The Ideal Log-Change Index Number

Abstract

RICE and quantum indexes (P, Q) are dual to each other if PQ = E where E is the expenditure index. They satisfy the weak factor reversal test.' If they share an identical weighting formula as weighted averages of price and quantity relatives, they satisfy the strong factor reversal test, that is, they are ideal. The most celebrated ideal economic index is the one associated with the name of Irving Fisher though it was discovered before him. No ideal index as simple as Fisher's has been discovered since. Log-change index numbers have become increasingly popular in recent years, particularly as an approximation to the theoretically desirable Divisia index. Theil (1973) proposed a new log-change index number that alhnost satisfies the strong factor reversal test. I derived several alternative formulas that improve in the degree of approximation (Sato, 1974b). But neither Theil nor I was able to obtain the ideal log-change index. In section II, I report its discovery. Our pessimism has proved premature. Indeed, the formula was self-evident from the very beginning -we simply failed to see it.2 There are dual dualities between economic indexes and homothetic preferences (Samuelson and Swamy, 1974). A price or quantum index is associated with a homothetic indirect or direct preference ordering. If P and Q are dual to each other, so are the direct and indirect preference orderings corresponding to them. If P and Q are ideal, the latter are not only dual but also share an identical mathematical form. They are strictly self-dual as I call them elsewhere.3 An obvious example is the association of Cobb-Douglas indexes and preferences. A less obvious example is the association of Fisher's ideal indexes and quadratic preferences. The association itself was discovered by Konuis and Buscheguence a half century ago in 1926.4 Note that homothetic quadratic preferences are self-dual. Then, what is the selfdual preference ordering that corresponds to our ideal log-change index? We shall show in section III that it is the CES function that has become so popular in the economic literature, originally discussed by Bergson (1936), rediscovered by Solow (1956), and popularized by Arrow et al. (1961). The CES function is known to be self-dual (Samuelson, 1965) and yet the economic index associated with it has eluded discovery until now. Economic indexes are useful because they apply even when underlying preferences are not homothetic.5 We shall show in section IV that the ideal log-change index corresponds to the addilog preference ordering introduced by Houthakker (1960).