Ch.

13 INDEX NUMBERS

1. CONCEPT AND DEFINITION OF INDEX NUMBERS

Index number are series of numbers by which changes in the magnitude of a phenomenon are measured from time to time or place to place.

2. FEATURES OR CHARACTERISTICS OF INDEX NUMBERS

1. Relative Changes: Index numbers measure relative or percentage changes in the variable (s) over time, Index number of prices, for
example, is not simply a statement of prices at different dates, it presents estimates of percentage changes in the prices over years with
reference to some selected base year.
2. Quantitative Expression: Index numbers offer a precise measurement of the quantitative change in the concerned variable (s) over
time.
3. Averages: Index numbers show changes in terms of averages. For example, when it is said that between the years 2017 and 2018,
prices have risen by 7 per cent, it does not mean that prices of all goods and services have uniformly risen by 7 per cent; it only mean
that on an average there has been a 7 per cent rise in the prices of various goods and services.

3. ADVANTAGES OR USES OF INDEX NUMBERS

1) Measurement of Changes in the Price Level or the value of Money: We can use index numbers to know the impact of the change
in the value of money on different sections of the society. Accordingly, devices or means can be worked out to correct inflationary or
deflationary gaps in the system.
2) Knowledge of the change in standard of Living: Index numbers help to ascertain the living standards of people. Money incomes
may increase but if index numbers show a decrease in the value of money, living standards may even decline. Thus index numbers
indicate change in real income.
3) Adjustments Salaries and Allowances: Cost of living index is a useful guide to the Government and Private Enterprises to make
necessary adjustments in salaries and allowances of the workers. Increase in the cost of living index suggests increase in salaries and
allowances.
4) Information Regarding Production: Index numbers of production shows whether the level of agricultural and industrial production in
the economy is increasing or decreasing. Accordingly, agricultural and industrial development policies are formulated.

4. LIMITATIONS OF INDEX NUMBERS

1) Not Completely True: Index numbers are not fully true. Index numbers simply indicate arithmetical tendency of the temporal changes
in the variable.
 2) International Comparison not Possible: Different countries have different basis of index numbers. These do not help international
comparisons.
3) Difference of Time: With the passage of time, it is difficult to make comparisons of index numbers, with the changing times, man’s
habits, tastes, etc., also undergo a change. Consequently, index numbers constructed on the basis of old consumption pattern cannot
be compared with the index numbers constructed on the basis of new consumption pattern.
4) Limited Use: Index numbers are prepared with certain specific objective. If they are used for another purpose they may leave to wrong
conclusions. For example, index numbers prepared to know about the economic condition of the teachers cannot be used to know
about the economic condition of the labourers.

SIMPLE AND WEIGHTED INDEX NUMBERS

‘Simple’ and ‘weighted’ are the two broad categories of index numbers. Here is a brief description of these concepts.

Simple index Numbers

These are the index numbers in which all items of the series are accorded equal weightage or importance. In case of a simple index of prices.

Weighted index Numbers

These are the index numbers in which different items of the series are accorded different weightage, depending upon their relative importance. It
is not a simple average of prices of different goods and services, as in case of a simple price index.

Thus, if the expenditure of rice is twice the expenditure on cloth, then in the construction of price index, price of rice may be accorded ‘2’ as the
weight compared to the weightage of ‘I’ to the price of cloth.

Method of Constructing index Numbers

The following chart shows the various methods of constructing index numbers (Simple as well as weighted):
 Methods of Constructing index Numbers

Construction of Simple Index Numbers Construction of weighted index Numbers

Weighted Average of Weighted

Simple Simple Average of Price Aggregative Method
Aggregative Method Relative Methods Price Relatives Method

Construction of Simple Index Numbers

There are two methods of constructing simple index numbers:

1. Simple Aggregative Method

In this method, aggregate of the price of commodities in the current year are divided by the aggregate of their prices in the base year and
multiplied by 100 to get index value for the current year. It is expressed by the following formula,

Formula
∑ P1
P01= ×100
∑ p0

Here, P01= Price index of current year.

