UNIT III

INDEX NUMBERS
Index numbers are the indicators which reflects changes over a specified period of time for example

Prices of different commodities

Industrial production
Sales
Imports and exports
Cost of living etc.

These indicators are of paramount importance to the management personal or any government
organisation or industrial concern for the purpose of reviewing position and planning action, if
necessary and in the formulation of executive decisions. They reflect the pulse of an economy and
serve as indicators of inflation or deflation.

DEFINITION
According to the Spiegel:
An index numbers is a statistical measure, designed to measure changes in a variable, or group
of related variables with respect to time, geographical location or other characteristics such as
income.
According to Patterson:
An index numbers is the ratio of two index numbers expressed as a percent. A statistical measure
designed to show changes in one variable or a group of related variables over time with respect
to geographical location to other characteristics.
According to Wheldon:
An index numbers is a device which shows by its variation the changes in a magnitude which is
not capable of accurate measurement in it or of direct valuation in practice.

Problems in constructing of index numbers

Before constructing index numbers a careful thought must be given to the following problems:
1. The purpose of Index
The purpose of constructing the index must be very clearly decided There is no all purpose
indexes. Every index is of limited and particular use. Thus as a price index that is intended to
measure consumers price must not include wholesale prices and if such an index is intended
to measure the cost of living of poor families. Great care should be taken not to include goods
ordinarily used by middle and upper class groups. If failed to decide the purpose of the index
it would lead to confusion and wastage of time with no fruitful result.
2. Selection of a Base Period
Whenever index numbers are constructed a reference is made to some base period. The base
period of index numbers (also called reference period) is the period against which comparison
are made. It may be a year, a month, or a day.
To consider a base period following points are required.

3.

4.

5.

6.

7.

The base period should be normal one:

The period that is selected as base should be normal i.e. it should be free from
abnormalities like wars, earthquakes, famines, booms, depression etc.
The base period should not be too distant in the past:
It is desirable to have a index based on a fairly recent period, since comparisons with
a familiar set of circumstances are more helpful than comparisons with vaguely
remembered conditions.
Fixed base or chain base:
While selecting the base a decision has to be made as to whether the base should
remain fixed or not. i.e whether we have a fixed base or chain base index. In the
fixed base method, the year or the period of the years to which all other prices are
related is constant for all times. On the other hand chain base method the prices of a
year are linked with those of the preceding years and not with the fixed year.
Naturally the chain base method gives a better picture than what is obtained by fixed
base method.
Selection of number of items
The purpose of index numbers is defined then we have to select only those commodities
which are relevant to the index. For example: If the purpose of index numbers is to measure
the cost of living of low income group (poor families) we must select only those commodities
or items which are consumed/ utilised by persons belonging to this group and should not
consider those goods which are ordinarily consumed by middle-income or high- income
groups.
Data for index numbers
The data usually the set of prices and of quantities consumed of the selected commodities for
different periods, places etc. Constitute the raw material for the construction of index
numbers. The data should be collected from the reliable sources such as a standard trade
journals, official publications, periodical special reports from the producers, exporters etc.
For example: For the construction of retail price index numbers, the price quotations for an
adequate number of commodities should be obtained from super bazaars, fair price shops,
departmental stores, etc and not from whole sale dealers.
Choice of an average
Index numbers are specialised averages a decision has to be made as to which particular
averages should be used for constructing the index number basically or choice has to be made
between arithmetic mean and geometric mean. Theoretically speaking geometric mean is the
best average in the construction of index numbers. Despite theoretical justification for
favouring geometric mean, arithmetic mean is more popularly used while constructing index
numbers this is for the reason that arithmetic mean is much simpler to compute than
geometric mean.
Selection of an appropriate weights
Generally, various items commodities, say, wheat, rice kerosene, clothing etc included in the
index are not of equal importance, proper weights should be attached to them to take into
account their relative importance. Thus there are two types of indices:
a. Un-weighted indices:- No specific weights are attached to various commodities.
b. Weighted indices:- Appropriate weights are assigned to various items.
Choice of formulae
A large number of formulae have been devised for constructing the index. The problem very
often is that of selecting the most appropriate formula. The choice of the formula would
depend not only on the purpose of the index but also on the data available.

Methods of Construction of Index Numbers

Notations
p0, pn denotes the price per unit in base year and current year respectively.
q0, qn denotes the quantity in the base year and current year respectively.
p0, p1, p2....... denotes price in the years 0, 1, 2...... respectively.
q0, q1, q2...... denotes quantities in the years 0,1,2..... respectively.
I stands for Index numbers.
I0n denotes index numbers for year n with base year 0.
In0 denotes index numbers for year 0 with base year n.
I23 denotes index numbers for year 3 with base year 2.

1.
2.
3.
4.
5.
6.
7.
8.

Unweighted

Simple Aggregative
In this method, the aggregative price of all items in the given year is expressed as a
percentage of the same in the base year.

