CHAPTER 7: INDEX NUMBERS

- Index numbers are used to measure, or indicate, how much something has changed
from one time to another or how something compares with something else.
- Percentages that compare two things are simple examples of index numbers.
- An index number is a ratio or an average of ratios expressed as a percentage. Two or
more time periods are involved, one of which is the base time period. The value at
the base time period serves as the standard point of comparison, while the values at
the other time periods are used to show the percentage change in the value from the
standard value of the base period.
- The principal use of index numbers in business and economics is to make
comparisons between two different time periods.
Example: Consumer Price Index (CPI).

Unweighted Index Numbers

1. Simple Price Index, IP
- Which is just the price relative expressed as a percentage.
p
I P  n  100
po
2. Simple Quantity Index, IQ
- Which is just the quantity relative expressed as a percentage.
q
I Q  n  100
qo
e.g.1 The average retail prices of 500g of butter, 250g of tea and a 125g can of baby food in
Sydney for the September quarter at 5-year intervals between 1976 and 1996
Find the simple price index for each item relative to the base year 1976.
Price of one unit ($)
Item Unit 1976 1981 1986 1991 1996
Butter 500g 0.22 1.28 1.63 1.94 1.80
Tea 250g 0.47 0.76 1.44 1.79 1.86
Baby food 125g 0.14 0.24 0.33 0.51 0.57

3. Simple Aggregate Price Index, I

I
p n
 100
p o

where p n = sum of prices in the current period.

p o = sum of prices in the base period.

Weaknesses:
(i) An item with a relatively large price can dominate the index.
(ii) If prices are quoted for different quantities, the simple aggregate index will
yield a different answer.
(iii) It does not take into account the quantity of each item sold.

e.g.2 The price shown in the following table are the prices in cents per pound of four
nonferrous metals in the years 1988 and in 1989. Comment.

1
 Price (cents per pound)
Metal 1988 1989
Aluminum 110 88
Copper 121 131
Lead 37 39
Zinc 60 82

Construct a simple aggregative comparing the year 1989 prices of these nonferrous
metals with their prices in the year 1988. Comment.

Weighted Aggregate Index Numbers

4. Laspeyres Indexes
- Special case of a weighted aggregate index which always uses base time period
weights.
(i) Laspeyres Price Index uses base time period quantities as weights.

LP =
p n qo
 100
p o qo

(ii) Laspeyres Quantity Index uses base time period prices as weights.

LQ =
 q n po  100
 qo po
e.g.3 The following table shows farm prices (per bushel) and quantities produced (in
billion of bushels) of three kinds of grain produced in the US during the years 1987,
1988, and 1989.
Price per bushel Quantity of bushels (in billion)
1987 1988 1989 1987 1988 1989
Corn 1.94 2.55 2.35 7.1 4.9 7.5
Wheat 2.57 3.72 3.72 2.1 1.8 2.0
Oats 1.56 2.61 1.49 0.4 0.2 0.4
With 1988 as the base year, and using base-year quantities as weights, construct a
weighted aggregative index which measures the change in the prices of these grains
from 1988 to 1989. Comment.

5. Paasche Indexes
- It measures the change in the cost of purchasing items, in terms of quantities or prices
relating to the current period.
(i) Paasche Price Index uses current time period quantities as weights.

PP =
p n qn
 100
p o qn
(ii) Paasche Quantity Index uses current time period prices as weights.

PQ =
q n pn
 100
q o pn

e.g.4 Using the data given below and find the Paasche price index for 1996 using:
(a) 1986 as the base year.
(b) 1991 as the base year.

Quantity sold in 1986 Quantity sole in 1996 Price ($)

Item Unit (millions) (millions) 1986 1991 1996

2
 Baked beans 440g 30 55 0.45 0.87 0.98
Sausages 1 kg 120 150 2.27 4.46 4.07
Cheese 500g 50 76 1.45 3.42 3.44

Comparisons of the Laspeyres and Paasche Indexes

1. The Laspeyres price index measures the ratio of expenditures on base year quantities
in the current year to expenditures on those quantities in the base year.
2. The Paasche price index measures the ratio of expenditures on current year quantities
in the current year to expenditures on those quantities in the base year.
3. Since the Laspeyres index uses base period weights, it may over estimate the rise in
the cost of living (because people may have reduced their consumption of items that
have become proportionately dearer than others).
4. Since the Paassche index uses current period weights, it may under estimate the rise
in the cost of living.
5. The Laspeyres index is usually larger than the Paasche index.
6. With the Paasche index it is difficult to make year-to-year comparisons since every
year a new set of weights is used.
7. The Paasche index requires that a new set of weights be obtained each year, and this
information can be expensive to obtain.
8. Because of points 6 and 7, the Laspeyres index is the one most commonly used.

Changing of base year

e.g.5 From the accompanying table, find the price indexes for the three items in 1996 using
1991 as the base year. Find also the price indexes for 1981 using 1986 as the base.
Simple price index
Item 1976 1981 1986 1991 1996
Butter 100.0 581.8 740.9 881.8 818.2
Tea 100.0 161.7 306.4 380.9 395.7
Baby food 100.0 171.4 235.7 364.3 407.1

1. http://www.youtube.com/watch?v=vFituwiUFXU (Laspeyres price index)

2. http://www.youtube.com/watch?v=TvX41H7bOfE (Paasche price index)

STA2204.chap7