In this lesson, we’ll learn about price level in economics. We’ll define the term, learn how it changes, determine a popular way to measure it, and then learn how to calculate it.
Price Level Defined
Most of us are familiar with how a camera works. When we want to capture a particular moment so that we don’t forget it, we immediately pull out our cell phones or cameras and snap a few shots. We’ve all done this at one time or another. Perhaps it was when our child reached a milestone, or we were reunited with a loved one we haven’t seen in many years, or we were on vacation and saw a historical landmark.
Whatever the occasion, a camera has been the go-to source to preserve memories for years to come. But, what if we needed to visualize how the economy was performing at a particular time? Would a camera be efficient in documenting this kind of information? Probably not, but thankfully, economists have developed what we call a price level, which works in a similar fashion.
A price level is the measurement of current prices of goods and services produced in the economy in a specific region or country at a specific time. In simpler terms, price level can be compared to a picture we take with our cameras, only the picture is ‘hypothetical’ and is of the price of goods or services in a particular time frame. This picture allows economists to monitor changes to the price level.
Changes to the Price Level
In order to understand how to calculate price level, we need to explain situations that affect it. The first thing you need to know is that the price level can change. These changes are related to inflation and deflation. Inflation refers to an increase in the price level of goods, whereas deflation describes a decrease in the price level of goods.
Measuring Price Level
Perhaps the most popular way to measure price level is utilizing the consumer price index (CPI), which is an estimate of how common goods and services that consumers purchase change in price. You may be asking yourself right now, how are the prices of goods measured? Well, first of all, the government decides what goods and services are frequently purchased by average consumers and compiles a list. Since the list contains things a consumer would purchase, it is given the name consumer price index. Items range anywhere from bananas and crackers to a stove to a TV and even an amusement park ticket. However, the CPI doesn’t include investments, like stocks or life insurance. The government then determines the price for every item on the list and calculates what the total cost would be for those items, known as the price level.
Price Level Equation
Now that we have the important pieces that are needed to calculate price level, let’s try it out on an example. The following is the equation we can use to determine consumer price index, which we have learned is one of the more popular ways to find the price level.
CPI = [ (base year basket quantities * current year prices) / (base year basket quantities * base year prices) ] * 100
So, let’s take a few common items many of us purchase, such as coffee, diapers, and hamburger.
|Good||Base-year quantity||Base-year price||Base-year expenditure||Current-year price||Current-year expenditure|
The base-year quantities, base-year price and the current-year price are just hypothetical numbers used for this example. The base-year expenditure, however, is calculated by multiplying base-year quantity and price. Current-year expenditure is calculated by multiplying current price by base-year quantity. The totals are determined by simply adding the column of numbers together.
Next, you take the totals for base-year expenditure and current-year expenditure and plug them into the equation, which gives you the CPI:
Current year CPI = (279.30 / 297.25) * 100 = 93.96
Keep in mind that the CPI for your base year is always 100, but if you want to calculate it, you can do so the following way:
(297.25 / 297.25) * 100 = 100
Price level can be compared to a snapshot taken with a camera of the current prices of goods and services at a particular time in the economy. Price level can change due to inflation and deflation. The most popular way to calculate price level is the consumer price index, which uses base prices and current prices.