INDEX NUMBERS

Meaning and Origin

Index numbers are special type of averages used to measure relative change of a group of related, but
distinct variables over time or from one place to another place. i.e., Index numbers are the devices for
measuring differences in the magnitude of a group of related variables.

E.g. People are interested to know about the price level, agricultural production in manufacturing. In
fact, price level means the average level of prices of various commodities which are available in the
market. Similarly, production involves production of rice, wheat, pulse, etc.

Index numbers measures the average change in these variables as a group over two or more periods or
from one place to another place.

Characteristics of Index Numbers

1. Index Numbers are Specialized Averages: -

It involves computation of average value of a phenomenon. In case of index numbers, the figures
averaged need not necessarily expressed in homogenous units. They can be measured in different units
of measurement. Also index numbers are meant to study the relative changes and not the absolute
changes. i.e., a rise in the price index number does not mean prices of all commodities rise. It is possible
that prices of many are rising while some are falling, but on average, they rise.

2. Index Numbers are Relative Numbers: -

It measures the change of a group of variables from one period to another period or from one place to
another place.

3. Index numbers are Expressed in Percentages: -

Index numbers are independent of the units in which individual variables are measured. So, it is easy to
compare two or more index numbers. The sign (%) is never used.

4. Index Numbers Measure Change which is not being Directly Measured: -

This is the only method for measuring the change of a group such as price level, volume of production,
cost of living etc.

5. Index Numbers measure in the Level of a Phenomenon in one Single Figure.

Uses of Index Number

1. Index Numbers Measure and Compare Changes: -

Index numbers are used to measure the relative change of a phenomenon over a period of time. Also, it
helps to compare the state of the phenomenon over two or more periods or over two or more places.

2. Index Numbers are Used for Deflating Values: -

Index numbers are useful for deflating so that we can measure the real values from nominal values. i.e,.
Index numbers are indicators of inflationary or deflationary tendencies.

3. Index Numbers Help to Study the Trend and Tendencies: -

Index numbers helps to access the general trend of any phenomenon under study over a period of time.

4. Index Numbers Help to Frame Policies: -

Almost all the economic and business policies of government and industrial firms are guided by index
numbers. While framing plans and budgets, governments have to consider index numbers. Allowances
of employees are declared after studying the changes in their cost of living. Also, business firms
formulate their investment plans and pricing policies after considering the changes in relevant index
numbers.

5. Index Numbers are useful to Measure the value of Money: -

Price index numbers can be used to measure the value of money or purchasing power of money.

6. Index Numbers Act as an Economic Barometer: -

A barometer is used for recording the changes in atmospheric pressure. Similarly index numbers are
used for recording changes in economic activity. Whole sale index numbers record the changes in the
price level of a country. Index numbers of agricultural production tell the changes in the corresponding
fields. Also index numbers of business activity give economic progress in various countries. Therefore,
index numbers are called economic barometers.

Types of Index Numbers

Based on the variables measured, index numbers are classified into four. They are:

1. Price index numbers

2. Quantity index numbers
3. Value index numbers
4. Special purpose index numbers.
Price Index Numbers
Price index numbers measure the change in general price level over a period of time.
E. g. If the price of a commodity A in 2005 was Rs. 50 and that in 2007 was Rs. 55, then the
relative change in price is 10%. i.e., price index of that commodity in 2007 is 55/50 X 100 = 110.
Similarly, we can measure relative changes of all commodities in a group. The combined effect
of changes in individual commodities on the group can be expressed in a single number. This
number is called composite index number. It is single index which reflects overall changes of all
commodities in the group taken together. Whole sale price index, consumer price index, cost of
living index, stock price index, etc. are examples of index numbers.
Whole sale price index numbers
Whole sale price index numbers measure the changes in the Whole sale prices of large
number of commodities. They help in measuring the purchasing power of money.
Method of Construction of Index Numbers
Various methods used for the construction of index numbers are:
1. Simple (unweighted) aggregative method.
2. Simple (unweighted) average relative method.
3. Weighted aggregative method
4. Weighted average of relative method.

