Statistics for Management Unit 15

Unit 15 Index Number

Structure:
15.1 Introduction
Objectives
Relevance
Statistics in practise
15.2 Definition of an Index Number
Relative
Classification of Index Numbers
Base year and Current year
Chief characteristics of Index Numbers
Main steps in the construction of Index Numbers
15.3 Methods of Computation of Index Numbers
Unweighted Index Numbers
Weighted Index Numbers
15.4 Tests for Adequacy of Index Number
15.5 Cost of Living Index or Consumer Price Index
Utility of Consumer Price Index Numbers
Assumptions of Cost of living Index Numbers
Steps in construction of Cost of living Index Numbers
15.6 Methods of constructing Consumer Price Index
Aggregate expenditure method
Family budget method
15.7 Limitations of Index Numbers
15.8 Utility and Importance of Index Numbers
15.9 Summary
15.10 Glossary
15.11 Terminal Questions
15.12 Answers
15.13 Case Study

15.1 Introduction
In the previous unit, we studied about the definition and components of time
series. We also studied about different forecasting methods using time
series analysis. In this unit, we will discuss about the meaning and definition

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of index numbers. We will also study the different kinds of index numbers
and their limitations.
We know that almost all values change and so we wish to know the
changes taken place over a period of time. For example, we may want to
know how much the price of various essential household items increase or
decrease to make necessary adjustments to the monthly budget.
Consequently, in all such situations, an average measure needs to be
defined to compare such difference over a time period. Index numbers are
yardsticks for describing such differences. These differences may have to
do with the physical quantities of the goods, the prices of the commodities,
or such concepts as ‘efficiency’, ‘intelligence’ or beauty’. The comparison
may be between the periods of time, between places, between categories,
etc.
We can have index numbers comparing the cost of living at different times
or in different localities or countries. Index numbers are used in comparison
of the physical volume of production in different years. However, we must
confine most of our attention to the construction of index numbers
measuring changes over time.
Objectives:
After studying this unit, you should be able to:
 represent a data set in an index number form
 describe how much the economic variables have changed over time
 describe three principal types of indices: price indices, quantity indices,
and value indices
 calculate various kinds of index numbers
15.1.1 Relevance
The CEO of Bestview television was quite happy with the excellent growth in
the company’s television sales. However, he was confronted by the
employees union and the officers association to increase the pay package
every quarter in order to compensate for the cost of living, as reflected by
the wholesale and consumer price indices, released by the government of
India. After being apprised of the calculation of these indices, the CEO felt
that these indices, which were for all of India, might not be relevant for his
company, as all of its operations were at one location near Mumbai. He
therefore asked the HRD department to coordinate with the management
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information system and to evolve an index that could be more sensitive to

the expenditure pattern of his officers and other staff. Accordingly in
consultation with the employees union and the officers association, two
different costs of living indices were evolved for the two categories of staff in
the company. This one can be done by adopting the broad methodology of
choosing items, deciding their weights and recording of prices, etc.
15.1.2 Statistics in practise
The US Department of labour through the bureau of labour statistics
compiles and distributes indexes and statistics that are indicators of
business and economic activity in the United States. For instance, the
bureau complies and publishes the consumer price index, the product price
index, and statistics on average hours and earning of various groups of
workers. Perhaps the most widely quoted index produced by the bureau of
labour statistics is the consumer price index which is often used as a
measure of inflation. Another indicator to show that inflationary pressures
would be low in the near future was given by the producer price index. It
measures price changes in wholesale markets and is often seen as a
leading indicator of changes in the consumer price index. The producer
price index fell by 2% during August. Federal Reserve policymakers had
raised the overnight bank lending rate six times since June 1999. However,
with the data that prices were not rising rapidly, the interest rates were
expected to remain unchanged for the near future. Many economists and
analysts proclaimed that consumer price index report confirmed that the
United States was in noninflationary era. In addition to the CPI report, they
focused on very little upward pressure on wages. The labour department
also reported that average weekly earnings adjusted for inflation rose only
by 1% in August after being unchanged in each of the prior two months.
In this chapter we will discuss how various indices such as the consumer
and product price index are computed and how they should be interpreted.

15.2 Definition of an Index Number

An index number is a number which is used to measure the level of a
certain phenomenon as compared to the level of the same phenomenon at
some standard period. In other words, an index number is a number which
is used as a device for comparison between the price, quantity or value of a

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group of articles in different situations for example, at a certain place or a

period of time and that of another place or period of time.

Key statistic
An index number is a statistical measure which is designed to express
changes or differences in a variable or a group of related variables. It is
usually expressed in percentage form.

When a comparison is with respect to prices, it is called an index number of

price, when it is with respect to physical quantities; it is named as index
number of quantities. Other index numbers are defined in the similar
manner. The index numbers are meant for comparison of variations arising
out of the difference in situations, for example, change of time or change of
place.
15.2.1 Relative
The value of a variable in a given year (or place) divided by the value of the
same variable in a specified year (or place) is called a relative. It is generally
expressed in percentage.
I. Price relative
The price of commodity in a given year expressed as a percentage of the
price of the same commodity in a specified year is called price relative.