∑ P1=¿ Sum of the prices of the commodities in the current year.
∑ P0=¿ Sum of the prices of the commodities in the base year.
Current year: Current year is the year for which average change is to be measured or index number is to be calculated.
Base Year: Base year is the year of reference from which we want to measure extent of change in current year. The index number of base year
is generally assumed to be 100.

Illustration.
Given the following data and assuming 2004 as the base year, find out index value of the prices of different commodities for the year 2018.

Commodity A B C D E
Price in 2004 (`) 50 40 10 5 2
Price in 2018 (`) 80 60 20 10 6

Solution:
Constructing of a Simple Index Number- simple Aggregative Method
Commodity 2004 Price (`) 2018 Price (`)
( P0 ) ( P 1)
A 50 80
B 40 60
C 10 20
D 5 10
E 2 6
Total ∑ P0=107 ∑ P1=176

∑ P1
P01= ×100
∑ P0

176
= ×100
107

= 164.49
Price Index = 164.49

2. Simple Average of Price Relative Method

According to this method, we first find out price relatives for each commodity and then take simple average of all the price relatives.

What is price Relative?

A price relative is the percentage ratio of the value of a variable in the current year to its value in the base year. In other words, a price
relative is a percentage ratio between price of commodity in the current year and that in the base year.

Current year Price (P1)

Price Relatives, P01= × 100
Base Year Price(P0 )

FORMULA

=
∑
( P1
P0
× 100
)
N
P1
(Here, ×100 = Price relatives; N = Number of goods; P1=¿ current Year’s value’ P0=¿Base year’s value.)
P0
Illustration
Given the following data and using the price Relatives Method, construct an index number for the year 2018 in relation to 2004 prices.
Commodity Wheat Ghee Milk Rice Sugar
2004 Price (`) 100 8 2 200 1
(Per qt.) (Per Kg) (per l ) (Per qt.) (per kg)
20018 Price (`) 200 40 16 800 6

Solution:
Construction of a simple Index Number- simple Average of price Relative Method
Commodity Base year 2018 Price Price Relatives of 2018
2004 ( P 1) In relation to 2004

( )
P
Price ( 0) P1
×100
P0
Wheat 100 (per qt) 200 (per qt) 200
×100=200
100
Ghee 8(per kg) 40(per kg) 40
× 100=500
8
 Milk 2 (per l ) 16(per l ) 16
×100=800
2
Rice 200 (per qt) 800(per qt) 800
× 100=400
200
Sugar 1 (per kg) 6 (per kg) 6
× 100=600
1

( )
N=5 P1
∑ ×100 =2,500
P0

P01=
∑
( P1
P0
× 100
)
N

2,500
= =500
5

Price Index = 500.

CONSTRUCTION OF WEIGHTED INDEX NUMBERS

There are two methods of constructing weighted index numbers, as discussed below:

1) Weighted Average of Price Relative Method

According to this method, weighted sum of the price relative is divided by the sum total of the weights, In this method, goods are given
weight according to their quantity. Thus,

Formula
∑ RW
P01=
∑W

Here, P01=¿ Index number for the current year in relation to the base year; W= Weight; R = Price relative.)

Illustration.
Given the following data and using Weighted Average Price Relative Method, construct index number for 2018 based on 2004 Prices.
 Goods Weight 2004 Price (`) 2018 Price (`)
Wheat 40 100 (Per qt) 200 (per qt)
Rice 30 200 (per qt) 800 (per qt)
Milk 15 2 (per l ) 16 (per l )
Ghee 10 8 (per kg) 40 (per kg)
Sugar 5 1 (pe kg) 6 (per kg)

Solution:
Goods Weight 2004 Price 2018 Price P1 RW
R= ×100
(W) ( P0 ) ( P 1) P0
Wheat 40 ` 100 per qt ` 200 per qt 200 200 × 40=8,000
×100=200
100
Rice 30 ` 200 per qt ` 800 per qt 800 400 × 30=12,000
× 100=400
200
Milk 15 ` 2 per l ` 16 per l 16 800 ×15=12,000
×100=800
2
Ghee 10 ` 8per kg ` 40 per kg 40 500 ×10 = 5,000
× 100=500
8
Sugar 5 ` 1 per kg ` 6 per kg 6 600 ×5=3,000
× 100=600
1
Total ∑ W =100 ∑ RW =40,000

∑ RW 40,000
P01= = =400
∑W 100

Price Index = 400.

