Laspeyres Index

Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What is the Laspeyres Price Index?

Laspeyres Index is a methodology to calculate the consumer price indexConsumer Price IndexThe Consumer Price Index (CPI) is a measure of the average price of a basket of regularly used consumer commodities compared to a base year. The CPI for the base year is 100, and this is the benchmark  point.read more by measuring the change in the price of the basket of goods in the present year to the base year. It was invented by Etienne Laspeyres, an economist from Germany, to analyze the changes in the prices compared to the base year period.

  • The index generally uses a base year of 100 to analyze the index. An index greater than 100 implies a rise in prices, and an index less than 100 means a fall in prices.
  • Year 0 is termed as the base year, while the calculating year will be termed as an observation year period.
  • Economists use it more to analyze the country’s economic growth, considering the inflation in goods and services.

Key Takeaways

  1. The Laspeyres index is a method for calculating the consumer price index that compares the current year’s price of the basket of items to the base year. 
  2. German economist Etienne Laspeyres developed it to examine price fluctuations relative to the base year era.
  3. Since base year numbers were used and the current quantities were disregarded, it provides a realistic representation and value of the commodities.
  4. The government will implement new market-clearing rules in response to a significant change in the Laspeyres pricing index, decreasing the effect of price increases on the general populace.

Laspeyres Price Index Formula

Laspeyres Index Formula= ∑ ( Observation Price * Base Qty) / ∑ ( Base Price * Base Qty)

Laspeyres-Index

You are free to use this image on your website, templates, etc, Please provide us with an attribution linkHow to Provide Attribution?Article Link to be Hyperlinked
For eg:
Source: Laspeyres Index (wallstreetmojo.com)

Where,

  • Observation price refers to the price at the current levels for which the index needs to be calculated.
  • Observation quantity refers to the quantity at the current levels for which the index must be calculated.
  • Base price refers to the price at year 0, known as the base year for calculating the index.

Financial Modeling & Valuation Courses Bundle (25+ Hours Video Series)

–>> If you want to learn Financial Modeling & Valuation professionally , then do check this ​Financial Modeling & Valuation Course Bundle​ (25+ hours of video tutorials with step by step McDonald’s Financial Model). Unlock the art of financial modeling and valuation with a comprehensive course covering McDonald’s forecast methodologies, advanced valuation techniques, and financial statements.

Example of Laspeyres Price Index

Let’s take an example for a better understanding of this index.

You can download this Laspeyres Index Excel Template here – Laspeyres Index Excel Template

Let us take the below-mentioned example to understand the calculation of the Laspeyres price index for commodities A, B & C.

Laspeyres Index Example

Solution :

In the above example, to calculate the Laspeyres price index, the quantities for the future years are not required; hence the same has not been plotted in the table. However, below mentioned are the steps to calculate the Laspeyres price index.

Laspeyres price index at year 0 = 100. Since both the numerator and denominator here will be the same, the base year result would be 100, which shall be used in future years to compare the performance of the goods and services and draft a suitable plan of action to control the same if there is any excessive price rise or decline which would affect the consumers directly and in turn the economy.

This index will show a relative and absolute valuationAbsolute ValuationThe term "absolute valuation" refers to a method of business valuation that uses DCF analysis to determine the firm's fair value based on its projected cash flows.read more without considering the future changes in the economy and the government policies, which keep on changing every year to benefit the common public at large.

Calculation of Laspeyres Price Index at Year 1 will be –

Laspeyres Index Example.1

Laspeyres Price Index formula for year 1 = {(25*10)+(30*20)+(35*30)} / {(10*10)+(15*20)+(20*30)}

Index at year 1 = 190

Calculation of Laspeyres Price Index at Year 2 will be –

 Example.1.1

Laspeyres Price Index formula for year 2 = {(40*10)+(45*20)+(50*30)} / {(10*10)+(15*20)+(20*30)}

Index at year 2 = 280

Hence we can observe the inflation impact in the prices since the prices increased from 100 to 190 in year one and finally up to 280 in year two, the price of commodities have climbed up.

Advantages of Laspeyres Index

It is one of the most important tools to observe the inflation in the basket of goods and services by comparing the current price levels with the base year quantities.

Below mentioned are some of the major advantages of the Laspeyres index ratio:

  • It is very easy to calculate in an excel sheet.
  • It focuses only on base year quantities and current level prices; hence, there is no need to calculate the quantities for future years.
  • It gives a fair picture and value of the commodities since base year quantities have been used, thus ignoring the current level quantities.
  • It is a good parameter to frame future policies that will control inflation.

Disadvantages of Laspeyres Index

  • It does not take into account the current level of quantities.
  • It ignores the growing economy.
  • Since there can be a change in the production level in the future years, ignoring this fact will not be correct in the model.
  • It completely ignores the new entrants in the market.
  • It does not consider the change in quality and substitute goods that can have a major impact on the prices.
  • In the case of substitute goods, the old ones that become obsolete may push the price up to the production levels. Hence ignoring the future quantities will not show a correct index figure and will have a direct impact on the government policies ahead.

Limitations of Laspeyres Index

  • More mathematical, less practical.
  • It is not used commonly among economists since the Pastiche index gives a better picture.
  • Prices tend to rise every year, keeping in mind the consumption patterns and rising living standards.
  • Deciding on the base year is a major challenge.

Points to Note

A significant change in the Laspeyres price index will trigger the government to control the growing inflation by implementing new policies that will clear the market, thereby reducing the price rise pressure on the common public.

Conclusion

It is one of the key ratios to determine the speed of inflation for goods and services. However, since this index is different from the Paasche price indexPaasche Price IndexPaasche Price Index is defined as a methodology to calculate inflation by measuring the price change in a commodity compared to the base year.read more, which uses current level quantities in its formula, while the Laspeyres price index uses base year quantities, both cannot be compared and will give an altogether different picture reflecting on the rise or fall in the prices.

Economists have widely used this index to make the country’s financial and economic decisions and drive the consumer market without passing on the pressure of price rise to the common public.

Frequently Asked Questions (FAQs)

What is the difference between Paasche Index and Laspeyres Index?

A “current weighted index” is another name for the Paasche index. For example, the Laspeyres index is the weighted arithmetic average that uses weights from a previous period. Instead, it is a weighted harmonic average of the price relatives considering the real spending shares in the latter time t.

What is the interpretation of Laspeyres Index?

The index analysis typically uses a base year of 100. An index above 100 suggests a price increase, whereas one below 100 suggests a price fall.

What is Laspeyres index based on?

The price development of the basket of goods and services purchased during the base period is tracked using the Laspeyres price index, a method used in price statistics. Therefore, the subject of how much a basket of goods that customers purchased in the base period would cost now is addressed.

Recommended Articles

This has been a guide to the Laspeyres Index and its definition. Here we discuss the formula to calculate the Laspeyres Price index along with an example and advantages and disadvantages. You can learn more about accounting from the following articles –

Reader Interactions

Leave a Reply

Your email address will not be published. Required fields are marked *