Index numbers obtained by the first two methods are known as simple index number and by
the last two methods are known as weighted index numbers.
Main Problems or Steps in Construction of Index Numbers
Construction of Index Numbers involves the following problems:
1. Purpose of index number: - The first step is to define the purpose for which the index number
is constructed. Any index number has a limited and specific use. Data collection, use of formula
and selection of averages all depends upon the purpose. Purpose of Index number must include
the people to be covered, the area and the scope of the study.
2. Selection of Commodities: - While constructing an index number it is not possible to include
all commodities. Therefore a few items which truly represent the tastes and requirements of the
concerned people are to be selected.
3. Obtain Price Quotation (data Collection): -
Price of many commodities vary from place to place and even from shop to shop in the same
market. Therefore, price quotations must be obtained from some selected markets or from
some trading firms. In order to quote prices, one or more agencies should be appointed and
reliable journals and newspapers can be used.
4. Selection of Base Period: -
The base year chosen should be normal year, free from wars, famines, natural calamities, etc.
and it is too distant from the current period. The value of the variable should not be too large or
too small in the base year compared to other years. Index number for the base year is always
taken as 100.
5. Choice of Average: -
Index number is a special type of average. In the construction of index numbers any of the
averages such as arithmetic mean, median, geometric mean can be used. However, depending
on the purpose of the index number, an appropriate average is to be selected.
6. Choice of Weight: -
All items included may not have equal importance or weight. Some are more important than
others. Therefore, depending on its relative importance, appropriate weight is to be given to
each individual item.
E. g. While constructing a cost of living index number, higher weight is given to food items than
to house rent as the proportion of income.
7. Selection of Formula: -
The last step is to select formula. It depends on the purpose of the index number, availability of
data and other circumstances. There are different formulas. We have to decide whether simple
index number or weighted index number is appropriate.
Weight
The term weight refers to the relative importance of an item. All items selected for the
construction of index numbers are not of equal importance. The problem of selecting suitable
weights is quite important and at the same time quite difficult to decide. There are two types of
weights: quantity weights and value weights. A quantity weight is the amount of a commodity
produced, exchanged or consumed and which is denoted as 'Q'. A value weight is the products
of quantity and price, i. e. P X Q where P is the price.
Limitations of Index numbers
1. Index numbers based on a set of values of variate collected by sampling. Index numbers are
constructed taking into account only a representative set of variates.
2. Only quantitative characteristics can be considered in the construction of index number. So
qualitative changes in the items are not reflected by index numbers.
3. There are different index numbers and the choice in any particular case is an arbitrary. So
errors can happen due to wrong choice.
4. If the choice of base period is wrong, the results are misleading. In this way, it is possible to
manipulate and misuse of index numbers by dishonest persons.
5. Errors may be entering in the collection of data, selection of appropriate weights, etc.
6. An index number roughly indicates only the relative changes in the values of variable. Hence
accuracy cannot be assured.
7. They are specilised averages. So, it suffers from all limitations of an average.

Whole Sale Price Index Numbers

The various methods used for the construction of index numbers are:
1. Simple (or unweighted) aggregative method
It is the simplest method of constructing index numbers. Simple aggregate index for the current
period is defined as the ratio of current period aggregate prices to base period aggregate prices
expressed in per cent age. Each commodity is assumed to have equal importance.
 Let P1 and P0 are current year and base year prices of a group of commodities. Then, index
ΣP1
number P01 = X 100
ΣP0

2. Simple (or unweighted) Average Relative Method.

In this method price relatives are used to construct index numbers and index number for the
current period is defined as the average of price relatives expressed as a per cent age. Also,
price of each commodity has equal importance.
P1
Price relative of a commodity = I = X 100
P0
P
Σ 1
P0 ∑I
When arithmetic mean is used for the calculation then price index = P01 = X 100 =
n n
When Geometric mean is used
n Σ log I
P01 = √π I = Antilog [ ]
𝑛

3. Weighted Aggregative Method

In the construction of weighted index numbers, appropriate weights are assigned to each item
depending its relative importance. The consumer attaches varying importance to rice, fuel,
cloth, vegetables, etc. In such cases due weight is quantity weight or value weights should be
assigned to the prices of commodities.
Important methods used to construct weighted index numbers are the following:
1. Laspeyer's Method
2. Paasche's Method
3. Fisher's Ideal Index
4. Marshall- Edgeworth Formula
5. Bowley - Dorbish Formula
6. Kelly' Formula
1. Laspeyer’s Index Formula

Laspeyer's Index Number uses base year quantities (Q0) as weights. So, it has an upward bias.

