Chapter 5

Index Numbers
 Index Numbers

• An index number measures the relative change

in price, quantity, value, or some other item of
interest from one time period to another.
• A simple index number measures the relative
change in just one variable.
• Price index number are helpful in understanding
and interpreting changing economic and business
conditions over time.
 Introduction
• An index number is a statistical value that measures the
change in a variable with respect to time
• Two variables that are often considered in this analysis
are price and quantity
• With the aid of index numbers, the average price of
several articles in one year may be compared with the
average price of the same quantity of the same articles
in a number of different years
• There are se eral sour es of offi ial statisti s that
contain index numbers for quantities such as food
prices, clothing prices, housing, wages and so on
 Simple index numbers
• We will examine index numbers that are constructed
from a single item only
• Such indexes are called simple index numbers
• Current period = the period for which you wish to find
the index number
• Base period = the period with which you wish to
compare prices in the current period
• The choice of the base period should be considered
very carefully
• The choice itself often depends on economic factors
1. It should e a or al period ith respe t to the rele a t
index
2. It should not be chosen too far in the past
 Simple index numbers
• The notation we shall use is:
– P1 = the price of an item in the current period
– Po = the price of an item in the base period

• Price relative
– The price relative of an item is the ratio of the price
of the item in the current period to the price of the
same item in the base period
– The formal definition is:

IS 
P1
po
 Simple index numbers
• The simple price index finds the percentage change in the price of an item
from one period to another

– If the simple price index is more than 100, subtract

100 from the simple price index. The result is the
percentage increase in price from the base period to
the current period

– If the simple price index is less than 100, subtract the

simple price index from 100. The result is the
percentage by which the item cost less in the base
period than it does in the current period
 Composite index numbers
• A composite index number is constructed from changes in a number of
different items

• Simple aggregate index

– the simple aggregate index has appeal because its
nature is simplistic and it is easy to find
– The formal definition is:


P
 100
P 1
IC
o

SP1 = the sum of the prices in the current period

Where

SPo = the sum of the prices in the base period

 Composite index numbers
• Si ple aggregate i dex co t…
– Even though the simple aggregate index is easy to
calculate, it has serious disadvantages:
1. An item with a relatively large price can dominate the index
2. If prices are quoted for different quantities, the simple aggregate index
will yield a different answer
3. It does not take into account the quantity of each item sold

– Disadvantage 2 is perhaps the worst feature of this

index, since it makes it possible, to a certain extent,
to manipulate the value of the index
 Weighted index numbers
• The use of a weighted index number or weighted index allows greater
importance to be attached to some items
• Information other than simply the change in price over time can then be
used, and can include such factors as quantity sold or quantity consumed
for each item

• Laspeyres index
– The Laspeyres index is also known as the average
of weighted relative prices
– In this case, the weights used are the quantities of
each item bought in the base period
 Weighted index numbers
– The formula is:


P Q
  100
PQ 1 o
IL
o o

Where:
Qo = the quantity bought (or sold) in the base period
P1 = price in current period
Po = price in base period

– Thus, the Laspeyres index measures the relative change in

the cost of purchasing these items in the quantities specified
in the base period
 Weighted index numbers
• Paasche index
– The Paasche index uses the consumption in the current
period
– It measures the change in the cost of purchasing items,
in terms of quantities relating to the current period
– The formal definition of the Paasche index is:

P Q
  100
PQ1 1
IP
o 1

Where:
P1 = the price in the current period
Po = the price in the base period
Q1 = the quantity bought (or sold) in the current period
 Weighted index numbers
• Comparison of the Laspeyres and Paasche indexes

– The Laspeyres index measures the ratio of expenditures on

base year quantities in the current year to expenditures on
those quantities in the base year
– The Paasche index measures the ratio of expenditures on
current year quantities in the current year to expenditures
on those quantities in the base year

– Since the Laspeyres index uses base period weights, it may

overestimate the rise in the cost of living (because people
may have reduced their consumption of items that have
become proportionately dearer than others)
 Weighted index numbers
• Comparison of the Laspeyres and Paasche i dexes co t…

– Since the Paasche index uses current period weights,

it may underestimate the rise in the cost of living
– The Laspeyres index is usually larger than the Paasche
index
– With the Paasche index it is difficult to make year-to-
year comparisons, since every year a new set of
weights is used
– The Paasche index requires that a new set of weights
be obtained each year, and this information can be
expensive to obtain
– Because of the last 2 points above, the Laspeyres
index is the one most commonly used
 Weighted index numbers
• Fisher’s ideal i dex
– Fisher’s ideal i dex is the geometric mean of the
Laspeyres and Paasche indexes
– Although it has little use in practice, it does
demonstrate the many different types of index that
can be used
– The formal definition is:

Fisher' s index  Laspeyres index Paasche index 

 I L  I S 100
 Example: Besco Products
• Price Relatives
The prices Besco paid for newspaper and
television ads in 1992 and 1997 are shown below.
Using 1992 as the base year, compute a 1997
price index for newspaper and television ad
prices.
1992 1997
Newspaper $14,794 $29,412
Television 11,469 23,904
 Example: Besco Products
• Price Relatives
Newspaper Television

 (100)  199
29,412
I
1997 14,794

Television advertising cost increased at a

greater rate.
 Example: City of Newton
• Aggregate Price Indexes
Data on energy consumption and expenditures
by sector for the city of Newton are given below.
Construct an aggregate price index for energy
expenditures in 2000 using 1985 as the base year.
Quantity (BTU) Unit Price ($/BTU)
Sector 1985 2000 1985 2000
Residential 9,473 8,804 $2.12 $10.92
Commercial 5,416 6,015 1.97 11.32
Industrial 21,287 17,832 .79 5.13
Transport. 15,293 20,262 2.32 6.16
 Example: City of Newton
• Unweighted Aggregate Price Index (composit)
I2000 = 10.92 + 11.32 + 5.13 + 6.16 (100) = 466
2.12 + 1.97 + .79 + 2.32
• Weighted Aggregate Index (Laspeyres Method)
I2000 = 10.92(9473) + . . . + 6.16(15293) (100) = 443
2.12(9473) + . . . + 2.32(15293)
• Weighted Aggregate Index (Paasche Method)
I2000 = 10.92(8804) + . . . + 6.16(20262) (100) = 415
2.12(8804) + . . . + 2.32(20262)
The Paasche value being less than the Laspeyres
indicates usage has increased faster in the lower-
priced sectors.