Market Basket

You may go grocery shopping each month to get the same set of items. Even if you do not always get the exact same set of items, the items you get tend to fall within the same category, as there are supplies a household cannot do without. This usual set of items is your market basket. Why is it important to know your market basket? Because you have a specific budget each time you go grocery shopping, and you would hate for this budget to suddenly be insufficient for the same things you buy! This analogy is applicable to the economy as a whole. Want to know how? Then, read on!

Market Basket Economics

In economics, the market basket is a hypothetical set of goods and services usually purchased by consumers. Economists are usually interested in measuring the general price level, and to do this, they need something to measure with. This is where the market basket comes in handy. Let's explain this using an example.

From the example, we have a couple of options to answer the question asked. We could answer the question by indicating the three different prices for gasoline, diesel, and kerosene. But this would result in numbers all over the place!

Remember, economists are concerned with the general price level. So, instead of providing three different prices each time we're asked how much fuel prices have increased, we can try to get a general answer that accounts for the increase in the prices of all three fuels. This is done by indicating the average change in prices. This average change in prices is measured using the market basket.

Figure 1 is an example of a market basket.

Fig. 1 - Market Basket

Market Basket Economics Formula

So, what is the formula for the market basket in economics? Well, the market basket is a hypothetical set of goods and services consumers typically purchase, so we use this set. We simply combine the prices of all the goods and services in the market basket. Let's use an example.

Take a look at Table 1 below to help you answer the question in the example above.

Table 1. Market Basket Example

From Table 1 above, we can see that the cost of the market basket equals $95.

Market Basket Analysis

So, how do economists perform market basket analysis? We compare the cost of the market basket before prices change (the base year) to the cost of the market basket after prices have changed. Take a look at the following example.

Fig. 2 - Car Refueling

The change in the cost of the market basket is the new cost minus the old cost.

Let's use Table 2 below to help our calculations!

Table 2. Market Basket Example

From Table 2 above, we can calculate the change in the cost of the market basket as follows:

\(\$190-\$95=\$95\)

This indicates that the market basket is now twice its previous cost. This means the general price level of fuels has increased by 100%.

Market Basket Applications

There are two main market basket applications. The market basket is used to compute the price index as well as inflation.

Calculating Price Index using the Market Basket

The price index (or consumer price index in the case of consumer goods) is a normalized measure of the general price level. However, to arrive at the technical definition for the price index, let's look at this formula:

\(\hbox{Price Index for Year 2}=\frac{\hbox{Cost of Market Basket for Year 2}}{\hbox{Cost of Market Basket for Base Year}}\times100\)

From this, we can say that the price index is a normalized measure of the change in market basket cost between a given year and a base year.

Let's use the example below to calculate the consumer price index for fuels.

The old price represents the market basket for the base year, whereas the new price represents the market basket for the new year (year in question). Therefore, we have:

\(\hbox{Price Index for New Year}=\frac{$190}{$95}\times100=200\)

Given that the price index for the base year is 100:

(\(\frac{$95}{$95}\times100=100\))

We can say that there has been a 100% increase in the average price of fuels.

Calculating Inflation Rate using the Market Basket

The inflation rate is the annual percentage change in the consumer price index. To calculate inflation, economists usually use the cost of the market basket in a base year and the cost of the market basket in the year that follows it.

Let's take a look at the market basket table below.

From Table 4 above, the consumer price index for year 1 is as follows:

\(\hbox{Consumer Price Index for Year 1}=\frac{$95}{$95}\times100=100\)

The consumer price index for year 2 is as follows:

\(\hbox{Consumer Price Index for Year 2}=\frac{$190}{$95}\times100=200\)

Therefore:

\(\hbox{IR}=\frac{\Delta\hbox{Consumer Price Index}}{100}\)

\(\hbox{IR}=\frac{200-100}{100}=100\%\)

where IR is inflation rate.

Market Basket Benefits

So, what are the benefits of the market basket? The market basket simplifies the measurement of the price level in the economy. Imagine having to compute the prices of every single thing that is sold; that is almost impossible! There's no time for that. Instead, economists use the market basket to simplify calculations involving the general price level.

Specifically, the market basket helps to:

1. Determine the general price level.
2. Calculate the consumer price index.
3. Calculate the inflation rate.

Figure 3 shows the major types of spending in the CPI for the USA¹.

Fig. 3 - USA Consumer Expenditure Shares for 2021. Source: Bureau of Labor Statistics¹