASPEYRE’S AND PAASCHE’S PRICE INDICES

18. • Laspeyre’s Price Index is used to compare the company’s welfare
scheme with the prices index of the past to find out the situation of
the welfare program for their employees
• When compared with the Income index, this shows improvements
over time
• It cannot determine the fall in welfare
• Paasche’s Price Index is used to derive the index of real income by
comparing the company’s welfare program with current prices
• When compared with the Income index, this shows detoriations
over time
• It cannot identify improvement in welfare
LASPEYRE’S AND PAASCHE’S PRICE INDICES

19. • Welfare improvement with time
• Necessary condition : Income Index > Passche’s Price index
• Sufficient condition : Income Index ≥ Passche’s Price index
• Welfare deterioration with time
• Necessary condition : Income Index < Passche’s Price index
• Sufficient condition : Income Index ≤ Passche’s Price index
LASPEYRE’S AND PAASCHE’S PRICE INDICES