ΣP1 q0
Laspeyer's Index Number P01 = = X 100
ΣP0 q0

2. Paasche's Index Formula

Paasche's Index Formula uses current year of quantities as (Q1) as weights. So, it has a downward

ΣP1 q1
Number P01 = = X 100
ΣP0 q1
3. Fisher's Index Formula

It is based on the price and quantities of both base year and current year. According to him, the ideal
index number is the geometric mean of Laspeyer's and Paasche's index numbers. geometric mean is the
best average in the calculation of index numbers. So, Fisher's Index number is called Ideal Index
Number. Also, it satisfies Factor Reversal Test and Time Reversal test and it is free from the bias which
Laspeyer's or Paasche's index number has.

∑𝑝 𝑞 Σ𝑝 q
Fisher's Index number = 𝑝01 = √ 1 0 × 1 1 × 100
ΣP q Σp q0 0 0 1

4. Marshall- Edgeworth Index Number

This index number uses arithmetic mean of base and current year quantities as weight.

∑ 𝑝1 𝑞0 + Σ𝑝1 q1
P01 = [ ] X 100
ΣP0 q0 + Σp0 q1

5. Bowley - Dorbish Formula

This index number is defined as the A. M. of Laspeyer's and Paasche's index numbers

1 Σp1 q0 Σp1 q1
P01 = [ + ] X 100
2 Σp0 q0 Σp0 q1

6. Kelly's Index Number

Kelly used the quantities purchased during any particular period as weights. It need not relate to
current year or base year. Once weights are decided it is fixed for all years.

Σp1q q0 +𝑞1
Kelly's Index Number = X 100 where, q =
Σp0𝑞 2

Comparison between Laspeyer's and Paasche's index numbers

Laspeyer's Paasche's
1.Base year quantities (q0) are used as 1. Current year quantities (𝑞1 ) are used as
weight weight.
2. Weight do not change from year to year 2. Weight change from year to year
3. It has upward bias 3. It has downward bias
Σ𝑝1 𝑞0 Σp1 𝑞1
4. P01 = = X 100 4. P01 = = X 100
Σp0 𝑞0 Σp0 𝑞1
4. Weighted Average of Price Relative Method.

In this method price relatives are used to construct index umbers. Price relative of a commodity for the
current year is estimated on

P1
I= X 100.
P0

In this method, appropriate weights are assigned to the commodities according to the relative
importance of these commodities in a group. In this method price relatives are averaged to get the
required index number. To find out the average A.M. or G.M. can be used. When A.M. is used, the index
ΣIV
number is ΣV where V stands for weights and V = p0 q 0 ,

If weights are not given

Σ(V ×log 𝐼)
When G.M. is used P01 = Antilog ΣV

Bias in Index Number

When an index number of overestimates or underestimates the true value, then it is biased. When the
Index number overestimates, bias is upward and underestimates bias is downward.

Laspeyer's index number is based on the base year quantities (q0). It has an upward bias as it
overestimates the true value. Due to increase in their prices or for some other reasons, the consumption
of some commodities decreases in the current year. So, in Laspeyer's index number calculation, the
commodities whose prices increases get more weight. Therefore, the numerator Σ𝑃1 𝑞0 is relatively
larger. Thus, Index number gets greater value than actual value.

But, Paasche's index number is based on the current year quantities (q1). It has a downward bias as it
underestimates the true value. Due to decrease in their prices or for some other reasons, the
consumption of some commodities increases in the current year. So, in Paasche's index number
calculation, the commodities whose prices decreases get more weight. Therefore, the denominator
Σ𝑃0 𝑞1 relatively larger. Thus, index number gets lower value than actual value. In general, the value of
price index lies between the two.

