The Measurement of General Price Changes

It is difficult, because of the diverse changes in prices, to say whether the dollar will purchase more at one time than at another.It will purchase more of some commodities and less of others. A summary or average of these many changes must be made in order to determine what the change, in general, has been. An index number is the device by which these changes are summarized and expressed.Index numbers may be used to express other changes as well as changes in prices; for example, changes in the physical volume of production or the volume of business, but their more common use is in connection with prices. The prices to be included in the index depend upon the particular purpose for which the index is prepared.For example, an index of the general price level will require that all prices be represented, or at least the prices of all the more important commodities. Some indices, on the contrary, will deal only with the prices of a particular group of products; for example, an index of the cost of living will include only the prices of the commodities that the consumer purchases.The problems involved in the construction of index numbers are complex and can only be briefly mentioned here.

Index numbers are of two general types: (1) those in which the prices of individual items have each been reduced to a percentage of the price or size of those items in a year or period, called the base, and an average taken to represent the change in the group; and (2) those in which the group of items is represented by an appropriate average or total, and these averages or totals expressed as relatives of the averages or totals in the base periods. Index numbers of the first type are averages of relatives, and of the second type ratios of averages, or aggregates.

A simple summation of prices is seldom sufficient to constitute a desirable index.If people generally consume five times as much butter as cheese, the decrease of 5 cents in the price of butter in our illustration would have had five times the significance of the 5-cent decrease in the price of cheese. Commodities, in consequence, are usually "weighted," or multiplied by some number that indicates their relative significance for the particular purpose for which the index is being prepared.The result is a weighted index number.Hence the effect of weighting is an index number which indicates proportional changes.When the prices are not weighted, the index is called a simple, or unweighted, index.Indices using actual prices will be weighted by quantities, and indices constructed from relatives will use relative expenditures as weights. The significance of an actual price change depends upon the quantity of the product affected by that change, whereas the importance of a relative change in price depends upon the relative expenditure upon that commodity.

Where index numbers are prepared for special purposes, such as to show changes in the cost of living, they are nearly always weighted.It has sometimes been argued that where index numbers of prices in general are constructed by an average of relative prices weighting may be dispensed with. The unweighted index number, however, is sensitive to abnormal variations of unimportant prices and is too little influenced by large variations of important prices.Usually, therefore, index numbers are more accurate when weighted.

An additional opportunity for variation in index numbers arises because of the different averages that may be used to summarize the data.The most common is the arithmetic mean, or ordinary average, derived by dividing the sum of the individual items by the number of items or by the sum of the weights in the weighted index.The other average that is frequently used is the geometric mean, where all the prices or ratios for a given date are multiplied together and the nth root extracted, n standing for the number of commodities included.

Index numbers have many uses. The conditions of economic life are complex, and we need summary expressions to indicate clearly exactly what has happened.Index numbers are utilized for this purpose in various sections of this book. For example, when it is desired to show the growth of advertising in the United States, to picture changes in real wages over a period of time, or to indicate the degree of change in national income during the depression, the device is utilized.

2. Types of Price Movements. —When the general level of prices is observed for a considerable period of time, three distinct types of price movements appear.

The secular changes in the price level are explained by the economist principally by the quantity theory of money. The price level is thought to depend upon the relation between the amount of money and credit, its velocity of circulation, and the quantity of commodities that are bought and sold. The greater the quantity of money (in the broad sense) relative to a given quantity of goods, the higher the price level is likely to be. If the quantity of goods increases more rapidly during a given period than the quantity of money, other things remaining equal, prices may be expected to fall. If the opposite condition obtains, a rise in prices can be expected. Periods of inflation usually result from very large issues of paper money. When this money cannot be exchanged for gold as formerly, the general price level ceases to depend directly upon the stock of gold; the principal factor is now the quantity of paper money.

3. Effect of Changes in the General Price Level on Various Classes. —Changes in the general price level are of great significance in the economic life of the people.Any change of considerable magnitude shifts purchasing power among groups, resulting in benefits to some and hardships to others. This is because all prices do not change with equal rapidity or to the same extent. A considerable group of prices, such as those of annuities, interest payments, and public-utility rates, change very slowly, and the groups concerned with such transactions are influenced particularly.

The most marked changes take place in the relationship of debtor and creditor. The debtor gains on rising prices. His obligations may now be paid with the equivalent of a smaller quantity of goods than before.

Business generally gains when prices rise. The businessman is usually in a debtor position, and many of the payments he must make for things such as rents, salaries, and interest do not rise so rapidly as the prices of goods that he has for sale. Profit margins tend to widen, and business activity is stimulated. If we include the farmer in this group, we find him affected most of all because of his generally important debtor situation and because of a tendency of agricultural prices to rise faster and fall faster than industrial prices. The opposite situation prevails when prices fall, and generally losses are incurred.

