Final answer:
A price index relates the average price of a given set of goods in one time period to the average price of the same goods in another, using a weighted average based on actual quantities purchased. It reflects changes in relative prices over time and is often expressed as an index number with an arbitrary base year set to 100.
Step-by-step explanation:
Typically a price index relates the average price of a given set of goods in some time period to the average price of the same goods in another period. To understand how price indices work, it's important to recognize that they serve as tools to measure the average change in relative prices over time. Moreover, a weighted average is used to construct an overall measure of the price level, where the weights in the calculation are based on the actual quantities of goods and services people buy.
For instance, when housing costs increase by a certain percentage, it typically impacts people's finances more significantly than a similar percentage increase in the price of a less significant item, like carrots. This is because people spend a larger portion of their income on housing. Consequently, items that comprise a more considerable share of expenditures receive higher weighting in the construction of a price index. This allows the index to more accurately reflect the economic impact of price changes on consumers.
Economists often choose a base year with an index number of 100 to simplify the interpretation of price levels for complex baskets of goods. The price in the base year is the starting point from which changes in prices are measured. To calculate price indices for other years, the cost of the basket of goods in each year is compared to the cost in the base year, adjusting the value to maintain the same proportion to the index of 100.