ndex number- Characteristics, types, uses and limitation

Index Numbers: Characteristics, Formula, Examples, Types,

Importance and Limitations

Meaning of Index Numbers:

The value of money does not remain constant over time. It rises or falls
and is inversely related to the changes in the price level. A rise in the
price level means a fall in the value of money and a fall in the price level
means a rise in the value of money. Thus, changes in the value of
money are reflected by the changes in the general level of prices over a
period of time. Changes in the general level of prices can be measured by
a statistical device known as ‘index number.’

Index number is a technique of measuring changes in a variable or group

of variables with respect to time, geographical location or other
characteristics. There can be various types of index numbers, but, in the
present context, we are concerned with price index numbers, which
measures changes in the general price level (or in the value of money)
over a period of time.

Price index number indicates the average of changes in the prices of

representative commodities at one time in comparison with that at some
other time taken as the base period. According to L.V. Lester, “An index
number of prices is a figure showing the height of average prices at one
time relative to their height at some other time which is taken as the base
period.”

Features of Index Numbers:

The following are the main features of index numbers:

(i) Index numbers are a special type of average. Whereas mean, median
and mode measure the absolute changes and are used to compare only
those series which are expressed in the same units, the technique of
index numbers is used to measure the relative changes in the level of a
phenomenon where the measurement of absolute change is not possible
and the series are expressed in different types of items.

(ii) Index numbers are meant to study the changes in the effects of such
factors which cannot be measured directly. For example, the general price
level is an imaginary concept and is not capable of direct measurement.
But, through the technique of index numbers, it is possible to have an
idea of relative changes in the general level of prices by measuring
relative changes in the price level of different commodities.

(iii) The technique of index numbers measures changes in one variable or

group of related variables. For example, one variable can be the price of
wheat, and group of variables can be the price of sugar, the price of milk
and the price of rice.

(iv) The technique of index numbers is used to compare the levels of a

phenomenon on a certain date with its level on some previous date (e.g.,
the price level in 1980 as compared to that in 1960 taken as the base
year) or the levels of a phenomenon at different places on the same date
(e.g., the price level in India in 1980 in comparison with that in other
countries in 1980).

Steps or Problems in the Construction of Price Index Numbers:

The construction of the price index numbers involves the following steps
or problems:

1. Selection of Base Year: The first step or the problem in preparing the
index numbers is the selection of the base year. The base year is defined
as that year with reference to which the price changes in other years are
compared and expressed as percentages. The base year should be a
normal year.

In other words, it should be free from abnormal conditions like wars,

famines, floods, political instability, etc. Base year can be selected in two
ways- (a) through fixed base method in which the base year remains
fixed; and (b) through chain base method in which the base year goes on
changing, e.g., for 1980 the base year will be 1979, for 1979 it will be
1978, and so on.

2. Selection of Commodities: The second problem in the construction

of index numbers is the selection of the commodities. Since all
commodities cannot be included, only representative commodities should
be selected keeping in view the purpose and type of the index number.

In selecting items, the following points are to be kept in mind:

(a) The items should be representative of the tastes, habits and customs
of the people.

(b) Items should be recognizable,

(c) Items should be stable in quality over two different periods and places.

(d) The economic and social importance of various items should be

considered

(e) The items should be fairly large in number.

(f) All those varieties of a commodity which are in common use and are
stable in character should be included.
3. Collection of Prices: After selecting the commodities, the next
problem is regarding the collection of their prices:

(a) From where the prices to be collected;

(b) Whether to choose wholesale prices or retail prices;

(c) Whether to include taxes in the prices or not etc.

While collecting prices, the following points are to be noted:

(a) Prices are to be collected from those places where a particular

commodity is traded in large quantities.

(b) Published information regarding the prices should also be utilised,

(c) In selecting individuals and institutions who would supply price

quotations, care should be taken that they are not biased.

(d) Selection of wholesale or retail prices depends upon the type of index
number to be prepared. Wholesale prices are used in the construction of
general price index and retail prices are used in the construction of cost-
of-living index number.

(e) Prices collected from various places should be averaged.

4. Selection of Average: Since the index numbers are, a specialised

average, the fourth problem is to choose a suitable average. Theoretically,
geometric mean is the best for this purpose. But, in practice, arithmetic
mean is used because it is easier to follow.

