INDEX NUMBERS

Introduction
Index numbers are a useful way of expressing economic data time series and comparing /
contrasting information. An index number is a figure reflecting price or quantity compared
with a base value. The base value of the index number is usually 100, which indicates price,
date, a level of production, and more. An index number is a method of evaluating variations
in a variable or group of variables in regards to the geographical location, time, and other
features.

There are various kinds of index numbers. However, at present, the most relatable is the price
index number that particularly indicates the changes in overall price level (or in the value of
money) for a particular time.

Here, the value of money is not a constant; even if it falls or rises it will affect and change the
price level. An increase in the price level determines a decline in the value of money. A
decrease in the price level means an increase in the value of money.

Therefore, the differences in the value of money are indicated by the differences in the
overall price level for a particular time. Therefore, the changes in the overall prices can be
evaluated by a statistical device known as ‘index number. Important note is that no units are
attached to index numbers.

The consumer price index is a monthly price index that uses the price changes in a market
basket of consumer goods and services to measure the changes in consumer prices over time

A monthly price index that is designed to measure changes in prices of goods sold in primary
markets (i.e., first purchase of a commodity in non retail markets) is the Producer price
index.

Ex: Aggregate price indexes reflecting the prices of stocks listed on the New York Stock
Exchange are Dow Jones average.

A quantity index which is designed to measure changes in the physical volume of production
levels of industrial goods over time is the Index of Industrial Production.
Types of Index Numbers
Price index number: It evaluates the relative differences in costs between two particular
points in time.

 Single price index measures the percentage change in the current price per
unit of a product to its base year

 Composite price index measures the average price change for a basket of
related items from base period to the current period

 Retail price index reflects the general change in the retail prices of various
items. Note that consumer price index is a special type of retail price index.

Quantity index number: It measures the differences in the physical quantity of the product’s
manufacturing, buying, or selling of one item or a group of items between two time periods.
While constructing quantity index numbers, it is necessary to hold price levels constant over
time to isolate the effect of quantity (consumption level) changes only.

Value index number measures general changes in the total value of some variable. A value
index actually measures the combined effects of price and quantity changes.

Various Index Numbers

1. A price index for a given item which is computed by dividing a current unit price by a base
period unit price and multiplying the result by 100 is known as the Price Relative. The
general formula for calculating price index (or price relative) is

Price Index in nth period =

where Pn is the price per unit of an item in nth year and Po is the price per unit of an item in
the base year.

Example-1: You are given the following information about items A, B, C, and D. Calculate
the price relative of item based on 1994.

Unit Price ($) Price

Item 1994 2001 Relative
A .85 .92 =(0.92/0.85)*100
= 108.25
B 1.15 1.30 =(1.30/1.15)*100
 =113.04
C 25.16 32.50 =(32.50/25.16)*100
= 129.20
D 114.75 120.25 =(120.25/114.75)*100
=104.80

Example-2: The prices of a college Statistics book for the years 1996 through 2001 are
shown below. (a) Determine the price relatives for the years 1996 through 2001. (b) Interpret
the meaning of the price relative for 1997.
Solution: Let 1996 be the base period.

Year Price ($) Price Relatives

1996 25.00
1997 28.00 =(28.0/25.0)*100 =112.00
1998 31.25 =(31.25/25.0)*100=125.00
1999 35.00 140
2000 45.00 180
2001 50.00 200

b. Book price in 1997 was 12% above 1996.

2. A composite price index based on the prices of a group of items is also known as the
Aggregate Price Index. This is calculated by the following formula:

Aggregate Price Index P01 =

where P1 is the price per unit of an item in current year; Po is the price per unit of an item in
the base year and n denotes the number of items.

Example-3: The following table shows the retail price of a typical family’s shopping basket.
The data pertain to retail prices during 2001 and 2002 are given in the following table.
Calculate the aggregate price index.

Unit Price ($) Price

Item 2001 2002 Relative
Milk (1L) 18 26 (26/18)*100 =144.44

Butter (1 Kg) 120 165 (165/120)*100=

137.50
 Bread(500 gms) 14 17 (17/14)*100 = 121.43

Eggs (1Dozen) 15 22 (22/15)*100= 146.67

Now aggregate price index (relative) = (144.44+137.50+121.43+146.67)/4

=137.51

Example-4: A computer equipment dealer sells three types of printers: Laser I, Laser II, and
Laser III. The prices of these printers for the years 1998 and 2001 are given below.
Unit Price ($)
Printer 1998 (Po) 2001 (Pt)
Laser I 2,800 2,000
Laser II 1,200 1,100
Laser III 800 644
a. Compute an unweighted aggregate price index for the printers. Let 1998 be the
base period.
b. Interpret the meaning of the value that you found in Part a.

