To calculate a price index, first select a base year. Then, take a sample of representative items and determine their base year prices and current prices, notes EconPort from Georgia State University. The ratio of expenditures on the basket of goods at current prices to the expenditure at the base year prices is the price index.
A price index is a statistical estimate of the price levels of goods and services bought by households for consumption, according to Boundless. It is calculated by determining prices of a sample of representative goods and services over a specified period.
Goods and services are divided into subindexes and subcategories. All information is computed to give the overall index of household consumption. The annual change in a price index can be used to estimate price changes and inflation, notes Synonym. It can also be used to index the value of salaries, wages and pensions, explains Boundless.
The price index is a convenient method of calculating the cost of living and price level for a specified period.
However, it does not completely provide an accurate estimate for the cost of living, states Boundless. Factors that affect the accuracy of a price index include changes in quality, introduction of new products and substitution bias.