CFA 2017 Level 1 Schweser Notes Book 2 - Economics, page 91:
[Question removed by admin]
Why can’t I just add up the items for the current price and divide it by the sumation of the items for the previous price? Why is the quantity involved?
Thanks
People buy more gasoline than movie tickets.
The short answer is that the price index is a weighted average, not an unweighted one. Here’s the longer one: what we’re trying to capture with a price index is the percentage change in the cost of a representative consumer’s total expenditures over time. To see why your approach wold be wrong, consider the following example - it’s overstated, but it should get the point across:
Assume you buy 100 units of good A at $10 each and 1 unit of Good B at $20. The price of A goes up to $11 (i.e. by 10%) and B goes up to $21 (i.e. by 5%). If you take the simple weighted price increase, you’d get an increase of 7 1/2 %. But your total expenditures have increased from $1020 to 1121, or 1121/1020, or 9.8%%.
In effect, the change in good A has a much higher “weight” in the index, so the percentage change in the index is more heavily affected by the change in A’s price than by the change in B’s price (since you spend $1000 A and only $20 on B, it’s affect is 50X that of B’s).