Tests of Consistency of Index Numbers

The important test to examine the consistency of any index number formula are:

1. Time Reversal Test 2. Factor Reversal Test 3. Unit Test

4. Circular Test
1. Time Reversal Test

This test states that the products of two index numbers calculated from the same data by inter changing
time must be equal to unity. Thus, if P01 is the index number of the current period 1 with the base period
0 and P10 is the index number of the period 0 with base 1 period, then the time reversal test is satisfied if

P01 X P10 = 1 (after ignoring the factor 100 from each index)
i.e., to get P10 we charge 1 in to 0 and 0 in to 1 of P01
e.g., For Laspeyer’s formula
Σp1 q0 Σp0 q1
P01 = then P10 =
Σp0 q0 Σp1 q1

Hence P01 X P10 ≠ 1 i.e. Laspeyer’s does not satisfy time reversal test.

Fisher's index, Marshall - Edgeworth Index and Kelly’s index satisfies time reversal test. But Laspeyer’s
does not satisfy time reversal test.

2. Factor Reversal Test

Factor reversal test states that the product of price index and corresponding quantity index should be
equal to the value index i.e., if P01 is the price index number and Q01 is the quantity index number based
Σp1 q1
on the same data, then factor reversal test is satisfied if P01X q01 = V01 where V01 =
Σp0 q0

To get q0 we change P into q and q into P from P01

E.g. For Laspeyer's Formula

Σp1 q0 Σp0 q1
P01 = then q01 =
Σp0 q0 Σp0 q0

Σp1 q1
P01 X q01 ≠ i.e. Laspeyer's Formula does not satisfy factor reversal test.
Σp0 q0

This test is satisfied only by the Fisher Index. Neither Laspeyer’s nor Paasche’s index formula satisfies
time reversal test.

3. Unit Test

This test states that the value of an index number must not be affected by the changes in the units of
price and quantities used in the calculation.

E.g. the index number obtained by using the price per K.G. of a group of commodities should be equal to
index number that takes price per quintal of group of commodities. All methods except the simple
aggregate method satisfy the unit test.
4. Circular Test

This is an extent ion of the time reversal test. Suppose we are given data for different periods and index
period for period 1 is calculated by taking 0 as the base period, index number for period 2 is calculated
by taking 1 as the base period, index number for period 3 is calculated by taking 2 as the base period
and so on. They are denoted by P01, P12, P23, etc. The circular test is satisfied if the product of these index
numbers is equal to 1.

I.e. P01 X P12 X p23 X.... Xp𝑛0 = 1

Fisher’s, Laspeyer’s and Paasche’s index numbers do not satisfies this test. This test is satisfied by the
simple aggregative method only.

Consumer Price Index Number (Cost of Living Index Number)/ Retail Price Index Number

Cost of Living Index Number is an index number constructed to measure the changes in the price of a
set of goods and services and Cost of Living varies to different classes of people living in a society. The
standard of living in a society vary from place and from geographical region.

E.g. Consumption pattern of teachers and that of workers are different and consumption pattern of
Kochi is different from teachers in Bangalore.

Consumption pattern of people in rural and urban areas in a state are different.

Therefore, in order to measure the effects of rise and fall in the prices of various commodities on the
cost of living of different classes of people, separate index numbers are constructed for different groups
of people i.e. one single cost of living index number is not suitable for measuring the cost of living of all
the people. So, a separate cost of living index number is prepared for each class of people namely,
Government employees, Factory workers, agricultural workers, etc. This index number is also used to
measure the changes in the retail prices of commodities consumed by the people. So cost of living index
number is also known as consumer price Index number or retail price index number.