Solved Problem 1:
The price of a commodity in India in 2001 was Rs. 95 per kg and in 2000 it
was Rs.80 per kg. Calculate the price relative for the year 2001.
Solution: The price relative for 2001, (using 2000 as base) is calculated as:
95
Price relative for 2001   100  118 .75 %
80
Hence, the price relative for 2001 is 118.75 %.
II. Production relative
Let us understand production relative with an example.
Solved Problem 2:
If the wheat production in India in 2002 was 5,82,000 metric tons and in
2004, it was 6,96,000 metric tons, then calculate the production relative for
2004.

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Solution: Let us take the production of 2002 as base.

696000
Production relative for 2004  100  119 .6%
582000
Hence, the production relative for 2004 is 119.6 %.
III. Quantity relative
The quantity (q1) of a commodity consumed in a given year expressed as a
percentage of the quantity (q0) of the same commodity consumed in a
specified year is called quantity relative. Thus,
q1
Quantity relative   100
q0

IV. Value relative

If ‘p1’ and ‘q1’ are the price and quantity respectively for a commodity in a
given year and ‘p0’ and ‘q0’ are the specified price and quantity respectively
of the same commodity, in a specified year, then the value of the given year,
‘V1’ and the value of the specified year, ‘V0’ are calculated as:
V1 = p1 q1
V0 = p0 q0
The value relative of the given year with respect to the specified year is
calculated as the ratio of ‘V1’ to ‘V0’, and then the ratio is multiplied with 100.
That is,
V pq
Value relative  1  100  1 1  100
V0 p 0 q0

The overall change in price, production, quantity or value, etc, is

represented by these typical summaries which are known as relatives.
15.2.2 Classification of Index Numbers
There are various approaches for classification of index numbers. They are:
a. Based on Variables
Price index: When the variable is price.
Quantity index: When the variable is quantity.
Value index: When the variable is value.
Production index: When the variable is production.

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b. Based on retail or wholesale prices

Cost of living index number: Where we use retail prices.
Wholesale price index number: Where we use wholesale prices.
c. Based on weights
Simple (unweighted) index number
Weighted index number
d. Based on number of commodities
When the number of commodities is more than one, then we obtain a
single (combined) index number. This can be done in four ways:
 Simple average of relatives
 Weighted average of relatives
 Simple aggregate
 Weighted aggregate
15.2.3 Base year and current year
In the computation of an index number we require two years (or places).
The given year whose values are to be compared is called a current year (or
current period) and the specified year whose values are taken as standard
(for example, 100) is called a base year (base period).

Example 1:
If the prices of 2005 are compared with the prices of 2004, then 2005 is
the current year and 2004 is the base year. The index number of 2005
based on 2004, is denoted by ‘Q01’ or ‘P01’, where subscript ‘0’ stands for
the year 2004, and subscript ‘1’ stands for the year 2005.

15.2.4 Chief Characteristics of Index Numbers

1. Expressed in numbers
Index numbers represent the relative changes such as increase in
production; reduction in prices etc. in the numbers.
2. Expressed in percentage
Index numbers are expressed in terms of percentages so as to show the
extent or relative change where the value of base is assumed to be 100 but
the sign of percentage (%) is not used.
3. Relative measure
Index numbers measure changes which are not capable of direct
measurement.

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4. Specified averages
Index number represents a special case of average, in general known as
weighted average. It is a special type of average, because in a simple
average, the data is homogenous having the same unit of measurement,
whereas the average variables have different units of measurement.
5. Basis of comparison
Index numbers by their very nature are comparative. They compare
changes over time or between places or similar categories.
15.2.5 Main steps in the construction of index numbers
To follow the steps many problems are encountered which are to be
discussed carefully. There are many difficulties in following the steps
involved in the construction of index numbers. The following steps are
discussed in detail.
1. Purpose of index number
The steps which are taken in the construction of index numbers generally
depend on the purpose of the index number. Hence, the purpose of index
numbers must be defined clearly and precisely. For example, the purpose of
the general index number of wholesale price index number is to know the
general price level. On the other hand, the purpose of the consumer price
index number is to give an idea of the effect of the change in retail prices on
the cost of living in the classes of people.
2. Selection of base period
The base period of an index number is the period of time against which the
comparisons are made. There are three types of base periods.
Fixed base (a single period)
Fixed base (an average of selected periods)
Chain base
While selecting the base, a decision has to be made to decide whether we
have fixed base or chain base.
Fixed base (a single period): In a fixed base (a single period), the base
period must be a normal period. A normal period means that the period
must be free from all sorts of abnormalities or random causes such as
financial crisis, floods, famines, earth quakes, strikes of labourers, wars, etc.

