Index Number

Contents :
1. Definition and Meaning of Index Number
2. Characteristics of Index Number
3. Uses of Index Number
4. Base year
1. Fixed Base method, merits and limitations
2. Chain Base method, merits and limitations
5. Conversion of Fixed Base to Chain Base and Chain Base to Fixed Base
6. Computation of Index Number
1. Laspeyre’s Formula
2. Paasche’s Formula
3. Fisher’s Formula
7. Cost of Living Index Number Explanation and Construction
 MEANING OF INDEX NUMBER:

“The percentage change in the value of a variable associated

with any item for the given (current) period compared to its
value in a fixed (base) period is called an index number.”
Price of base Price of current Price relative or Percentage of
Item year 2015 year 2016 Relative change Price Relative=
P1/P0
P1/Po x 100

Wheat 24 30 30/24 = 1.25 125

Rice 40 46 40/46= 1.15 115

Total 2.40 240

 The index obtained by multiplying the average of price relatives of the
current year for these two items by 100 is called the price index number of the
items for the current year. It is denoted by I. Thus,

I = PRICE RELATIVE OF WHEAT + PRICE RELATIVE OF RICE x 100

NO . OF ITEMS

(1.25+ 1.15) X 100 = 120

=
2

Hence, price index number of wheat and rice for the current year = 120.
The price index number of wheat and rice = 120 indicates that there is an
overall rise of 20 percent in the prices of the two items in the year 2016 as
compared to the year 2015. Index number is a relative measure based on
ratio.
 Characteristics of Index Number:
1. Index number is free from the unit as it is a relative measure.
2. The changes in the values of the variable having different units can be compared using
index number. Hence, index number is a comparative measure.
3. Index number is a relative measure showing percentage change.
4. Index number is a special average. It has all the characteristics of an average.
5. The situation at two different periods can be compared by ratio with the standard (base)
period using an index number.
Uses of Index Number:
1. Index Number for Trade
2. Wholesale Price Index Number
3. Cost of Living Index Number
4. Index Number of Human Development
5. Index Number of National Income
6. Index Number of Industrial Production
7. Index Number of Agricultural Production
8. Index Number of Import-Export
9. Index Number for Employment
10. Index Number of Capital Investment
11. Index Number of Raw Material
Base Year
In the construction of index numbers, the value of a variable for the current period is

compared with the value of the variable

with a fixed period (usually from the past). This fixed
period or year is called the base year.
For example, if the price of an item in the year 2016 is to be compared with
the price of the same item in the year 2015, the year 2015 is called base year and
the year 2016 is called the current year.

•The year selected as base year should be standard or normal.

• It should be free from natural calamities like floods, draught, earthquake, abnormal
man-made events like war, revolt, riot, strike, agitation, political events, economic
disturbance or any unusual events.
• It is also necessary that the base year should not be from a distant past.
• If the base year selected is an unusual year and the values of the variable are
unusually high or low then the value of index number could be misleading and it will
not reveal the realistic picture of the current situation.
Thus, the base year should be carefully selected while constructing index
number.
The base year can be selected in two ways :
(1) Fixed Base Method
(2) Chain Base Method

Illustration 1 : The data about wholesale prices of wheat in a region are as follows.
Taking the year 2005 as the base year, prepare the index numbers for the price of the
item for the remaining years. State the percentage increase in the price of wheat in
the year 2013 from these index numbers.

Year 2005 2006 2007 2008 2009 2010 2011 2012 2013
Price per 1650 1690 1730 1750 1810 1850 1870 1900 1950
Quintal (Z)

We will find the fixed base index number as the year 2005 is to be
taken as the base year. The index number for the price of wheat in the year
2005 will be taken as 100
 Price of wheat
Year per Quintal (Z) Index number

2005 1650 1650 x 100 100

1650
1690
2006 1690 1650 x 100 102.42
1730
2007 1730 1650 x 100 104.85
1750
2008 1750 1650 x 100 106.06
1810
2009 1810 1650 x 100 109.70

2010 1850
1850 1650
x 100 112.12
1870
2011 1870 1650 x 100 113.33
1900
2012 1900 1650 x 100 115.15
1950
2013 1950 1650 x 100 118.18

INDEX NO = P1/P0 X100 Where P1 = Current year

P0 = Base year(2005)
Illustration 2 : The prices per unit (T) of six food items in the year 2014 and 2015
are given in the following table. Taking 2014 as the base year, compute the general
index number for the price of food items and state the overall rise in prices of
these food items
Price per unit (Z) of the
Item Unit item
Year 2014 Year 2015

Bread Packet 25 28
Eggs Dozen 30 35
Ghee 375 380
Milk Litre 36 40
Cheese Kilogram 440 500
Butter Kilogram 265 300
 Price of item (T)
Item P0 P1 Price relative

Bread 25 28 28/25 1.1200

Eggs 30 35 1.1666
35/30
Ghee 375 380 380/375 1.0133

Milk 36 40 1.1111
40/36
Cheese 440 500 500/440 1.1364

Butter 265 300 300/265 1.1321

Total = 6.6795

General index number of six food items = 6.6795 x 100 = 111.

6
It can be seen from the value of the index number that there is an overall rise
in prices of food items by (111.33 — 100) = 11.33 % in the year 2015 as compared to
the year 2014.
Illustration 3 : The data about sugar production of a sugar manufacturing
company from the year 2008 to 2015 are as follows. Prepare index number by
fixed base method from these data by taking average production of the years
2009, 2010 and 2011 as the production of the base year.
Year 2008 2009 2010 2011 2012 2013 2014 2015
Production (thousand tons) 186 196 202 214 229 216 226 230

Ans:
The average production of the years 2009, 2010 and 2011
= 196+202+ 214/3 = 204
 Year Production
(thousand tons)
Index number by fixed base method

(P1/PO x100)

186 x 100
204
2008 186 91.18
2009 196 196 x 100 96.08
204

2010 202 202 x 100 99.02

204

2011 214 214 x 100 104.90

204

2012 220 220 x 100 107.84

204

2013 216 216 x 100 105.88

204

2014 226 226 x 100 110.78

204

2015 230 230 x 100 112.75

204
 Merits and limitations of fixed base method

Merits : .
1. Uniformity is maintained in calculation and comparison of the relative changes in the
values of the variable as the base year is constant in this method.
2. This method is useful to compare the long term changes in the values of the
variable.
3. This method is easy to understand and compute.

Limitations :
4. The taste, habits and fashion of consumers change with time and hence there is a
change in the items used by the consumer. The items with reduced usage which
were used in the past can not be removed in this method.
5. It is not always possible to have a standard year with normal conditions as the
base year. Therefore, selection of the base Year is difficult.
6. The reliability of the index number reduces if the base year is not selected
appropriately.
7. This method is not suitable to compare the short term changes in the value of the
variable.
8. The quality of selected items keeps changing. It is not possible to make necessary
change in their weights in this method.
9. If the base year is a year of very remote past, the comparison can not be
considered to be appropriate.
 CHAIN BASE METHOD
Illustration 4 : The data about bi-monthly closing prices of shares of a
company in the year 2014 are given. Compute the chain base index numbers from
these data.
Month January March May July September November
Price (T) 22 21.20 22 23 24.70 26.00

The price for the month before January is not given here. Hence, we will take the
index number for January, 2014 as 100. The calculation of index numbers for
remaining months using the chain base method are shown in the following table.

CHAIN BASE METHOD = Value of the variable in current month X 100

Value of the variable in preceding month