UNIT V

INDEX NUMBERS

Syllabus:

Index Numbers – Meaning – Uses – Steps involved in computing index numbers – Methods –
Simple, Weighted, Laspeyre’s Index number, Paasche’s Index Number, Fisher’s Ideal Index
Number (including TRT & FRT), Consumer Price Index under family budget method.

Introduction

An index number is a statistical measure used to compare the average level of magnitude of a
group of distinct but related variables in two or more situations. Index numbers are indicators
which reflect the relative changes in the level of a certain phenomenon in any given period (or
over a specified period of time) called the current period with respect to its values in some fixed
period called the base period selected for comparison.

For example, suppose we are interested in studying the general change in the price level of
consumer goods. Obviously, these changes are not directly measurable as the price quotations of
the various commodities of the various commodities are available in different units, e.g., cereals
(wheat, rice, pulses, etc.) are quoted in Rs. Per quintal or kg; milk, petrol, kerosene etc., in Rs per
litre, cloth in Rs per metre and so on.

Further, the prices of some of the commodities may be increasing while those of others may be
decreasing during the two periods and the rates of increase or decrease may be different for
different commodities. Index number is a statistical device which enables us to arrive at a single
representative figure which gives the general level of the price of the phenomenon
(commodities) in an extensive group.

Definition.

“Index Number is a statistical device for indicating relative movements of the data where
measurement of actual movements is difficult or incapable of being made”. – Wheldon.

Characteristics of Index Numbers

Following are the characteristics of index numbers:

1. Index numbers are specialized averages. As we know, an average of data is its

representative summary figure. In a similar way, an index number is also an average, often
a weighted average computed for a group. It is called a specialized average because the
figures, that are averaged, are not necessarily expressed in homogeneous units.
2. Index numbers measure the changes for a group which are not capable of being
directly measured. The examples of such magnitudes are: Price level of a group of items,
 level of business activity in a market, level of industrial or agricultural output in an
economy, etc.
3. Index numbers are expressed in terms of percentages. The changes in magnitude of a
group are expressed in terms of percentages which are independent of the units of
measurement. This facilitates the comparison of two or more index numbers in different
situations.

Uses of Index Numbers

The main uses of index numbers are:

1. To measure and compare changes. The basic purpose of the construction of an index
number is to measure the level of activity of phenomenon like price level, cost of living,
level of agricultural production, level of business activity, etc. it is because of this reason
that sometimes index numbers are termed as barometers of economic activity.
2. To help in providing guidelines for framing suitable policies: Index numbers are
indispensable tools for the management of any government or non-government
organization. For example, the increase in cost of living index is helpful in deciding the
amount of additional dearness allowance that should be paid to the workers to
compensate them for the rise in prices. In addition to this, index numbers can be used in
planning and formulation of various government and business policies.
3. Price index numbers are used in deflating: This is a very important use of price index
numbers. These index numbers can be used to adjust monetary figures of various periods
for changes in prices. For example, the figure of national income of a country is
computed on the basis of the prices of the year in question. Such figures, for various
years often known as national income at current prices, do not reveal the real change in
the level of production of goods and services. In order to know the real change in national
income, these figures must be adjusted for price changes in various years. Such
adjustments are possible only by the use of price index numbers and the process of
adjustment, in a situation of rising prices, is known as deflating.
4. To measure purchasing power of money: We know that there is inverse relation
between the purchasing power of money and the general price level measured in terms of
a price index number. Thus, reciprocal of the relevant price index can be taken as a
measure of the purchasing power of money.

Types of Index Numbers

Index numbers may be broadly classified into various categories depending upon the type of
the phenomenon or variable in which the relative changes are to be studied. Although index
numbers can be constructed for measuring relative changes in any field of quantitative
measurement, we shall primarily confine the discussion to the data relating to economics and
 business i.e., data relating to prices, production and consumption. In this context index
numbers may be broadly classified into the following three categories:

1. Price Index Numbers. The price index numbers measure the general changes in the
prices. They are further sub-divided into the following classes:

a) Wholesale price Index Numbers. The wholesale price index numbers reflect the
changes in the general price level of a country. The official general purpose index
number of wholesale prices in India was first compiled by the Economic Advisor,
Ministry of Commerce and Industry ( now the Ministry of Commerce) in 1947.

b) Retail Price Index Numbers. These indices reflect the general changes in the retail
prices of various commodities such as consumption goods, stocks and shares, bank
deposits, government bonds etc. In India, these indices are constructed by Labour
Ministry, in the form of Labour Bureau Index Number of Retail Prices – Urban
Centres and Rural Centres.