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The base period should be a period for which reliable figures are available.
The base period should not be too distant in the past.
Fixed base (an average of selected periods): When it is difficult to choose
just one single period as the normal, then a better choice is an average of
several periods.
Chain base: If the comparisons are required from year to year, a system of
chain base is used.
3. Selection of commodities
The following problems can occur while selecting the commodities.
First problem is the selection of commodities because it is not feasible to
include all commodities. The purpose of the index number is to help in
deciding the number of commodities.
Another problem is to decide on which commodities are to be included. A
careful selection of the commodities must be made in such a way that:
 It should represent the real tastes, habits and the customs of the people.
 It should be of a standard quality and there must be no significant
variation in the quality.
 It must be easily recognisable.
 It should not be a non-tangible commodity such as personal service.
4. Selection of the representative prices
In the collection of price quotations we have to consider the following points:
 The method of quoting prices of the commodities
 The type of quotations - whether wholesale prices or retail prices
 The place from where the quotations are to be obtained
5. Assignment of Weights
The term ‘weight’ refers to the relative importance of the different
commodities included in the construction of index numbers. There are two
methods of assigning weights. They are:
Implicit method: In this method, several varieties of a certain type of
commodity under study are used. Such weights are called implicit weights.
Explicit method: In this method, the weights are laid down on the basis of
one outward evidence of importance of commodities. One of the problems in
the selection of appropriate weight is to decide this evidence. Another

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problem with regard to the system of weighing is whether weights should be

fixed or fluctuating.
6. Selection of the average
To find composite index number we can use any average such as arithmetic
mean, geometric mean, harmonic mean, median and mode. The use of an
average depends on the relative merits and demerits of the various
averages. The average may be weighted or unweighted.
7. Selection of suitable formula
There are various formulae for computing index numbers so the selection of
a suitable formula also poses some problem. A particular formula is suitable
in a particular situation.

15.3 Methods of Computation of Index Numbers

The various methods of constructing index numbers can be classified into
two groups. They are:
a. Unweighted index numbers
b. Weighted index numbers
In Unweighted index numbers, each item is supposed to have the same
weight but in weighted index numbers the weights are assigned to various
items in accordance with their importance. Figure 15.1 illustrates the further
classification of methods of constructing index numbers.

Fig. 15.1: Methods of Constructing Index Numbers

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Unweighted index numbers can be further divided into two categories. They
are:
I. Simple aggregative method
II. Simple average of relatives method
Weighted index numbers can also be further divided into two categories.
They are:
I. Weighted aggregative method
II. Weighted average of relatives method
15.3.1 Unweighted index numbers
i. Simple aggregative method
To construct a price index by simple aggregative method, we proceed by
doing the following:
Add the prices of all commodities in the current year, that is, find P1
Add the prices of all commodities in the base year, that is, P0
Divide the total of current year prices by the total of base year prices and
multiply the quotient by 100, that is,
P
P01  1  100
P0
where, ‘P01’ is the simple price index number of current year based on
base year.

Solved Problem 3:
Find the simple aggregative price index from the data displayed in table
15.1.
Table 15.1: Price of Commodities for the Years 2000 and 2004
Price in Rs. per unit
Commodity Unit
2000 2004
A One kilogram 10 15
B One kilogram 40 30
C One dozen 10 12
D One litre 5 13
Total 65 70
Solution: The price index number of 2004 is based in 2000. Using the
formula:
P
P  1
100
01 P
0

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Where, P1 = total of prices in 2004 = 70

P0 = total of prices in 2000 = 65

Therefore,
70
P01   100  107.7
65

This implies that the prices had increased by 7.7% in the year 2004 as
compared to the year 2000.
Table 15.1 depicts the merits and demerits of simple aggregative method.

Table 15.2: Merits and Demerits of Simple Aggregative Method

Merits Demerits
This is the simplest method of This method gives inappropriate results when
constructing index numbers. the prices of different commodities are quoted in
different units.
It is simple and easy to Since weights are not used, this method does
understand. not give any consideration to the relative
importance of commodities.
It requires simple Index number calculated by this method is
calculations. unduly affected by high or low values.

Self Assessment Question

1. Find out the price index number using simple aggregate method for the
data represented in table 15.3.
Table 15.3: Price of the Commodities for Years 2001 and 2002

Price in Rs. per quintal

Commodity Base year Current year
2001 2002
Wheat 80 100
Rice 120 250
Gram 100 150
Pulses 200 300

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ii. Simple average of relative method

To construct a price index by this method, we proceed by doing the

following:
Obtain the price relative for each commodity, which is calculated as:
Pr ice of current year
Pr ice relative for current year   100
Pr ice of base year
P1
R  100
P0
Calculation of arithmetic mean, geometric mean for the price relatives
denoted it by ’P01’ is given by:
When arithmetic mean is used:
1  P1  R
=
P    100
01 N P  N
 0 
When geometric mean is used:
 log R
P  Anti log
01 N

Solved Problem 4:
The prices of three different commodities for 2002 and 2003 are displayed in
table 15.4. The price given is per each ton of the commodity. Taking the
year 2002 as base, calculate the price index by using the simple average of
relatives method by using both arithmetic mean and geometric mean.

Table 15.4: Prices of Commodities for 2002 and 2003

Commodity Corn Wheat Cocoa

Price in 2002 800 500 900
Price in 2003 880 480 940

Solution: Table 15.4a represents the calculated values for determining

price index.