2. Weighted Aggregative Method

I. Laspeyre’s Method: Laspeyre’s uses base year quantities (q 0) as weights of different items. His formula for estimating index
values is:

Formula
 ∑ P1 q 0
P01= × 100
∑ p0 q 0

II. Paasche’s Method: Passche’s on the other hand uses current Year’s quantities (q 1) as weight. His formula to construct the
index value is:

Formula
∑ P1 q1
P01= × 100
∑ P0 q1

III. Fisher’s Method: Fisher has combined the techniques of Laspeyre’s passche’s method. He used both year as well as current
year quantities (q 0 ,q 1) as weight. His formula to construct Index Number is:

Formula

P01=
√ ∑ P 1 q 0 ∑ P 1 q1
×
∑ P0q0 ∑ p0q1
× 100

Fisher’s method is treated as ideal Formula.

Fisher’s method is considered as ‘ideal’ because

I. It is based on variable weights.
II. It takes into consideration the price and quantities of both the base year and current year.
III. It is based on geometric mean (GM) which is regarded as the best mean for calculating index number.
IV. Fisher’s index number satisfies both the Time Reversal Test and Factor Reversal Test.

Illustration.
Construct index numbers of prices of the items in the year 2018 from the following data by:
I. Laspeyre’s Method,
II. Paashce’s Method, and
III. Fisher’s Method.

Items 2004 (Base Year) 2018 (Current Year)

 Price Quantity Price Quantity
A 10 10 20 25
B 35 3 40 10
C 30 5 20 15
D 10 20 8 20
E 40 2 40 5

Solution:
Construction of Price Index Numbers
Items Base Year Current Year p0 q 0 p0 q1 p1 q0 p1 q1
(2004) (2018)
Price Quantity Price Quantity
( p0 ) (q 0) ( p1 ) (q 1)
A 10 10 20 25 100 250 200 500
B 35 3 40 10 105 350 120 400
C 30 5 20 15 150 450 100 300
D 10 20 8 20 200 200 160 160
E 40 2 40 5 80 200 80 200
∑ P0 q 0=635 ∑ P0 q1 =1,450 ∑ P1 q0 =660 ∑ P1 q1=1,560

∑ P1 q0
I. Laspeyre’s Method: P01= × 100
∑ P0 q0

660
= ×100=103.94
635

∑ p1 q1
II. Paasche’s Method: P01= × 100
∑ p 0 q1
1,560
= ×100 = 107.59
1,450
 III. Fisher’s Method: P01=
√ ∑ p1 q0 ∑ p1 q1
×
∑ P 0 q 0 ∑ p0 q 1
×100

=
√
660 1560
×
635 1450
× 100

= √ 1.03 ×1.07 ×100

= √ 1.1021× 100
= 1.05 ×100=105

CONSUMER PRICE INDCEX OR COST OF LIVING INDEX NUMBER

To know the effects of changing prices on the living of different classes of society, we need a special type of price index, called consumer price
index or cost of Living Index Number.

The consumer Price index is the index number which measures the average change in prices paid by the specific class of consumers for goods
and services consumed by them in the current year in comparison with base year.

In india the consumer price indices are mainly constructed for the following consumer groups:
I. Industrial Workers (IW)
II. Urban- Non Manual Employees (UNME)
III. Agricultural Labourers (AL).

