This video helps understand how the Laspeyres index and the compensated variation work. We start by analyzing the Laspeyres index analytically, then use a graphical representation to explain what the compensated variation is.
Price indices are used to monitor changes in prices levels over time. This is useful when separating real income from nominal income, as inflation is a drain on purchasing power. The two most basic indices are the Laspeyres index (named after Etienne Laspeyres) and the Paasche index (named after Hermann Paasche).
They work by dividing expense on a specific basket in the current period by how much the same basket would cost in the base period. The main difference is the quantities used.
What this translates to is that a Laspeyres index of 1 means that, as the nominator is the same as the denominator, an individual can afford the same basket of goods in the current period as he did in the base period. As the quantities are the same, this just leaves price as a variable, which must remain unchanged. This translates to the concept of compensated variation: by how much do we need to increase an individual’s income in order to offset inflation?
The Laspeyres index overestimates this compensated variation: it assumes that inflation has a greater effect than it does.
Learn more by reading the dictionary entry.