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Table 15.4a: Calculated Values for Determining Price Index

Price
Price Price Relative log
Commodity in 2002 in 2003 P
R  1  100 R
Po P1
Po
Corn 800 880 880 2.04
 100  110
800
Wheat 500 480 480 1.98
 100  96
500
Cocoa 900 940 940 2.02
 100  104 .44
900
Total
P o  2200 P 1  2300  R  310.44 6.04

Simple average of relatives method by using arithmetic mean:

1 P  R
P    1 100  =
310.44
  103.48
01 N P  N 3
 0 
Simple average of relatives method by using geometric mean:
 log R 6.04
P  Anti log  Anti log  103.11
01 N 3
Hence, the price index obtained by simple average of relative method using
arithmetic mean and geometric mean are 103.48 and 103.11 respectively.
The table 15.5 depicts the merits and demerits of simple average of relative
method.
Table 15.5: Merits and Demerits of Simple Average of Relative Method
Merits Demerits
It is not affected by units in which As it is an unweighted average, the
prices are quoted. importance of all items is assumed to be
the same.
It is not affected by absolute values The index number constructed by this
of prices as prices are converted method does not satisfy all the criteria
into price relatives. laid down for an ideal index.
It gives equal importance to all The index number is unduly influenced
items and extreme items do not by high or low prices when arithmetic
unduly affect the index number. mean is used.
The index number calculated by More labour is involved if geometric
this method satisfies the unit test. mean is used.

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15.3.2 Weighted index numbers

To meet the weakness of the simple or unweighted method, we weigh the
price of each commodity by a suitable factor; often it is the quantity or the
volume of the commodity sold during the base year. In other words, in this
method, appropriate weights are assigned to various commodities to reflect
their relative importance in the group. The weight can be production figures,
consumption figures or distributive figures.

Key Statistic
For the construction of the price index number quantity weights are used.
If ‘w’ is the weight attached to a commodity, then the price index is given
by:
P  w
Pr ice Index P  1 100
01 P  w
0

Weighted aggregative index number

In the weighted aggregative index numbers, the weights are assigned to
various items and the weighted aggregate of the prices are obtained.
Weights are assigned in various ways and the weighted aggregates are
used in different ways for the construction of index numbers.
Some of the important methods of constructing weighted aggregative index
numbers are described below.

1. Laspeyre’s price index

Laspeyre’s method is based on fixed weights of the base year. Base
year’s quantities are used as weights.
The formula given by Laspeyre is given below.
P Q
Laspeyre' s Pr ice Index LP  1 0  100
01 P Q
0 0
Where, P1 = Current year price, P0 = Base year price,
Q0 = Quantity used for weight in the base year
This index number has an upward bias, that is, when prices increase,
there is a tendency to reduce the consumption of higher priced goods.
This index number is widely used in practical work.

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The quantity index number using Laspeyre’s formula is given by:

Laspeyre' s Quantity Index LQ 01 

Q P 1 0
 100
Q P 0 0

Solved Problem 5:
Compute Laspeyre’s price and quantity index number for the following data:

Table 15.6: Price and Quantity of commodities in the base year and current
year
Base year Current year
Commodity Price Quantity Price Quantity
A 3 25 5 28
B 1 50 3 60
C 2 30 1 30
D 5 15 6 12

Solution: Base year price and quantity are denoted by P0 and Q0 and
current year price and quantity are denoted by P1 and Q1 respectively
Table 15.6a

Commodity P0 Q0 P1 Q1 P0Q0 P1Q0 P0Q1 P1Q1

A 3 25 5 28 75 125 84 140
B 1 50 3 60 50 150 60 180
C 2 30 1 30 60 30 60 30
D 5 15 6 12 75 90 60 72
Total 260 395 264 422

Laspeyre’s price index number is given by

P Q
L P  1 0  100
01 P Q
0 0

Now substituting the values we get,

395
LP   100  151.92.
01 260

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Laspeyre’s quantity index number is given by

LQ 01 
Q P1 0
 100 
264
 100  101 .54.
Q P0 0 260

2. Paasche’s method
Paasche’s method is based on current year’s quantities. Current year’s
quantities are used as weights. Paache’s Price Index is given by:
 P1Q1
PP01  100
 P0 Q1

Where, P1 = Current year price, P0 = Base year price

Q1 = Current year quantity which are taken as weights.
This index number has downward bias. This formula is not used frequently
in practise where the number of commodities is large.
Quantity index number using Paasche’s formula is given by:
 Q1P1
PQ 01   100
 Q 0P1

Solved Problem 6: Compute Paasche’s price and quantity index number

for solved problem 5.

Solution
Paache’s Price Index is given by:
 P1Q1
PP01  100
 P0 Q1

From the table 15.6a, we have

422
PP01   100  159 .84 .
264
Paache’s quantity index is given by:
 Q1P1
PQ 01   100
 Q 0P1

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From the table 15.6a, we have

422
PQ  100  106.84.
01 395

3. Dorbish and Bowley’s method

This method is a combination of Laspeyre’s and Paasche’s method. If we
find out the arithmetic average of Laspeyre’s index and Paasche’s index,
we get the index suggested by Dorbish and Bowley. This index number
takes into account the base year’s as well as the current year’s weights.
Dorbish and Bowley’s Price Index is given by:
 P Q P Q 
 1 0  1 1
 LP  PP01  P Q P Q 
 0 0 0 1
DP   01    100
01
 
2  
2

Where, LP is Laspeyre’s price index and PP Paasche’s price index.

