Scribd
Upload
332 views

Lecture On Index Numbers

An index number measures the relative change in price, quantity, or value compared to a base period. There are two main types of price indexes - unweighted and weighted. A weighted index considers quantities while an unweighted index does not. Common weighted indexes include the Laspeyres index, Paasche index, and Fisher's ideal index. The Laspeyres index uses base period quantities while the Paasche index uses current period quantities. Fisher's index is the geometric mean of the Laspeyres and Paasche indexes. Choosing an index depends on whether quantities from the base or current period are preferred and whether an upward or downward bias is acceptable.

Uploaded by

muyi kunle
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
332 views

Lecture On Index Numbers

An index number measures the relative change in price, quantity, or value compared to a base period. There are two main types of price indexes - unweighted and weighted. A weighted index considers quantities while an unweighted index does not. Common weighted indexes include the Laspeyres index, Paasche index, and Fisher's ideal index. The Laspeyres index uses base period quantities while the Paasche index uses current period quantities. Fisher's index is the geometric mean of the Laspeyres and Paasche indexes. Choosing an index depends on whether quantities from the base or current period are preferred and whether an upward or downward bias is acceptable.

Uploaded by

muyi kunle
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
You are on page 1/ 5

INDEX NUMBERS

I. An index number measures the relative change in price, quantity, or value compared
to a base period.
A. The major characteristics of an index are:
1. It is a percentage, but the percent sign is usually omitted.
2. It has a base period.

B. The reasons for computing an index are:


1. It facilitates the comparison of unlike series.
2. If the numbers are very large, often it is easier to comprehend the change of the
index than the actual numbers.

Types of Index Numbers


a. Price Index Numbers : These measure the general changes in the prices. They are further
sub-divided into Wholesale Price Index and Retail Price Index (e.g Consumer Price Index).
b. Quantity Index Numbers : They study the changes in the volume of goods produced,
consumed or distributed, e.g indices of agricultural production, industrial production,
imports, exports, etc.
c. Value Index Numbers : They study the changes in the total value (price multiplied by
quantity) of production such as indices of retail sales or profits or inventories. They are,
however, not as common as price and quantity indices.

I. There are two types of price indexes, unweighted and weighted.


A. In an unweighted index, we do not consider the quantities.
1. In a simple index, we compare the base period to the given period.

where Pt refers to the price in the current period and P0 is the price in the base
period.
2. In the simple average of price indexes, we add the simple indexes for each item
and divide by the number of items.

3. In a simple aggregate price index, the price of the items in the group are totaled
for both periods and compared.

B. In a weighted index, the quantities are considered.


1. In the Laspeyres method, the base period quantities are used in both the base
period and the given period.

2. In the Paasche method, current period quantities are used.

3. Fisher’s ideal index is the geometric mean of the Laspeyres and Paasche indexes.

It is termed “ideal” because it is the only index that satisfies both time reversal
and factor reversal tests.

4. Marshall-Edgeworth Price Index


Taking the arithmetic cross of the quantities in the base year and the current year
as weights i.e., w = (qo + qt)/2, we obtain the Marshall-Edgeworth formula given
by
How do we decide which index to use? When is Laspeyres most appropriate and when
is Paasche the better choice?

Laspeyres
Advantage
 It requires quantity data from only the base period. This allows a more meaningful
comparison over time. The changes in the index can be attributed to changes in the price.
Disadvantage
 Does not reflect changes in buying patterns over time.
 Also, it may overweight goods whose prices increase. Hence, it overstates the price index
(upward bias)
Paasche
Advantage
 Because it uses quantities from the current period, it reflects current buying habits.
Disadvantage:
 It requires quantity data for the current year. Because different quantities are used each
year, it is impossible to attribute changes in the index to changes in price alone.
 It tends to overweight the goods whose prices have declined. Hence, it understates the
price index (downward bias).
 It requires the product of prices and quantities to be recomputed each year.

KEY NOTES
 From the above, Laspeyre’s Index is usually greater than Paasche’s Index but
not always. There are conditions where the Laspeyre’s Index can be greater
than, equal to or less than the Paasche’s Index. In fact, if prices of all the goods
change in the same ratio, both indices are equal.
 If PL ˂ PP then PL ˂ PF ˂ PM.E ˂ PP
 If PP ˂ PL then PP ˂ PF ˂ PM.E ˂ PL
 Since both PF and PM.E have no bias in any known direction, they provide a
better estimate of the true index. They, however, have practical limitations
because it is difficult and rather expensive to obtain correct information
regarding their weights since they require both base and current year prices
and quantities for their computations. Moreover, both are rarely used in
practice because of their computational difficulties.

Problems in the Construction of Index Numbers


i. The Purpose of Index Numbers: In the absence of the purpose of index being
clearly specified, we are liable to collect some irrelevant information which may
never be used and also omit some important data or items which might ultimately
lead to fallacious conclusions and wastage of resources.
ii. Selection of Commodities or Items: In the construction of price index, from
technical point of view we should study the price changes in all the items or
commodities. However, from practical point of view, it is neither possible nor
desirable to take into account all the items. We resort to sampling and only a few
representative are selected from the whole lot.
iii. Data for Index : Data must be obtained from reliable sources, must be relevant to the
purpose of the index and the principle of accuracy, suitability, comparability and
adequacy should be kept in mind in using secondary data.
iv. Selection of Base Period : Base period should be a period of normal and stable
economic conditions and should not be too distant from the given period.
v. Types of Averages to be Used: Basically, the effective choice of an appropriate
average for the construction of an index number is between the arithmetic mean and
geometric mean, each of which is commonly used in practice but gives different
figures for the index.
vi. Choice of the 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.
vii. System of Weighting : The commodities included for the construction of index
numbers are not of equal importance. In order that the index is representative of the
average changes in the level of phenomenon for the composite group, proper weights
should be assigned to different commodities according to their relative importance in
the group.

You might also like