Uses of Cost of Living Index Number

1. It is used to determine dearness allowance of workers.

2. They are useful to the government to formulate its wage policy, taxation policy, etc.
3. It is used to measure purchasing power of money.
4. It is used to analysis the changes in consumption pattern of a particular category of
people or different categories of people over a given period of time.
5. It is used in deflation of income and values.
6. It is used to analysis the market for particular types of goods and services.
Steps in the Construction of Cost of Living Index Number

1. Determination of the Class of People: -

One single cost of living index number is not suitable for measuring the cost of living of all the people
living in a society. So, it important to identify the class of people for whom the index number is meant.
The class of people can be industrial workers, agricultural labourers, teachers, etc. Again, a particular
class of people may contain different categories of people and their consumption patterns may be
different. Thus, different cost of living index number can be calculated to these specific groups.

2. Decision about Geographical Area: -

Before constructing a consumer price index number, the particular geographical area to be covered is to
be decided, because the standard of living and consumption habit of people living in a society vary from
place to place and from geographical region to region.

3. Selection of Items: -

While constructing a consumer price index, the prices of a selected group of commodities are
considered. It must include only those commodities which are generally consumed by the class of
people concerned and commodities are divided in to several groups of items like food, clothing, fuel and
light, house rent miscellaneous, etc.

4. Conducting Family Budget Enquiry: -

After determining the scope of the index and items to be considered, relevant data are to be collected
through a family budget survey of the concerned class of people to determine how much an average
family of concerned group spends on different items of consumption. Thus, the details regarding the
quantities of selected commodities used by these groups and their prices are collected.

5. Collection of Retail Prices: -

Retail prices of commodities are to be collected from the shops and areas where the concerned group of
people make their purchases. The retail prices may vary from shop to shop and from locality to locality.
So, the prices collected from different sources are to be averaged.

6. Selecting Base Period and Proper Weights: -

The period which is to be selected as the base period must be a stable and normal one so that the
consumption pattern remains same for a long period. Also, the different items of consumption are to be
given appropriate weights on the basis of the proportion of income spent by an average family to
purchase these items. E. g. More weight is to be given to food items than house rent as proportion of
income spent by an average family.
7. Selection of Suitable Methods for Constructing Index Number: -

After determining the weights and collecting prices of the commodities, cost of living index number may
be constructed by applying any one of the methods:

a) Aggregate Expenditure Method and

b) Family Budget Method or Method of Average Relatives

Methods of Construction of Cost of Living Index Number

There are two methods of construction of cost of living index number. They are:

a) Aggregate Expenditure Method and

b) Family Budget Method

a) Aggregate Expenditure Method

Aggregate Expenditure Method is similar to the Laspeyer’s method. Quantity of commodities purchased
during the base period is assigned as weights.

ΣP1 q0
Cost of living index number = × 100
ΣP0 q0

b) Family Budget Method

Family Budget Method is similar to the weighted average of price relative method. Value of
commodities purchased during the base period is taken as weights

ΣIV 𝑃1
Family Budget Method = ΣV where I = × 100
𝑃0

Quantity Index Number

Price index numbers are used to compare the variations in prices of a commodity or a selected group of
commodities over a period of time. Quantity index number used for comparison of quantity items
produced or distributed or consumed. In Quantity index number we measure the changes in quantities.
The indices of agricultural production, industrial production imports and exports are examples.

Quantity indices are obtained by interchanging P and q in the various formulas for price index. i.e.
quantity index number obtained using

Σq1 p0
1. Laspeyer's Method Q01 = X 100
Σq0 p0
 Σq1 p1
2. Paasche’s Method Q01 = X 100
Σq 0 p1

Σq1 p0 Σq1 p1
3. Fisher's Index number Q01 = √ × X 100
Σq0 p0 Σq0 p1

ΣIV q1
4. Weighted Average Relative Method = ΣV where I = X 100
q0

Value Index Number

Value Index Number measure the relative change of actual value of commodities between the base and
current periods. The value of production or commodities can be obtained by multiplying the price and
quantity

i.e., Value Index Number V01 = P01 X Q01

Σ𝑣1 Σp1 q1
i.e. V01 = X 100 = X 100
Σ𝑣0 Σp0 q0

Fixed Base and Chain Base Index Number

Fixed Base Index Number (FBI)

An index number series in which comparisons are made with a particular period as base period is called
fixed base index numbers.