01 01

4. Fisher’s ideal index number

This method is a combination of Laspeyre’s and Paasche’s method. If we
find out the geometric average of Laspeyre’s index and Paasche’s index,
we get the index suggested by Fisher. Fisher’s index number is given by
  P1Q 0  P Q 
FP  LP  PP    1 1   100
 P Q 
 0 0  P0 Q1 
01 01 01

Where, LP is Laspeyre’s price index and PP is Paasche’s price index.

01 01

Solved problem 7:
For the solved example 5, compute Dorbish and Bowley’s and Fisher index
numbers.
Solution: Dorbish and Bowley’s index number is given by
 P Q P Q 
 1 0  1 1
P Q P Q 
 0 0 0 1
DP   100
01 2

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From the calculation table 15.6a we get,

 395 422 
  
 260 264 
DP   100  155.9
01 2
Fisher’s index number is given by
 P Q P Q 
FP   1 0  1 1   100
01 P Q P Q 
 0 0 0 1

Substituting the values from the table 15.6a we get,

 395 422 
FP      100  155.84
01  260 264 

The table 15.7 depicts the merits and demerits of Fishers Index Number
Table 15.7: Merits and Demerits of Fishers Index Number
Merits Demerits
It is free from bias, upward as well as This formula is difficult to interpret.
downward.
This formula takes into account both It is not a practical index to compute
current years as well as base year because it is excessively laborious.
prices and quantities.
It satisfies both ‘time several test’ as It requires the prices and quantities for
well as the ‘factor reversal test’. This base year and current year.
is why it is called an ideal index
number.

15.3.3 Quantity index numbers

The quantity index numbers measure the average storage in quantities and
enable us to compare changes in physical quantity of goods produced or
sold. These index numbers can also be simple or weighted. Therefore,
quantity index numbers can be easily obtained from price index numbers
just by interchanging P’s and Q’s in the formulae used for calculating the
price index numbers. The weighted average of relative quantity index is
given by:
 Q1  
  Q  100 Q n Pn 
 0  
Quantity index =
 n n
Q P

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where,
‘Q1’ and ‘Q0’ are the quantities for the current and base period respectively
‘Pn’ and ‘Qn’ are the prices and quantities that determine values that we use
for weights.
15.3.4 Value index numbers
The value index numbers are easy to calculate. Value is the product of price
and quantity. A simple value index number is equal to the value of the
current year divided by the value of the base year. If this value is multiplied
by 100 we get the value index number. The required formula is:
 P1Q1
V  100
 P0 Q 0
Simple value index number is given by:
 V1
V 100
 V0
where, V1 = value of the current year.
V0 = value of the base year.
Such index numbers are not weighted, because they do not take into
account either the price or the quantity. These index numbers are not very
popular because the situation revealed by price and quantities are not fully
revealed by the values.

Solved problem 8:
For the solved example 5, compute Value index number.
Solution: The formula to compute Value index number is
 P1Q1
V  100
 P0 Q 0

From the table 15.6a we have

422
V  100  162 .31 .
260
15.4 Tests for Adequacy of Index Number
1. Unit test
This test requires that the formula should be free of units. Except simple
aggregative index, all the others satisfy this test.
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2. Time reversal test

This test requires the formula for calculating the index number that should
be such that it will give the same ratio between one period of comparison
and the other. Symbolically,
P01  P10  1
This test is satisfied by Fisher’s ideal index, simple geometric mean of price
relatives, weighted geometric mean of price relatives and Marshall-
Edgeworth index number.
3. Factor reversal test
The formula should permit the interchange of price and quantity without
giving inconsistent results.
 P1Q1
P01  Q 01 
 P0 Q 0
This test is satisfied by Fisher’s ideal index
4. Circular test
It is an extension of time reversal test. The test requires that if an index is
constructed for the year ‘a’ on base year ‘b’, and for the year ‘b’ on the base
year ‘c’, we should get the same result as if we calculated directly for the
year ‘a’ on the base year ‘c’ without going through ‘b’.

Symbolically,
P01  P12  P20  1

It is satisfied by index numbers with fixed weights by aggregate methods.

15.5 Cost of Living Index or Consumer Price Index
The ‘Cost of living index’, also known as ‘consumer price index’ or ‘Cost of
living price index’ is the country’s principal measure of price change. The
Consumer price index helps us in determining the effect of rise and fall in
prices on different classes of consumers living in different areas.

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Key statistic
Cost of living price index measures average change over time in the
prices paid by the consumer for specific basket of goods and services.
The cost of living price index numbers are designed to measure the
average change in the price paid by the ultimate consumers for specified
quantities of goods and services over a period of time.

