This video helps understand how the Paasche index and the equivalent variation work. We start by analyzing the Paasche index analytically, then use a graphical representation to explain what the equivalent 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.
A Paasche index of 1 means that the consumer could have afforded the same bundle of goods in the base period as they can now. This can be translated to the concept of equivalent variation: how much income would we have to take away from an individual, at the base price level, to have the same impact on their utility as the inflation between the base period and period 1? The Paasche index underestimates the equivalent variation.
Learn more by reading the dictionary entry.