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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.
Consider a global event, for instance, a pandemic, that affects crude oil supply around the world. This causes the prices of certain fuels to increase. Gasoline increases from $1 per liter to $2 per liter, Diesel increases from $1.5 per liter to $3 per liter, and Kerosene increases from $0.5 per liter to $1 per liter. How do we determine the increase in the price of fuels?
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.
The market basket is a hypothetical set of goods and services typically purchased by consumers.
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.
Let's assume that the typical consumer uses a gasoline-fueled car, a diesel-fueled lawn mower, and kerosene for their fireplace. The consumer buys 70 liters of gasoline at $1 per liter, 15 liters of diesel at $1.5 per liter, and 5 liters of kerosene at $0.5 per liter. What is the cost of the market basket?
The cost of the market basket is the sum of the prices of all the goods and services in their typical quantities.
Take a look at Table 1 below to help you answer the question in the example above.
| Goods | Price |
| Gasoline (70 liters) | $1 |
| Diesel (15 liters) | $1.5 |
| Kerosene (5 liters) | $0.5 |
| Market Basket | \((\$1\times70)+(\$1.5\times 15)+(\$0.5\times5)=\$95\) |
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.
Let's assume that the typical consumer uses a gasoline-fueled car, a diesel-fueled lawn mower, and kerosene for their fireplace. The consumer buys 70 liters of gasoline at $1 per liter, 15 liters of diesel at $1.5 per liter, and 5 liters of kerosene at $0.5 per liter. However, the prices of gasoline, diesel, and kerosene have increased to $2, $3, and $1, respectively. What is the change in the cost of the market basket?
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!
| Goods | Old Price | New Price |
| Gasoline (70 liters) | $1 | $2 |
| Diesel (15 liters) | $1.5 | $3 |
| Kerosene (5 liters) | $0.5 | $1 |
| Market Basket | \((\$1\times70)+(\$1.5\times 15)+(\$0.5\times5)=\$95\) | \((\$2\times70)+(\$3\times 15)+(\$1\times5)=\$190\) |
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:
\(\hbox{Price Index for Year 2}=\frac{\hbox{Cost of Market Basket for Year 2}}{\hbox{Cost of Market Basket for Base Year}}\times100\)
Year 2 is a placeholder for the year in question.
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.
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.
| Goods | Old Price | New Price |
| Gasoline (70 liters) | $1 | $2 |
| Diesel (15 liters) | $1.5 | $3 |
| Kerosene (5 liters) | $0.5 | $1 |
| Market Basket | \((\$1\times70)+(\$1.5\times 15)+(\$0.5\times5)=\$95\) | \((\$2\times70)+(\$3\times 15)+(\$1\times5)=\$190\) |
Table 3. Market Basket Example
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.
The inflation rate is the annual percentage change in the consumer price index.
Let's take a look at the market basket table below.
| Goods | Price in Year 1 | Price in Year 2 |
| Gasoline (70 liters) | $1 | $2 |
| Diesel (15 liters) | $1.5 | $3 |
| Kerosene (5 liters) | $0.5 | $1 |
| Market Basket | \((\$1\times70)+(\$1.5\times 15)+(\$0.5\times5)=\$95\) | \((\$2\times70)+(\$3\times 15)+(\$1\times5)=\$190\) |
Table 4. Market Basket Example
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:
- Determine the general price level.
- Calculate the consumer price index.
- 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
Market Basket and Inflation
Due to the recent inflation experienced after the Covid-19 pandemic, there have been significant changes in the CPI for the USA2, as shown in Figure 4 below.
Fig. 4 - USA CPI Change Rate from 2012 to 2021. Source: Federal Reserve Bank of Minneapolis2
The effect of inflation can be seen as the high spike after 2019.
You should read our articles on Inflation and Types of Inflation to see the market basket being used in practice!
Market Basket - Key takeaways
- The market basket is a set of goods and services typically purchased by consumers.
- The cost of the market basket is the sum of the prices of all the goods and services in their typical quantities.
- The price index is a normalized measure of the change in market basket cost between a given year and a base year.
- The inflation rate is the annual percentage change in the consumer price index.
- The market basket simplifies the measurement of the price level in the economy.
References
- Bureau of Labor Statistics, Consumer Expenditures - 2021, https://www.bls.gov/news.release/pdf/cesan.pdf
- Federal Reserve Bank of Minneapolis, Consumer Price Index, https://www.minneapolisfed.org/about-us/monetary-policy/inflation-calculator/consumer-price-index-1913-
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Frequently Asked Questions about Market Basket
What is the meaning of market basket?
The market basket is a hypothetical set of goods and services typically purchased by consumers.
What is market basket analysis explain with example?
The market basket is a hypothetical set of goods and services typically purchased by consumers. Market basket analysis is used to determine the general price level. For example, if consumers typically buy gasoline, diesel, and kerosene, the market basket combines the prices of these products as the general price level.
What is the purpose of the Market Basket?
The market basket is used to determine the general price level in an economy.
What are three metrics used in market basket analysis?
Market basket analysis uses the prices of products, the typical quantities bought, and their relative weights.
Which is the most important application of market basket analysis?
Market basket analysis is applied in determining the general price level, the consumer price index, and the inflation rate.
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