Laspeyres method, Financial Management

Laspeyres Method

Laspeyres method uses the quantities consumed during the base period in computing the index number. This method is also the most commonly used method which incidentally requires quantity measures for only one period. Laspeyres index can be calculated using the following formula:

Laspeyres Price Index = 1774_laspeyres method.png

where,     

P1 = Prices in the current year
P0  Prices in the base year
Q0 = Quantities in the base year

Laspeyres Index

454_laspeyres method1.png

In general, Laspeyres price index calculates the changes in the aggregate value of the base year's list of goods when valued at current year prices. In other words, Laspeyres index measures the difference between the theoretical cost in a given year and the actual cost in the base year of maintaining a standard of living as in the base year.

Also, Laspeyres quantity index can be calculated by using the formula,

 

Laspeyres quantity index 519_laspeyres method2.png

where,

Q1

=

 Quantities in the current year and Q0, P0 are as defined earlier.

Using the same data as provided in the above table, Laspeyres quantity index is

 

   =

2080_laspeyres method3.png =   122.96

A Laspeyres index is simpler in calculation and can be computed once the current year prices are known as the weights are base year quantities in a price index. This also enables easy comparability of one index with another. Interestingly, Laspeyres tends to overestimate the rise in prices or has an upward bias.

  • There is usually a decrease in the consumption of those items for which there has been a considerable price hike and the usage of base year quantities will result in assigning too much weight to prices that have increased the most and the net result is that the numerator of the Laspeyres index will be too large.

  • Similarly, when the prices go down, consumers tend to demand more of those items that have declined the most and hence the usage of base period quantities will result in too low weight to prices that have decreased the most and the net result is that the numerator of the Laspeyres index will again be too large.

This is a major disadvantage of the Laspeyres index.

However, the Laspeyres index remains most popular for reasons of its practicability. In most countries, index numbers are constructed by using Laspeyres formula.

Posted Date: 9/17/2012 2:40:32 AM | Location : United States







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