Consumer Price Index, commonly known as the Cost of Living Index is a specialized
kind of retail price index and enables us to study the effect of changes in the prices of
a basket of goods or commodities on the purchasing power or cost of living of a
particular class or section of the people like labour class, industrial or agricultural
workers etc. In India, cost of living index numbers are available for (i) Central
Government employees (ii) Middle Class people, and (iii) working class.

2. Quantity Index Numbers. Quantity index numbers study the changes in the volume of
goods (manufactured), consumed or distributed, like the indices of agricultural
production, industrial production, imports and exports, etc. They are extremely helpful in
studying the level of physical output in an economy.

3. Value Index Numbers. These are intended to study the change in the total value (price
multiplied by quantity) of production such as indices of retail sales or profits or
inventories. However, these indices are not as common as price and quantity indices.

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 arc
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 utilized,

(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 specialized 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. Choice of Formula.

The choice of formula to be used depends on the availability of the data regarding the prices and
the quantities of the selected commodities in the base and/or current year.

Notations and Terminology

Base year: the year selected for comparison, i.e., the year w.r.t. which comparisons are made. It
is denoted by the suffix zero.

Current Year: The year for which comparisons are sought or required. It is denoted by suffix 1

p0 : Price of a commodity ∈thebase year .. p1 : Price of a commodity∈the current year

q 0 :Quantity of a commodity consumed∨ purchased during thebase year

q 1 :Quantity of a commodity consumed∨ purchase d ∈thecurrent year

w :Weight assigned ¿ a commodity according ¿its relative importance∈the group

P01 : Price Index Number for the current year w . r .t . the base year.

P10 : Price Index Number for the base year w . r .t . the current year

Q01 :Quantity Index Number for the current year w . r .t . the base year

Q10 : Quantity Index Number for the base year w.r.t. the current year.

Methods of Constructing Index Numbers

Following are the methods used for the construction of index numbers:

We shall discuss price indices in detail. The quantity indices can be obtained from price indices
by interchanging the price (p) and quantity (q) in the final formula.

1. Simple (Unweighted) Aggregate Method.

This is the simplest of all methods of constructing index numbers and consists in
expressing the total price, i.e., aggregate of prices (of all the selected commodities) in the
current year as a percentage of the aggregate of prices in the base year. Thus, the price
index for the current year w.r.t. the base year is given by:
∑ p1
P01= ×100
∑ p0
Where ∑ p1is the aggregate of prices (of all the selected commodities) in the current year
∑ p0is the aggregate of prices in the base year.

This method, though simple, is not reliable and has the following limitations:

i) The price sof various commodities may be quoted in different units of

measurement.
ii) In this method the various commodities are weighted according to the magnitudes
of their prices and accordingly commodities which are highly priced exert a
greater influence on the value of the index than the commodities which are low-
priced. Hence, this index is dominated by commodities with large figure
quotations.
iii) The relative importance of the various commodities is not taken into
consideration.

Based on this method, the quantity index is given by the formula:

 ∑ q1
Q01= ×100
∑ q0

Where ∑ q 0 and ∑ q 1 are the quantities of all the selected commodities consumed in the
base year and the current year respectively.

Example:
 2. Weighted Aggregate method.

In this method, appropriate weights are assigned to various commodities to reflect their
relative importance in the group. The weights can be production figures, consumption
figures or distribution figures. For the construction of price index numbers, quantity
weights are used, i.e., the amount of quantity consumed, purchased or marketed. If w is
the weight attached to a commodity, then the price index is given by
∑w p1
P01= × 100
∑w p0

Nature of Weights

In case of weighted aggregative price index numbers, quantities are often taken as
weights. These quantities can be the quantities purchased in base year or in current year or an
average of base year and current year quantities or any other quantities. Depending upon the
choice of weights some of the popular formulae for weighted index numbers are as follows:

i) Laspeyre’s Index Number.