5. Selection of Weights: Generally, all the commodities included in the

construction’ of index numbers are not of equal importance. Therefore, if
the index numbers are to be representative, proper weights should be
assigned to the commodities according to their relative importance.

For example, the prices of books will be given more weightage while
preparing the cost-of-living index for teachers than while preparing the
cost-of-living index for the workers. Weights should be unbiased and be
rationally and not arbitrarily selected.

6. Purpose of Index Numbers: The most important consideration in the

construction of the index numbers is the objective of the index numbers.
All other problems or steps are to be viewed in the light of the purpose for
which a particular index number is to be prepared. Since, different index
numbers are prepared with specific purposes and no single index
number is ‘all purpose’ index number, it is important to be clear about
the purpose of the index number before its construction.
7. Selection of Method: The selection of a suitable method for the
construction of index numbers is the final step.

There are two methods of computing the index numbers:

(a) Simple index number and

(b) Weighted index number.

Simple index number

Simple index number again can be constructed either by – (i) Simple

aggregate method, or by (ii) simple average of price relative’s method.
Similarly, weighted index number can be constructed either by (i)
weighted aggregative method, or by (ii) weighted average of price
relative’s method. The choice of method depends upon the availability of
data, degree of accuracy required and the purpose of the study.

Types of Index Numbers:

Index numbers are of different types. Important types of index numbers

are discussed below:

1. Wholesale Price Index Numbers: Wholesale price index numbers

are constructed on the basis of the wholesale prices of certain important
commodities. The commodities included in preparing these index numbers
are mainly raw-materials and semi-finished goods. Only the most
important and most price-sensitive and semi- finished goods which are
bought and sold in the wholesale market are selected and weights are
assigned in accordance with their relative importance. The wholesale
price index numbers are generally used to measure changes in the value
of money. The main problem with these index numbers is that they
include only the wholesale prices of raw materials and semi-finished
goods and do not take into consideration the retail prices of goods and
services generally consumed by the common man. Hence, the wholesale
price index numbers do not reflect true and accurate changes in
the value of money.

2. Retail Price Index Numbers: These index numbers are prepared to

measure the changes.in the value of money on the basis of the retail
prices of final consumption goods. The main difficulty with this index
number is that the retail price for the same goods and for continuous
periods is not available. The retail prices represent larger and more
frequent fluctuations as compared to the wholesale prices.

3. Cost-of-Living Index Numbers: These index numbers are

constructed with reference to the important goods and services which are
consumed by common people. Since the number of these goods and
services is very large, only representative items which form the
consumption pattern of the people are included. These index numbers are
used to measure changes in the cost of living of the general public.

4. Working Class Cost-of-Living Index Numbers: The working class

cost-of-living index numbers aim at measuring changes in the cost of
living of workers. These index numbers are consumed on the basis of only
those goods and services which are generally consumed by the working
class. The prices of these goods and index numbers are of great
importance to the workers because their wages are adjusted according to
these indices.

5. Wage Index Numbers: The purpose of these index numbers is to

measure time to time changes in money wages. These index numbers,
when compared with the working class cost-of-living index numbers,
provide information regarding the changes in the real wages of the
workers.

6. Industrial Index Numbers: Industrial index numbers are constructed

with an objective of measuring changes in the industrial production. The
production data of various industries are included in preparing these index
numbers.

Uses of index numbers in the economic field

(a) They are useful in analysing markets for specific commodities.

(b) In the share market, the index numbers can provide data about the
trends in the share prices,

(c) With the help of index numbers, the Railways can get information
about the changes in goods traffic.

(d) The bankers can get information about the changes in deposits by
means of index numbers.

Limitations of Index Numbers:

Index number technique itself has certain limitations which have greatly
reduced its usefulness:

(i) Because of the various practical difficulties involved in their

computation, the index numbers are never cent per cent correct.

(ii) There are no all-purpose index numbers. The index numbers prepared
for one purpose cannot be used for another purpose. For example, the
cost-of-living index numbers of factory workers cannot be used to
measure changes in the value of money of the middle income group.
(iii) Index numbers cannot be reliably used to make international
comparisons. Different countries include different items with different
qualities and use different base years in constructing index numbers.

(iv) Index numbers measure only average change and indicate only broad
trends. They do not provide accurate information.

(v) While preparing index numbers, quality of items is not considered. It

may be possible that a general rise in the index is due to an improvement
in the quality of a product and not because of a rise in its price.