The economic approach
The axiomatic approach to constructing a price index revolves around finding a way to combine information on prices and quantities in order to satisfy certain conditions. The focus is essentially set theoretic, and the goal is to define a relationship between prices over time that has the properties a price index ought to have. Except for perhaps the product test, there is no economic content to the axiomatic approach—it is a purely mathematical exercise. The economic approach, by contrast, seeks to examine the underlying economic phenomenon that a price index should measure, using the microeconomic theory of a representative, competitive firm (for a producer price index) or a representative consumer (for a consumer price index). Exactly how price information should be combined to measure a change in prices over time is completely determined by the economic concept to be measured.
Although the economic approach offers a parsimonious way to construct a price index, the validity of this approach relies on making strong assumptions about firm/consumer behavior and market conditions. The most important—and perhaps strongest—assumption is that there is a single, representative firm or consumer in the market with no market power (i.e., takes market prices as given). Having a representative firm is not a restrictive assumption if the market is competitive, but competitive behavior is indispensable (ILO et al. 2004b, chap. 18).15 This is problematic as most markets are characterized by some degree of imperfect competition, causing the theory to fall apart. Conversely, having a consumer take prices as given is a standard assumption, but having a representative consumer is difficult to justify, and cannot be easily relaxed (Pollak 1980; Kirman 1992).16 Consequently, the economic approach is best seen as a consistent way to conceptualize a price index, rather than a recipe for finding an economically-superior price index, and is the least applicable of the three approaches.
This section of the course gives a brief introduction to the economic approach. As with the axiomatic approach, the focus is on motivating index-number formulas used in practice, and there is a good deal of interesting material that is not covered. Unlike the axiomatic approach, different types of indices require separate analysis because they’re measuring different economic phenomena.
📖 PPI Manual: Chapter 1, section E; Chapter 17, paragraphs 17.1–17.26 and 17.61–17.67.
📖 CPI Manual: Chapter 1, paragraphs 1.85–1.107.
The firm is also assumed to make choices to maximize profitability. Although not a controversial assumption, this need not be the only motivation for the firm—see Martin (2019).↩︎
The representative consumer is assumed to choose consumption to maximize utility. Although a standard assumption, it is becoming less accepted over time as behavioral considerations are becoming part of microeconomic theory.↩︎