Laspeyre’s price Index Number uses base year quantities as weights. Laspeyre’s
index is given by:
La ∑ p1 q0
P01 = ×100
∑ p0 q0
This formula was devised by French Economist Laspeyre in 1817.

ii) Paasche’s Index Number.

This index number uses current year quantities as weights. Paasche’s index number is
given by:
Pa ∑ p 1 q 1
P01 = ×100
∑ p0q1

iii) Fisher’s Ideal Index Number.

Laspeyre’s Index number has an upward bias and Paasche’s Index has a downward
bias. Irving Fisher suggested an index number which is the geometric mean of
Laspeyre’s and Paasche’s Index numbers. Thus, Fisher’s formula can be written as
follows
F
P01 =√ PLa Pa
01 × P 01 ¿
√ ∑ p1q0
∑ p0q0
×100 ×
∑ p1 q 1
∑ p0 q 1
×100=
√∑ p1 q0 ∑ p 1 q 1
×
∑ p0 q 0 ∑ p 0 q1
×100
 ∑ p1 q0 ∑ p1 q1
If we write L= and ¿ , the Fisher’s Ideal Index can also be written as
∑ p0 q0 ∑ p 0 q1
P01=√ L× P× 100.
F

Fisher’s Index Number is known as Fisher’s Ideal Index Number because it satisfies
time reversal and factor reversal tests for the consistency of index numbers.

Example:

For the data given in the following table, compute (i) Laspeyre’s Price Index (ii) Paasche’s Price
Index (iii) Fisher’s Ideal Price Index.

Solution:

Calculation Table

(i) Laspeyre’s Price index

La ∑ p1 q0
P01 = ×100
∑ p0 q0

La 690
P01 = × 100=118.97
580
(ii) Paasche’s Price Index
 Pa ∑ p1q1
P01 = ×100
∑ p0q1

Pa 1150
P01 = ×100=119.79
960

(iii) Fisher’s Ideal Price Index

F
P01 =√ PLa Pa
01 × P 01 ¿
√ ∑ p 1 q 0 ∑ p1 q1
×
∑ p 0 q 0 ∑ p0 q1
× 100

F
P01 =
√ 690 1150
×
580 960
×100=119.36

Example:
Note: Expenditure (V) = Price (p) x Quantity (q), therefore Quantity (q) = V/p

QUANTITY INDEX NUMBERS

A quantity index number measures the change in quantities in current year as compared with a
base year. The formulae for quantity index numbers can be directly written from price index
numbers simply by interchanging the role of price and quantity. Similar to a price relative a
quantity relative can be defined as:

q1
Q= ×100
q0

Various formulae for quantity index numbers are as given below:

∑ q1
i) Simple Aggregative Index Q01= ×100
∑ q0

ii) Simple average of quantity relatives

q1
∑ × 100
a) Taking A.M. q0 ∑Q
Q01= =
n n

b) Taking G.M. Q01= Antilog [ ∑ logQ

n ]
iii) Weighted Aggregative index
a) Laspeyre’s Quantity Index

La ∑ q 1 p0
Q01 = ×100
∑ q 0 p0
(Base year prices are taken as weights)

b) Paasche’s Quantity Index

∑ q1 p 1
Pa
Q01 = ×100
∑ q0 p 1
(Current year prices are taken as weights)

c) Fisher’s Ideal Quantity Index

 F
Q01 =√ Q01
La
× QPa
01 ¿
√ ∑ q1 p 0 ∑ q 1 p1
×
∑ q0 p 0 ∑ q 0 p1
× 100

iv) Weighted average of quantity relatives

∑ Qw
a) Taking A.M. Q01=
∑w

b) Taking G.M. Q01= Antilog [

∑ wlogQ
∑w ]
Like weighted average of price relatives, values are taken as weights.

