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- 1. Rohit Rohan 134, PGP-19 MICA
- 2. • 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
- 3. • 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?
- 4. • 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?
- 5. • 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
- 6. • 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?
- 7. 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?
- 8. 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
- 9. • 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
- 10. • 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
- 11. • 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
- 12. • 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

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