Different people consume different kinds of commodities and the same

commodities in different proportions. The consumer price index helps us in
determining the effect of size. Fall in price index helps us in determining the
effect of rise and fall in prices on different classes of consumers living in
different areas. The consumer price index number is significant because the
demand of a higher wage is based on the cost of living index and the wages
and salaries in most nations are adjusted according to this index number.
The cost of living index does not measure the actual cost of living or the
fluctuations in the cost of living due to causes other than the change in price
level. However, its object is to find out how much the consumers of a
particular class have to pay for a certain quantity of goods and services.
15.5.1 Utility of Consumer Price Index Numbers
The following are the uses of Consumer Price Index Numbers.
 It is useful to measure the change in purchasing power of currency, real
income.
 It helps the government in formulating wage policy, price policy, taxation
and general economic policies.
 Market prices for particular kinds of goods and services are analysed by
consumer price index.
 The salaries and wages are fixed on the basis of consumer price index.
So, it is very helpful to revise wage of dearness allowance.
15.5.2 Assumptions of Cost of Living Index Numbers
Cost of living index number is based on the following assumptions.
 Similar needs
The needs of the people for which this index number is constructed are
same.

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 Same goods
The goods consumed in the base years and current years remain
unchanged.
 No change in quantity of goods
It is also assumed that the quantity of goods consumed will remain
same in the base year and current year.
 Price quotations are same
It is assumed that the prices at different places are same and they do
not change frequently.
 True on the average
Cost of living index numbers are true on the average.
 Representative goods
The commodities included in the cost of living index number represent
the consumption of the class of people.
15.5.3 Steps in construction of cost of living index numbers
There are 5 steps involved in construction of cost of living index numbers.

Step 1: Select the class of people

Step 2: Define scope of the index
Step 3: Conduct family budget inquiry
Step 4: Obtain price quotations
Step 5: Prepare a frame or list of persons

15.6 Methods of Constructing Consumer Price Index

There are two methods for constructing consumer price index number. They
are:
I. Aggregate expenditure method
II. Family budget method or method of weighted average of price
relatives.
I. Aggregate Expenditure Method
This method is based on Laspeyre’s method where the base year quantities
are taken as weights (w = Q0).
P Q
P  1 0
100
01 P Q
0 0

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II. Family budget method

Family budget method or the method of weighted relatives is the method
where weights are the Value (P0Q0) in the base year often denoted by W.

 PW P
P , where P  1  100 for each item and

01 W P0
W= value weight, i.e., P0Q0
Solved problem 9:
Calculate the cost of living index for the current year on the basis of the
base year from the following data, using
(a) Aggregate expenditure method and (b) Family budget method
Table 15.8: Data for problem 9
Quantity Price in rupees
Article Consumed in Unit Base year Current
the Base Year
year
Wheat 8 Kgs 16 17.2
Rice 4 Kgs 12.2 13.5
Pulses 2 Kgs 7.25 8.50
Milk 16 Lts 2 2
Sugar 3 Kgs 24 25

Solution:
Table 15.8a: Table for calculating cost of living index
Quantity Price in rupees
Article Consumed
Base year Current
in the
year
Base Year
P0 P1 P0Q0 P1Q0
Q0
Wheat 8 16 17.2 128 137.6
Rice 4 12.2 13.5 48.8 54
Pulses 2 7.25 8.50 14.5 17
Milk 16 2 2 32 32
Sugar 3 24 25 72 75
Total 295.3 315.6

(a) Aggregate expenditure method

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The formula for aggregate expenditure method is given by:

 P1Q 0 315 .6
P01   100   100  106 .87.
 P0 Q 0 295 .3

Therefore the cost of living index number is 106.87.

(b) Family budget method or the method of weighted relatives
Table 15.8b: Family budget method
Quantity Price in rupees
Article consumed
Base Current P
in the 1
base year year year P  100 W=P0Q0
P0 P PW
Q0 P1 0

Wheat 8 16 17.2 107.5 128 13760

Rice 4 12.2 13.5 110.66 48.8 5400.208
Pulses 2 7.25 8.50 117.24 14.5 1699.98
Milk 16 2 2 100.0 32 3200
Sugar 3 24 25 104.2 72 7502.4
Total 33 ∑W= ∑PW=
295.3 31562.588

Formula for calculating the cost of living index is:

 PW 31562.588
P    106.88.
01 W 295.3
Therefore cost of living index number is 106.88
Solved Problem 10:
Calculate the cost of living index by using Family Budget Method for year
2011 with 2010 as base year from the following data:
Table 15.9: Table for calculating cost of living index
Item Weights Price in
2010 2011
Food 35 150 140
Rent 20 75 90
Clothing 10 25 30
Fuel and lighting 15 50 60
Miscellaneous 20 60 80

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Solution
Table 15.9a: Family Budget Method
Item W Price in P PW
1
P0 P1 P  100
P
0
Food 35 150 140 93.33 3266.55
Rent 20 75 90 120.00 2400.00
Clothing 10 25 30 120.00 1200.00
Fuel and 15 50 60 120.00 1800.00
lighting
Miscellaneous 20 60 80 133.33 2666.60
∑W =100 ∑PW =11333.15

Formula for calculating the cost of living index is:

 PW 11333.15
P    113.33.
01 W 100

15.7 Limitations of Index Numbers

There is no doubt that the technique of index numbers is a very useful tool.
However, there are certain limitations of index numbers which should be
borne in mind.
The chief limitations are:
1. Index numbers are not perfect. They are approximated values.
2. Difficulties in the construction of index numbers due to selection of base
year, items, changes in habits and selection of average.
3. Sampling errors occurs.
4. Index numbers can also be manipulated.
5. They have limited applications. An index number constructed for one
purpose cannot be used for other purposes.