100

Relative method




100

100

The average of price relatives, which shows the average percentage change for the whole group of
items, gives the index number
Price Index = Average of price Relatives
Usually arithmetic mean and geometric mean is used for averaging the relatives,
Thus,
Simple AM of relative Index (I0n) =

Simple GM of relative Index (I0n) = ,(

!" "#$% &"

'

) * )+

Weighted

Weighted Aggregative Index

This method provides for the different commodities to exert their influence in the index
number by assigning appropriate weights to each.
Laspeyres Method
The Laspeyres price Index is weighted aggregate price index, where the weights
are determined by the quantities in the base period.
.
100
.
Remark: Laspeyres Index attempts to answer the question What is the change in
aggregate value of the base period list of goods when valued at given period
prices?
Paasches Method
The paasche price index is a weighted aggregate price index in which the weights
are determined by the quantities in the given year.
.
100
.
Remark: In general this formula answers the question: What would be the value
of given period list of goods when valued at the base-period prices?
Comparison of Laspeyres and Paasche methods
Laspeyres index measures change in a fixed market basket of goods and
services. The same quantities are used in each period. The Paasche index method
continually updates the quantities to the level of current consumption.
Dorbish & Bowley Method
Dorbish & Bowley have suggested simple AM of the two indices (Laspeyres &
Paasche) so to take into account the influence of both the periods.
1
4
01
5

+3

2
.
1 .
6
+
7
.
2 .
Fisher Ideal Method
Geometric mean of Laspeyres Index and Paasches index.

(1
3

Marshall Edgeworth Method

In this both the current years as well as base year prices and quantities are
considered.
. +.
100
. +.
Kellys Method
.
100
.
Here weights are the quantities referred to some period, not necessarily the base
year or current year.
Weighted AM of relatives Index (I0n)

9
9

Where w weights employed (quantities)

Laspeyres Method

100;

100
.
.

100
.
The AM of relatives formula weighted by base year values (p0q0) gives exactly the
same formulae as Laspeyres.
AM of relatives formula weighted by value of current year quantities (p0qn) gives
paasches formula.

Quantity (or Volume) Index numbers (Q0n)

Just as price index numbers measures and permit comparison of price of a group of related items,
quantity index numbers. Similarly measure and permit comparison of physical quantities of goods
produced or consumed or marketed or distributed. Quantity index numbers formulae may be obtained
from corresponding price index numbers formulae by replacing p with q and q with p.

Tests of Adequacy of Index Numbers Formulae

Several formulae have been suggested for constructing index numbers and problem is that of selecting
the most appropriate one in a given situation. The following tests are suggested for choosing an
appropriate index.

Time Reversal Test

According to this test, a good index number formula should work both ways, forward and
backward, with respect to time. In other words, we should get the same picture of change
between two points of time, no matter which of the two is taken as base. Consequently, the
index number (I0n) for period 0 base n should be the reciprocal of the index number (In0)
for period 0 with base period n (omitting the factor 100 from each index)
1
An index number formula which obeys this relation is said to satisfy the time reversal test.
Factor Reversal Test
An index number formula is said to satisfy the factor reversal test, if the product of price
index (P0n) and quantity index (Q0n) gives the true value ratio (omitting the factor 100 from
each index).
.
3
<
.
Remark:
Fishers ideal index is the only formula which satisfies factor reversal test.
Simple aggregative, Marshall-Edgeworth, Fishers ideal and simple geometric mean
of relatives formula, weighted aggregative and weighted GM of relatives formula
satisfies the time reversal test.
Circular Test
This is an extension of time reversal test. An index number formula is said to satisfy the
circular test, if the time reversal test is satisfied through a number of intermediate years
1
=
=>
>?
?@ .
C=

This means that the relation is satisfied in a circular fashion through several years 0 to 1, 1
to 2, 2 to 3........ (n-1) to n and then finally from n back to 0.
Remark: Simple aggregative and simple GM of relative formula satisfies this test.
Weighted aggregative formula and weighted GM of relative formula satisfies this test, if
constant weights are used for all time periods.

Chain Base Method

There are two methods of constructing Index numbers depending upon the nature of base
period employed.
(i)
(ii)

Fixed Base Method

Chain Base Method

Most of the index numbers in common use are of the fixed base type, where a fixed period is
chosen as the base and the index number for any given year is calculated. The fixed base
index for any year is no, therefore affected by changes in price or quantity in any other year.
It is however considered that the net changes in any given year are the result of gradual
changes that have taken place during the past years. This idea is reflected in a chain base
index number.
For construction of index numbers by the chain base method, using an appropriate index
number formula. It is first necessary to compute index numbers for all the years, always using
the preceding year as base, these are known as Link Index.
1 D

E*

For example, using Laspeyres formula

1 D

+)

1 D

+)

=>

1 D

+)

>?

=.

> .=

= .=

? .>
> .>

100
100
100

Etc. The link indices I01, I12, I23..... are then multiplied successively (called chaining process)
in order to relate them to a common base.
4
4
4
4

Merits of Chain Base method

=
=

>
=

?
=

=>
=>

=>

>?
>?

?@

1. More realistic in nature than a fixed base index.

2. It enables comparison between two adjacent time periods through the link indecies.
Demerits
1. Calculations are quite tedious.
2. Any error committed in the calculation of any link index number the entire series of chain
base index numbers will be wrong and if any data is missing then subsequent chain index
numbers cannot be calculated.
3. Suitable for short periods only.