INDEX NUMBERS

Definition
Index numbers are devices for measuring differences in the magnitude of a group of related variables.

Characteristics.
1). Index numbers are specialized averages.
2). Index numbers are expressed in percentage.
3). Index numbers measure the change in the level of a phenomenon in one single figure.
4). Index numbers measure changes not capable of direct measurement.
5). Index numbers are meant for comparison.
6). Index numbers measure the effect of change from one time to another, from one place to another
etc.

Uses.
1). To measure and compare changes.
2). To provide guidelines to policy.
3). To study trends and tendencies.
4). Useful for deflating.

Problems in the construction of index numbers (various steps in the

construction of index numbers).
1). Purpose of the index
2). Selection of the base period
3). Selection of number of items.
4). Obtaining price quotations.
5). Selection of an average.
6). Selection of appropriate weights.
7). Selection of an appropriate formula.

Kinds of index numbers

1). Price index numbers.
2). Quantity index numbers
3). Value index numbers
4). Special purpose index numbers.

Price index numbers

Price index numbers measures the changes in prices over a period of time.
Price index numbers are whole sale price and cost of living index.

Whole sale price index number

The whole sale price index numbers intended to measure the changes in the whole sale prices of a large
number of commodities in order to know the general movement in prices.

Methods for construction of index numbers

1). Simple (un weighted ) aggregative method.
�
Simple index, �01 = �1 × 100 where p1 is the current prices and p0 is the base year prices.
0
Example: For the data given below calculate simple Index Number:

Commodities Price(2007) Price (2008)

(�0 ) (�1 )
A 5 7
B 8 9
C 12 15
D 25 24
E 3 4
53 59

�1 59
Solution: Simple index Number, �01 = �0
× 100 = 53 × 100 = 111.3

2). Simple ( un weighted ) average relatives method.

�
Price relative for commodity = � = �01 = �1 × 100
0
�
When A.M is used, P.I = �
log �
When G.M is used, P.I = �������( � )
Example: Compute a price index for the following by Simple average of price relative method by using
both arithmetic mean and geometric mean.

Commodity A B C D E F
Price in 2005 (Rs) 20 30 10 25 40 50
Price in 2008 (Rs) 25 30 15 35 45 55

Solution:

Commodity (�0 ) (�1 ) �1 Log �

� = �01 = × 100
�0

A 20 25 125 2.0969
B 30 30 100 2
C 10 15 150 2.1761
D 25 35 140 2.1461
E 40 45 112.5 2.0511
F 50 55 110 2.0414
175 205 737.5 12.5116

Simple average price relative method

� 737.5
When A.M is used = P.I = � = 6 = 122.92
log �
When G.M is used, P.I = �������( �
)
12.5116
= ������� 6
= ������� 2.0853 = 121.7
3). Weighted aggregative method.
a. Laspeyer’s Formula
� �
�01 = �1 �0 × 100
0 0
Here, quantity forms weight.
b. Paasche’s Formula
� �
�01 = � 1 �1 × 100
0 1

c. Fisher’s Formula
�1 �0 �1 �1
�01 = × × 100
�0 �0 �0 �1
Example: Calculate weighted Index Number by
a. Laspeyer’s method
b. Paasche’s method
c. Fisher’s method
Commodity Price Quantity
Base year Current year Base year Current year
A 4 7 10 8
B 5 9 8 6
C 6 8 15 12
D 2 2 5 6

Commodity �0 �1 �0 �1 �0 �0 �0 �1 �1 �0 �1 �1
A 4 7 10 8 40 32 70 56
B 5 9 8 6 40 30 72 54
C 6 8 15 12 90 72 120 96
D 2 2 5 6 10 12 10 12
180 146 272 218

a. Laspeyer’s method
� � 272
�01 = �1 �0 × 100 = 180
× 100 = 151.11
0 0
b. Paasche’s Formula
� � 218
�01 = � 1 �1 × 100 = 146 × 100 = 149.32
0 1

�1 �0 �1 �1
c. Fisher’s Formula, �01 = �0 �0
× �0 �1
× 100
272 218
= 180
× 146 × 100 = 150.2

Note:
a. Fisher’s ideal index satisfies time reversal tests and factor reversal tests.
b. Laspeyer’s and Paasche’s Formula does not satisfies time reversal tests and factor reversal tests.
4). Weighted average of relatives.

IV
When A.M is used, Index = V
where V = weight
(log � �)
When G.M is used, Index = �������( �
)

Bias in index numbers

When an index number over estimates or underestimates the true value, we say it is biased.
When the index number over estimates, bias is upward and when under estimates bias is downward.

Tests of index numbers

1). Unit test
This test requires the index numbers should be independent of the units in which prices and quantities
of various commodities quoted.

2).Time reversal test

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 the base or putting it in
another way, the index number reckoned forward should be reciprocal of the one reckoned backward.
This test thus implies that if the time subscripts of an index formula are inter changed,then the
resulting index should be the reciprocal of the original index.
Ie, P01 ×P10 =1 (omitting the factor100 from from each index). P01 = price index for the current year
with reference to base year.
P01 = price index for the current year with reference to base year
P10= price index for the base year with reference to the current year.
Fischer’s formula satisfies time reversal test.
Note.
To get P10 change 1 into ‘0’ and ‘0’ into ‘1’ of P01.