Example:

VALUE INDEX

A value index number gives the change in value in current period as compared with base period.
The value index, denoted by V 01is given by the formula

∑ p1 q1
V 01= × 100
∑ p0 q0

TESTS OF ADEQUACY OF INDEX NUMBER FORMULAE

A number of formulae have been given for the construction of index numbers. However, each
one of them suffers from one or the other type of drawbacks. It was, therefore, suggested that a
satisfactory index number formula should satisfy certain mathematical criteria. These
mathematical criteria, also known as tests of adequacy of index numbers are given below:

1. Unit Test.
This test requires that an index number formula should be independent of the units of
measurement of the variables, i.e., its value should not change with change in units of
measurement. This test is satisfied by all index numbers except simple aggregate formula.

2. Time Reversal Test.

The time reversal test, proposed by Prof. Irving Fisher requires the index number formula
to possess time consistency by working both forward and backward w.r.t. time. In his
words:
“the formula for calculating an index number should be such that it gives the same ratio
between one point of comparison and the other, no matter which of the two is taken as
base or putting it another way, the index number reckoned forward should be reciprocal
of the one reckoned backward.”
In other words, if the index numbers are computed for the same data relating to two
periods by the same formula but with the bases reversed, then the two index numbers so
obtained should be reciprocals of each other. Mathematically, we should have (omitting
the factor 100),
P01 × P10=1
Laspeyre’s and Paasche’s index numbers do not satisfy the time reversal test.
We can write Laspeyre’s index number as
La ∑ p1 q0
P01 =
∑ p0 q0
On reversing the timings, i.e., replacing 1 by 0 and 0 by 1, we have,
La ∑ p0 q1
P10 =
∑ p1 q1

Since, P01 × P10 ≠ 1, the Laspeyre’s index does not satisfy the time reversal test. Similarly,
it can be shown that Paasche’s index does not satisfy the time reversal test.

This test is satisfied by Fisher’s Ideal Index. It can be shown as follows:

F
P01=¿
√ ∑ p 1 q 0 ∑ p1 q1
×
∑ p 0 q 0 ∑ p0 q 1
and P10F =¿
√
∑ p 0 q 1 ∑ p0 q0
×
∑ p 1 q 1 ∑ p1 q0

∴ P01 × P 10=
√ ∑ p1 q0 ∑ p1 q1 ∑ p0 q 1 ∑ p 0 q 0
× × ×
∑ p0 q 0 ∑ p 0 q1 ∑ p1 q1 ∑ p 1 q 0
=1

3. Factor Reversal Test.

This is the second of the two important tests of consistency proposed by Prof. Irving
Fisher. According to him:
“just as our formula should permit the interchange of two times without giving
inconsistent results, so it ought to permit interchanging prices and quantities without
giving inconsistent results – i.e, the two results multiplied together should give the true
value ratio.”

This implies that if price and quantity indices are obtained for the same data, same base
and current periods and using the same formula, then their product (without the factor
100) should give the true value ratio, since price multiplied by quantity gives total value.
Symbolically, we should have (without factor 100),
∑ p1q1
P01 × Q01= =V 01
∑ p0q0

Where ∑ p1 q1 and ∑ p0 q 0 denote the total value in the current and base year respectively.

This test is neither satisfied by Laspeyre’s nor by the Paasche’s index number. Fisher’s
index is the only index which satisfies this test. To show that the test is satisfied by the
Fisher’s Index, we write
F
P01=¿
√ ∑ p 1 q 0 ∑ p1 q1
×
∑ p 0 q 0 ∑ p0 q 1
F
Q01 ¿
√ ∑ q1 p 0 ∑ q 1 p1
×
∑ q0 p 0 ∑ q 0 p1

∴ P01 ×Q 01=
√ ∑ p1 q0 ∑ p 1 q 1 ∑ q 1 p 0 ∑ q 1 p1 ∑ p1 q1
× × × =
∑ p0 q 0 ∑ p 0 q1 ∑ q 0 p 0 ∑ q 0 p1 ∑ p 0 q0

Since Fisher’s index is the only index which satisfies both the time reversal and factor
reversal tests, it is sometimes termed as Fisher’s Ideal Index number.