Method of Constructing consumer price index (CPI)

Corresponding to the two methods of assigning weights to different commodities, there are two methods of the construction of consumer’s price
index.
1) Aggregative Expenditure Method
2) Family Budget Method.

1) Aggregative Expenditure Method: This method is similar to the Laspeyre’s method (already discussed).
The following formula is used in this method.
 Formula
∑ p1 q0
Consumer Price Index (CPI) = × 100
∑ p 0 q0
Where, P1=¿ Price of the commodities in the current year.
P0=¿ Price of the commodities in the base year.

Thus,
q 0=¿ Quantity consumed in base year.
∑ P1 q0 shows aggregate expenditure in the current year.
∑ P0 q 0 shows aggregate expenditure in the base year.

∑ P1 q0
P01= × 100
∑ P0 q0
2) Family Budget Method: The following formula is used in this method to find Consumer’s Price Index.

Formula
∑ RW
Consumer’s price index =
∑W

Where, R = Current year’s Price relative of various items.

W = Weights of Various items.

Price of the Current year

Price Relative of the current year = × 100
Price of the Base year
p1
R= × 100
P0
The sum of weights ∑ W of ∑ p0 q 0 is calculated.

Illustration.
Construct Cost of Living Index for 2018 based on 2004 from the following data:
 Group Food Housing Clothing Fuel Light Miscellaneous
Group Index 122 140 112 116 106
Number for 2018
(Based on 2004)
Weights 32 10 10 6 42

Solution:
Group Group index Weights Weighted Relative
Number (R) (W) (RW)
Food 122 32 3904
Housing 140 10 1400
Clothing 112 10 1,120
Fuel and light 116 6 696
Miscellaneous 106 42 4,452
∑ W =100 ∑ RW =11,572

∑ RW 11,572
Thus, Cost of Living Index = =¿ =115.72
∑W 100

Importance of the Consumer Price index or Cost of Living Index

1. Formulation of Price Policy: The Consumer price indices are used by government to frame policies on prices. Government
policies like rent control and taxation, general economic and fiscal policies etc. are framed on the basis of the consumer price
index numbers to a large extent.
2. Wage Adjustment: The rates of dearness allowances are decided by the government on the basis of these indices.
3. Measurements of Real value; These index numbers are used power the real value of the rupee or its purchasing power and
real income (or revenue), etc.
4. Analysis of Markets: The consumer price indices are also used for the analysis of the market of specific commodities for their
demand and supply.
5. National Income Deflator: These indices are also used as deflators of national income. Accordingly, real change in national
income is estimated.

WHOLESALE PRICE INDEX (WPI)

The Wholesale Price Index (WPI) measures the relative changes int the prices of commodities traded in the wholesale markets, in india, the
wholesale price index numbers are constructed on weekly basis. The year 2011-12 is being used as the base year.

Uses of Wholesale Price Index

1) Forecasting Demand and Supply: An increase in wholesale price index is an indication of excess demand. It is a situation in which
demand is greater than supply. On the other hand, a decrease in wholesale price index implies deficient demand. It is a situation in
which demand is less than supply.
2) Estimation of Monetary value Real Value: The Wholesale price index can be used to estimate the monetary value and real value of
aggregates like national income and expenditure.

Price index of Base year

Real Aggregate of the Current Year = Monetary Aggregate of the Current Year ×
Price index of current Year

3) Indicator of Rate of Inflation: The wholesale price index is also applied to calculated the rate of inflation in a country. It refers to the
rate at which prices tend to increase over time.

What is Rate of Inflation?

Wholesale Price index is prepared for every week, If for week 1, wholesale price index is A1 and for week 2, the wholesale price index is A2 , then
the rate of inflation between week 1 and week 2 would be estimated as under:

A 2− A1
× 100
A1

Illustration.
If wholesale price index for week 1 = 200 and for week 2 = 250, then
250−200
Rate of inflation = ×100
200

50
= ×100=25 %
200

Annual rate of inflation is estimated by considering average of the wholesale price index for all weeks of the year.