The situation of the wage earners is somewhat more complex. The employed worker gains on falling prices and loses on rising prices because his wages usually lag. But because of the changes in business activity, which usually are associated with price movements, employment generally increases with rising prices and declines with falling prices. Thus, while wage rates lag, the number employed increases on the upswing and the laboring group gains in total purchasing power, whereas the reverse occurs when prices are falling. The gain from reemployment would be largest in the early stages of the price increase and the losses from the wage lag greater for the group in the later stages.

4. The Business Cycle and the Consumer. —The cyclical changes in the general level of prices above and below the secular trend are, in a large measure, due to the variations in business called the business cycle. In these fluctuations, there are periods of considerable expansion and contraction of credit by banks. During a portion of the cycle, bank credit expands the means of payment for goods more rapidly than goods are increasing, and here we find rising prices, and in another phase we find the greater contraction of credit and falling prices. There are many other factors, such as the general business psychology, which influence these short-time movements, but bank credit probably plays a dominant part.

Cyclical fluctuations in business activity are indicated by changes in the general price level about as well as by any other single index.The business cycle, however, consists of a great deal more than simply a change in the general price level. There are changes in employment, rates of wages, volume of production, profits, interest rates, volume of credit, and other important relationships. Consumers will be variously affected by the cycle and in different portions of it. This is because the term consumers includes everyone, and different groups are affected differently by the cycle and its stages. As has been suggested, incomes and the prices of the products that are purchased with those incomes do not change simultaneously, and in consequence real incomes vary.

These fluctuations in business activity follow one another in a fairly definite succession. The cycle is generally divided into four stages: periods of depression, of recovery, of prosperity, and of liquidation. There is no constant length for the entire cycle nor for any of the stages of the cycle. Each cycle is distinct in itself and differs from other cycles in important details. There is no sharp break between the different stages of the cycle—they pass gradually from one to the other. The stages, however, differ somewhat in their lengths; the period of recovery, for example, is generally the longest, that of liquidation the shortest.

The relations between the production of goods, their consumption, the accumulation of stocks of goods, and the prices of goods vary during the cycle. If we begin with the period of depression, we find that it is characterized by small production, low prices, and low profits. There is a great deal of unemployment. The volume of physical production in some industries frequently falls to as low as 50 or 60 per cent of the average production. There are large stocks of goods accumulated from earlier phases of the cycle. These consist of consumers' goods, partially processed goods, and raw materials. Consumption is low, relative to other periods, but is greater than current production. The real income of society is low for nearly all classes. Since current production is less than current consumption, the existing stocks of goods must be cut down; and, after they have been exhausted, goods must be produced at an increased rate if the current rate of consumption is to be maintained. The increase in production is not immediately accompanied by a rise in prices, since many of the plants have been operating at only a part of their capacity and may actually lower their unit costs as they expand operations. Sooner or later, however, additions to plants and repairs become necessary, and the industries making producers' goods increase their activity. Prices now begin to rise, and the cycle has passed into the so-called recovery stage.

The increase of employment that begins during the period of depression and extends through the period of recovery and well into that of prosperity brings an increasing real income to labor as a class. The increase in the rates of wages comes somewhat after the increase in prices has begun, and the rate of increase continues to lag behind that of prices. The laborer who has been previously employed thus suffers a decrease in real income, since the prices of the goods that he is purchasing are rising more rapidly than his wages. The amount paid laborers as a total, however, is increasing, and increasing even more rapidly than prices, because of the greater employment of labor, and in consequence the real income of labor as a whole is increasing. Profits are also increasing, since wages, rents, and capital costs are lagging behind prices. This means that the real income of the employing class will be increasing.

The rising prices stimulate the production of consumers' goods and greatly intensify the activity in the production of producers' goods as well. Dealers, manufacturers, and even consumers begin to expect the increase of prices to continue and begin to accumulate stocks. This continues through the period of prosperity. For this to take place, the production of goods must exceed the current consumption. Prices now rise rapidly. The period of recovery passes into that of prosperity. During the early phase of this period the real wages of labor are high, both because more are employed and because the rates of wages begin to creep up to the level of prices. Men may also move into higher grades of employment. It is quite common during periods of prosperity, when labor is scarce, for laborers to advance beyond their accustomed class. For example, an unskilled laborer may secure a job as a skilled laborer. The income of the employing class probably begins to decrease during the period. Certain producers begin to recognize that their lines are overcrowded and lessen their activities toward expansion. This affects materially the demand for production equipment and the buying power of the laborers in these industries.

There is now a rapid passage into the period of liquidation. Dealers try to work their stocks off and cease buying. Industries shut down as far as possible. Employment decreases very rapidly. The rates of the wages fall, but not so rapidly as prices, so that the real wages of those who remain employed are higher. The great increase of unemployment and part-time work, however, lowers the real income of the laboring class a great deal. Workers also change from higher to lower grades of work, which lowers real incomes even though the rates of pay for each type of work remain the same. Heavy losses are sustained by many businessmen, and the incomes of this class are seriously curtailed. The period of depression has arrived, which is turned into a period of increasing activity in the manner that has been indicated.

Source: The Consumer and the Economic Order