E.g. we construct index numbers for six periods such as 0, 1, 2, 3, 4 and 5. For index number of all six
periods, the base period is '0' remains the same.

Price of that year

Fixed base index number of any year = X 100
Price of the fixed base year

Merits

1. It is very convenient for computation.

2. It is adopted by various organisations for constructing different kinds of index numbers.
3. A normal year is chosen as the base year, so the relative values obtained will be more
reasonable.

Demerits

1. As the base period becomes too distant past, the consumption pattern of people changes.
2. Some commodities which are available in the base period may not exist at present.
3. There might have a lot of changes in tastes, preferences and fashions and new commodities
emerge.
 4. Consumption of group of commodities in the current period to the base period will not be
reasonable.

Chain Base Indices (CBI)

An index number series in which each current period is compared to the just previous period is called
Chain Base Index Numbers.

E.g. we construct index numbers for six periods such as 0, 1, 2, 3, 4 and 5. Here 0 is taken as the base
period for the index of 1st period '1' is taken for 2nd period and so on.

Chain Base Index Numbers are defined as the 'average of Link relative'

Price of current year

Link relative = Lt = X 100
Price of the just preceding year

Pt
i.e., Lt = X 100
Pt−1

Conversion of Fixed Base Index into Chain base Index

A Fixed Base Index number series can be converted into Chain base Index number series. Using the
formula,

Current year FBI

Current year CBI = X 100
Previous year FBI

In the first year CBI = FBI

Conversion of Chain base into Index Fixed Base Index

Chain Base Index number series can be converted into Fixed base Index number series. Using the
formula,

Current year CBI × Previous year FBI

Current year FBI =
100

Distinction between Fixed Base Index and Chain base Index Number

Fixed Base Chain Base

1. It has a fixed base, so it helps to compare 1. Compare the changes in any period with a
changes in any period to that fixed period only. previous period.
2. Base is one arbitrarily chosen. 2. Base is to be preceding period.
3. It does not permit inclusion of new items. 3. Inclusion of new item is possible.
4. Weights cannot be adjusted so frequently. 4. Weights can be adjusted so frequently.
5. Comparison between adjacent periods is not 5. Comparison between adjacent periods is
possible. possible.
6. Seasonal variation will affect to some extent. 6. Seasonal variation will not affect.
7. Any error in a particular year will not affect the 7. An error in one year will affect the results of all
results of all years. subsequent years.

Base Shifting

Base shifting means changing the base year of a series of index numbers to another and recalculating
the index number with the new base.

The reasons of shifting base year are:

1. The base year is too far away from current year so that it becomes unsuitable i.e. comparisons with
that base becomes meaningless.

2. For the comparison two series of index numbers, it would be meaningful only if the two index
numbers have a common base. If not, the base of one of them is shifted to that of the other.

Index Number of an Year

The formula for shifting base X 100
Index Number of Base Year

Splicing

Splicing is the process by which new series of indices is tied with old series of indices or old series of
indices is tied with new series of indices. i.e., Splicing means combining of two or more overlapping
series of index numbers with different base years into one with common base year. Splicing is possible
only when there is at least one overlapping year. Splicing is very useful for enabling comparison
between the new and old index numbers.

There are two types of splicing:

1. Forward Splicing (Splicing of new index series to old Index series)

Spliced new index series to old index series
Old index of New Base Year×Index of current year
=
100
2. Backward Splicing (Splicing of old index series to new Index series)
100×Old index number
Spliced new index series to old index series =
Old index of New Base Year

Deflating

Deflating means making adjustments for the effect of changing price levels. Index number like cost
price index number is used to measure the changes in the purchasing power of money. When price
index increases, the purchasing power of money decreases. The process to measure the value
(purchasing power) of money giving allowance to the changes in price level is known as deflating.

Purchasing power of money is the reciprocal of price index.

 1
i.e., purchasing power of money =
Price Index

Deflating refers to the correction for price changes in money wages or money income series.

A rise in the price level means a reduction in the purchasing power of money.

Money Wages
Real wages (Deflated wages) = X100
Price Index

Real Wages of Current Year

Real Wage Index Number = × 100
Real Wages of Base Year