Self Assessment Questions

2. The data in table 15.10 is related to workers in an industrial town.
Calculate consumer price index number by using family budget method.

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Table 15.10: Price Index and Percentage Expenditures of Items

Item of Consumption Price Index Percentage
P Expenditure
Food 200 50
Clothing 175 10
Fuel & lighting 160 12
Housing 225 15
Miscellaneous 150 13

15.8 Utility and Importance of Index Numbers

The primary purpose of index numbers is to measure relative temporal or
cross-sectional changes in a variable or a group of related variables which
are not capable of being directly measured. The greatest purpose of index
numbers has been to measure and compare the changes in prices and
purchasing power of money which have received great attention from
economists for many years.
Today, index number is not only used for measuring price changes alone.
Factors like wages, employment, production, trade, demand, supply,
business condition, industrial activity, financial problems etc. are also
studied through this statistical device. Just as a barometer measures the
pressure of atmosphere or gases, the index numbers measure the pressure
of economic behaviour. Thus, index numbers are called economic
barometers.
Main uses of Index Numbers:
 Comparative study is made possible
 Simplifies data
 Provides guidelines to economic policy and in formulating decisions
 Measures purchasing power of money
 Measures changes in cost of living
 National income calculations
 Reveals trends and tendencies
 Useful in deflating
 Universal utility

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Activity
1. Calculate Fishers Ideal index and show that it satisfies the Time
and Factor Reversal Tests
Table 15.11: Data for Activity
Commodities Base Year Current Year
Price Quantity Price Quantity
P0 Q0 P1 Q1
A 6.5 500 10.8 560
B 2.8 124 2.9 148
C 4.7 69 8.2 78
D 10.9 38 13.4 24
E 8.6 49 10.8 27
Activity Solution
Table 15.11a: Table for calculation of index numbers
Commodities P0Q0 P1Q0 P0Q1 P1Q1
A 3250 5400 3640 6048
B 347.2 359.6 414.4 429.2
C 324.3 565.8 366.6 639.6
D 414.2 509.2 261.6 321.6
E 421.4 529.2 232.2 291.6
Total 4757.1 7363.8 4914.8 7730
Laspeyre’s Price Index Number:

 P Q P Q   
 1 0  1 1    7363.8  7730 
P 
P Q  4757.1 4914.8 
01 P Q  
 0 0 0 1  

P Q P Q   
 0 1  0 0    4914.8  4757.1 
P 
 P Q  7730 7363.8 
10 P Q  
 1 1 1 0  

Time Reversal Test is satisfied if P01  P10  1 (without multiplying by 100)

 
P01  P10  
7363 .8 7730 4914 .8 4757 .1 
 x   1 =1,
 4757 .1 4914 .8 7730 7363 .8 
 

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Hence Time Reversal Test is satisfied.

Factor Reversal Test is satisfied if,

 P1Q1
P01  Q 01  (without multiplying by 100)
 P0 Q 0

 Q P Q P   
 1 0  1 1    4914.8  7730 
Q 01 
 Q P Q P   4757.1 
 0 1  7363.8 
0 0  

 
 7363 .8 7730 4914 .8 7730 
P01  Q01 =   x  
 4757 .1 4914 .8 4757 .1 7363 .8
 

 7730 7730  7730  P1Q1

=     
 4757 .1 4757 .1 4757 .1  P0 Q 0

Hence Factor Reversal Test is satisfied.

15.9 Summary
Let us recapitulate the important concepts discussed in this unit:
 An index number is a number which is used as a device for comparison
between the price, quantity or value of a group of articles in different
situations.
 In the computation of an index number the given year whose values are
to be compared is called a current year and the specified year whose
values are taken as standard is called a base year.
 The various methods of constructing index numbers can be classified
into two groups. They are: unweighted index numbers and weighted
index numbers.
 Unit test, time reversal test, factor reversal test and circular test are the
test for adequacy of index numbers.
 The cost of living price index numbers also known as consumer price
index numbers are designed to measure the average change in the

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price paid by the ultimate consumers for specified quantities of goods

and services over a period of time.
 There are two methods for constructing consumer price index number.
They are: Aggregate expenditure method and Family budget method or
method of weighted average of price relatives.

15.10 Glossary
Explicit method: In this method, the weights are laid down on the basis of
one outward evidence of importance of commodities.
Implicit method: In this method, several varieties of a certain type of
commodity under study are used. Such weights are called implicit weights.
Index number: An index number is a number which is used to measure the
level of a certain phenomenon as compared to the level of the same
phenomenon at some standard period.
Price relative: The price of commodity in a given year expressed as a
percentage of the price of the same commodity in a specified year is called
price relative.
Relative: The value of a variable in a given year (or place) divided by the
value of the same variable in a specified year (or place) is called a relative.
It is generally expressed in percentage.