3). Factor reversal test

This test states that an index of price when multiplied by an index of quantity, gives the true value ratio
(omitting the factor, 100 from each index).
�1 �1
�01 × �01 =
�0 �0
� �
Where � 1 �1 is called true value ratio.
0 0

P01 = price index for the current year with reference to base year.
Q01= quantity index for the current year with reference to base year.
Example: From the following data find Fisher’s index number and show that the Time and Factor
Reversal tests are satisfied by it.

Commodity Base year Current year

price Expenditure price Expenditure
A 8 80 10 120
B 10 120 12 96
C 5 40 5 50
D 4 56 3 60
E 20 100 25 150

�����������
Solution: Quantity = �����

Commodity �0 �1 �0 �1 �0 �0 �0 �1 �1 �0 �1 �1
A 8 10 10 12 80 96 100 120
B 10 12 12 8 120 80 144 96
C 5 5 8 10 40 50 40 50
D 4 3 14 20 56 80 42 60
E 20 25 5 6 100 120 125 150
396 426 451 476

�1 �0 �1 �1
Fisher’s Index number = �0 �0
× �0 �1
× 100
451 476
= 396
× 426 × 100 = 112.81
a. Time reversal test:
�1 �0 �1 �1 �0 �1 �0 �0
P01 ×P10 = �0 �0
× �0 �1
× �1 �1
× �1 �0
451 476 426 396
= 396
× 426 × 476
×
451
=1
b. Factor reversal test :

�1 �0 �1 �1 �1 �0 �1 �1
�01 × �01 = × × ×
�0 �0 �0 �1 �0 �0 �0 �1

451 476 426 476

= 396
× 426 × 476
× 451
476 476
= 396
× 396
476
= 396
�1 �1
which is �0 �0
Therefore, Time reversal test and Factor reversal test are both satisfied.
4).Circular test
This test nearly an extension of time reversal test.
According to this test the index numbers works in a circular fashion.
Ie, P01 × 12 × P23 ×…… …….= 1

Consumer price index numbers (cost of living index numbers)or (Retail price
index numbers)
` The consumer price index numbers are generally intended to represent the average change over
time in the prices paid by ultimate consumer of a specialized basket of goods and services. They
measure changes in the cost of maintaining a certain standard of living from time to time. They indicate
the effect of change in prices on the consumers.
A change in the level of price affect different classes of people in different manner. Different
people consumes different types of commodities and even the same types of commodities are not
consumed in the same proportion by different classes of people. For example, the consumption pattern
of teachers and that of workers vary widely. Further the consumption pattern of same class of people
varies from place to place. The mode of expenditure of teachers in Thiruvananthapuram differ from
that of teachers in Bangalore. The consumption pattern of different income groups in rural and urban
Kerala vary much. The relative importance of various commodities thus is different in case of different
types of people. The consumer price index numbers helps us in determining the effect of rise and fall of
prices in different classes of consumers living in different areas. 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.
Cost of living index numbers are constructed by any of the following methods.

1). Aggregative expenditure method.

�� ��
Weighted Aggregative method ��� = �� ��
× 100
2). Family budget method.
��
��� =
�
Example: Construct cost of living index number for the following

Group: A B C D E
Index: 350 200 240 150 250
Weight: 5 2 3 1 2
Solution:
Commodities Index No.(I) Weight(V) IV
A 350 5 1750
B 200 2 400
C 240 3 720
D 150 1 150
E 250 2 500
13 3520

�� 3520
Cost of living index number ��� = �
= 13
= 270.77
Quantity index numbers
Quantity index numbers permits us to compare the quantity of items.it is used to measure the physical
volume of goods produced or distributed or consumed.
Quantity indices can be easily obtained by changing ‘p’ to ‘q’ and ‘q’ to ‘p’.

Fixed base index numbers

When we want to construct index number of a phenomenon (say price) for a number of periods, with a
particular period as base period, the method applied is called fixed base method. Therefore in the fixed
base method, the period to which the levels of a phenomenon for all the given years are related is
constant.
For example, in fixed base method the price index for the fixed base year is taken as 100. Indices
for other years are obtained by dividing the price for that year with the fixed base year price and
multiplied with 100.
����� ��� ���� ����
����� ���� ����� ��: ��� ��� ���� = × ���
����� ��� ����� ���� ����

Chain base index number

Chain base index numbers are index numbers in which the relative changes in the level of a
phenomenon for any period are compared with that of the immediately preceeding period. The chain
base method thus consists in computing a series of index numbers for each year with the preceeding
year as the base year.
����� ��� ������� ����
������� ��� ���� ��������� = × ���
����� �� ��� ���� ���������� ����

Conversion of CBI into FBI

Formula =
������� ����'� ��� × �������� ����'� ���
���
Deflating
By deflating we mean making allowances for the effect of changing levels. A rise in price level causes a
reduction in the purchasing power of money. When we express the value of money giving allowances to
the changes in price level, the process is known as deflating. Therefore deflating removes the effect of
price changes from the value at present and it express in terms of its original value.
The value of rupee (purchasing power of money) is the reciprocal of an appropriate price index.

�
������� ���������� ����� �� ����� = × ���
����� �����

������� ���� ����

���� ���� = × ���
������� ����� �����

Splicing
By splicing we mean combining two or more overlapping series of index numbers with different base
years in to one with a common base year. Splicing is possible only when there is atleast one overlapping
year.
Splicing is very useful for enabling comparison between the new and old index numbers.
Base shifting
Base shifting means changing the base year of a series of index numbers to another and recalculating
the index numbers with the new base.
����� �� �� �� ����
������� ��� ���� �������� = × ���
����� �� �� ���� ����