Example:
CONSUMER PRICE INDEX NUMBER

The whole sale price index numbers measure the changes in the general level of prices and they
fail to reflect the effect of the increase or decrease of prices on the cost of living of different
classes or groups of people in a society. Consumer Price Index Numbers, also termed as ‘Cost of
living Index Numbers’ or ‘Retail Price Index Numbers’ are designed to measure the effects of
changes in the prices of a basket of goods and services on the purchasing power of a particular
section or class of the society during any given (current) period w.r.t. some fixed (base) period.
They reflect upon the average increase in the cost of the commodities consumed by a class of
people so that they can maintain the same standard of living in the current year as in the base
year.

Construction of Consumer Price Index

The following steps are involved in the construction of a consumer price index:
i) Scope and Coverage.
The scope of Consumer Price index (CPI) proposed to be constructed, must be clearly
defined. This implies the identification of the class of people for whom the index will
be constructed such as industrial workers, agricultural workers, urban wage earners,
etc. further it si also necessary to define the coverage of the class of people, i.e., the
definition of geographical location of their stay such as a city or two or more village,
etc. The selected class of people should form a homogeneous group so that weights of
various commodities are same for all the people.

ii) Selection of base period.

A normal period having comparative economic stability should be selected as a base
period in order that the consumption pattern used in the construction of the index
remain practically stable over a fairly long period.

iii) Conducting Family Budget Enquiry

A family budget gives the details of expenditure incurred by the family on various
items in a given period. In order to estimate the consumption pattern, a sample survey
of family budgets of the group of people, for whom the index is to be constructed, is
conducted and from this an average family budget is prepared. The goods and
services that are to be included in the construction of index are selected from this
average family budget. Efforts should be made to include as many commodities as
possible. Generally the commodities are divided into five broad groups: (i) Food, (ii)
Clothing, (iii) Fuel and lighting, (iv) House Rent and (v) Miscellaneous.
If necessary, these groups may further be divided into sub-groups. Percentage
expenditure of a group is taken as its weight.

iv) Obtaining Price Quotations

The next step in the construction of CPI is to obtain the retail price quotations of
various items that are selected. The price quotations should be obtained from those
markets from which the group of people, for whom the index number is being
constructed, normally make purchases. The quality of various goods and services
used by the group of people should also be kept in mind while obtaining price
quotations.

v) Computation of the Index Number

After the collection of necessary data, the CPI can be computed by using either
Aggregate Expenditure method or Family Budget method.

Family Budget Method

 This method is also known as weighted average of price relative method and
accordingly values of quantities consumed (expenditure) in the base year are taken as
weights. The formula for the CPI under Family Budget method is given by

∑ PW
Cost of Living Index=
∑W

p1
Where P= × 100 and W =p 0 q0
p0

Example:
Uses of CPI

1. A CPI is used to determine the real wages from money wages and the purchasing power
of money.
1
Purchasing power of money=
Cost of living index number
Money wages
Real wages= ×100
Cost of living index
2. It is also used to determine the dearness allowance to compensate the workers for the rise
in prices.
3. It can be used in the formulation of various economic policies of the government.
4. It may be useful in the analysis of markets of certain goods or services.

Limitations of Index numbers

Despite the fact that index numbers are very useful for the measurement of relative changes,
these suffer from the following limitations:
i. The computation of an index number is based on the data obtained from a sample,
which may not be a true representative of the universe.
ii. The composition of the bundle of commodities may be different for different years.
This cannot be taken into account by the fixed base method. Although this difficulty
can be overcome by the use of chain base index numbers, but their calculations are
quite cumbersome.
iii. An index number doesn’t take into account the quality of the items.
iv. Index numbers are specialized averages as such these also suffer from all the
limitations of an average.
v. An index number can be computed by using a number of formulae and different
formulae will give different results. Unless a proper method is used, the results are
likely to be inaccurate and misleading.
vi. By the choice of wrong base period or weighing system, the results of the index
number can be manipulated and thus, are likely to be misused.