15.11 Terminal Questions

1. What is index number? State its utility.
2. Discuss the problems of:
a. Selection of the base year
b. Selection of weights in the construction of index numbers
3. What are the characteristics of an index number?
4. Construct Fisher’s ideal index for the data depicted in table 15.12

Table 15.12: Price of Commodities for the Years 1997 and 2005
Base year 1997 Current year 2005
Commodity
Price Qty Price Qty
A 16 110 25 132
B 5 220 5 264
C 10 132 15 165
D 25 66 30 55

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5. The table 15.13 depicts the price of commodities along with the weights
of respective commodities. Calculate index number for 2000 based on
the year 1995.
Table 15.13: Price of Commodities along with the Weights
Commodity 1995 2000 Weights
A 0.50 0.75 2
B 0.60 0.75 5
C 2.00 2.40 4
D 1.80 2.10 8
E 8.00 10.00 1

15.12 Answers

Self Assessment Questions

1. For the data in table 15.3, we can calculate the price index number of
2002 based on 2001 as:
P
1
P  x100
01 P
0

where, P1 = Total of prices in 2002 = 800

P0 = Total of prices in 2001 = 500
800
Therefore, P   100  160
01 500
This means that the price has increased by 60% in 2002 as compared to
2001
2. The table 15.14 depicts the price of items along with the weighted price.

Table 15.14: Price of Items along with the Weighted Prices

Item P W(weight) PW
Food 200 50 10000
Clothing 175 10 1750
Fuel & Lighting 160 12 1920
Housing 225 15 3375
Miscellaneous 150 13 1950
Total W = 100 PW = 18995

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Consumer price index number by family budget method is given by:

 PW 18995
P    189.95
01 W 100
Hence, the consumer price index number by family budget method is
189.95.

Terminal Questions
1. Refer section 15.2, section 15.5.1, section 15.8
2. Refer section 15.2.5
3. Refer section 15.2.4
4. The Fisher ideal index is equal to 134.69
5. The required index number for the year 2000 is 123.3

15.13 Case Study

In Asian countries alcohol consumption rates are increasing among the
youth. A market research company wanted to have a survey related to this
topic. It has taken the percentages of 15 and 16 years old who admitted to
being drunk 4 times or more than in a 30 day in 2003.
Table 15.15: Data based on Survey
Country Percentage
India 25
China 26
Pakistan 20
Nepal 5
Srilanka 15
Bangladesh 4
Bhutan 29
Burma 10
Maldives 6
Iran 10
i. Using India as a base, develop a relative regional index for the
percentage of 15 and 16 years olds who admitted to being drunk four
times or more in a 30 day period.
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Statistics for Management Unit 15

ii. Using the index for India developed in question i, how would you
describe the percentage of 15 and 16 years olds who admitted to being
drunk four times or more in a 30 day period in Bhutan, Bangladesh and
Sri Lanka.
iii. Using Pakistan as the base, develop a relative regional index for the
percentage of 15 and 16 years olds who admitted to being drunk four
times or more in a 30 day period.
iv. Using the index for Pakistan developed in question iii, how would you
describe the percentage of 15 and 16 years olds who admitted to being
drunk four times or more in a 30 day period in Bhutan, Bangladesh and
Sri Lanka.
v. Using China as a base develop a relative regional index for the
percentage of 15 and 16 years olds who admitted to being drunk four
times or more in a 30 day period.
vi. Using the index for China developed in question v, how would you
describe the percentage of 15 and 16 years olds who admitted to being
drunk four times or more in a 30 day period in Bhutan, Bangladesh and
Sri Lanka.
vii. Based on the data what general conclusion can you draw?

References:
 Bevington, Philip R. & Robinson, D. Keith. Data Reduction and Error
Analysis for the Physical Sciences. 3rd Ed.
 Cowan, Glen. Statistical Data Analysis, Oxford Science Publications.
 Devore, Jay L. (2008) Probability and Statistics for Engineering and the
Sciences.
 Froedesen, A.G., Skjeggestad D., & Tofte, H. (1979) Probability and
Statistics in Particle Physics.
 James, Frederick. (2006). Statistical Methods in Experimental Physics.
2nd Ed.
 Levin, Richard I., & Rubin, David S. (2008) Statistics for Management.
7th Ed. PHI Learning Private Limited.
 Lyons, Louis. (1989) Statistics for Nuclear and Particle Physicists.
 Mandel, John. .
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Statistics for Management Unit 15

 Meyer, Stuart L. Data Analysis for Scientists and Engineers.

 Morris H., Schervish, Mark J. (Paperback - Jan. 31, 2002), Probability
and Statistics
 Press, William H., Teukolsky, Saul A., Vetterling, William T., & Flannery,
Brian P. Numerical Recipes : The Art of Scientific Computing
 Ross, Sheldon M. (2009) Introduction to Probability and Statistics for
Engineers and Scientists. 4th Ed. .
 Taylor, John R. An Introduction to Error Analysis: The Study of
Uncertainties in Physical Measurements.

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