Solution: The price relatives are calculated in the following table:

Printer 1998 (Po) 2001 (Pt) Price Relative

Laser I 2,800 2,000 =(2000/2800)*100=71.43
Laser II 1,200 1,100 =(1100/1200)*100=91.67
Laser III 800 644 =(644/800)*100= 80.5

(a) So the unweighted aggregate price index = (71.43+91.67+80.5)/3 = 81.2

(b) The prices of printers have gone down by 18.8% between 1998 and 2001 (not considering
volume of sales).

3. A Composite price index where the prices of the items in the composite are weighted by
their relative importance is called the Weighted aggregate price index.

The reason why weights are used in an aggregate index is to insure that all items have an
influence on the index which is relative to their respective importance. Three ways to weight
an index are
(i) Laspeyre’s method uses quantities consumed during the base period in computing each
index number. Alternatively, a weighted aggregate price index where the weight for each
item is its base-period quantity is known as the Laspeyres index.
 Laspeyre’s Price index =

where p1 – prices of the current period; p0 – price in the base period and q0 – quantities
consumed in the base period.

(ii) Paasche’s method uses quantities consumed during the current period for each index.
Alternatively, a weighted aggregate price index where the weight for each item is its current-
period quantity is called the Paasche index.

Paasche’s price index =

where p1 – prices of the current period; p0 – price in the base period and q1 – quantities
consumed in the current period.

Example – 5: You are given the following information about items A, B, C, and D.
Unit Annual Unit Annual
Price $ Usage Price $ Usage
Item 1994 1994 2001 2001
A .52 4,000 .63 4,100
B 1.15 1,125 .92 1,300
C 32.50 120 30.00 130
D 135.25 5 115.20 8

Calculate the price index number of 2001 with 1994 as the base year using Laspeyre’s and
Paasche’s methods.

Solution: The following table contains the necessary information to calculate the index
numbers:

Unit Annual Unit Annual

Price $ Usage Price $ Usage p1q0 p1q1 p0q0 p0q1
(p0) (q0) (p1) (q1)
Item 1994 1994 2001 2001
A .52 4,000 .63 4,100 2520 2583 2080 2132

B 1.15 1,125 .92 1,300 1035 1196 1293.7 1495

5
C 32.50 120 30.00 130 3600 3900 3900 4225
 D 135.25 5 115.20 8 576 921.6 676.25 1082
7731 8600.6 7950 8934

(i) Laspeyre’s Price index = =(7731/7950)*100 = 97.25

(ii) Paasche’s Price index = =(8600.6/8934)*100 = 96.27

(iii) Dorbish and Bowley’s price index = A.M. of (i) and (ii) = (97.25+96.27)/2
= 96.77

(iv) Fisher’s ideal price index = G.M. of (i) and (ii) = Sqrt(97.25*96.27) = 96.76

Example – 6: An electronics and appliance store sells three different types of VCRs. The
three types sold by the store are 4-head with stereo, 4-head, and 2-head. The unit prices for
the years 1996 and 2001, with the volume of sales (units sold) for 1996, are given below.

Unit Price ($) Units Sold

VCR 1996 (po) 2001 (p1) 1996(q0) 2001(q1)
4-Head with Stereo 700 900 200 275
4-Head 500 600 300 325
2-Head 300 420 500 400

a. Compute an unweighted aggregate price index for VCRs for 2001 with 1996 as
the base period.
b. Compute a weighted aggregate price index (Laspeyres index and Paasche) for
2001 with 1996 as the base period.

Example -7: Calculate Fisher’s ideal index number from the following data:
Commodity 1999 2000
Price(Rs.) Expenditure on Price(Rs.) Expenditure on
quantity consumed quantity consumed
A 8 200 65 1950
B 20 1400 30 1650
C 5 80 20 900
D 10 360 15 300
E 27 2160 10 600
(iii) Fixed weight aggregate method: Here, one period is chosen, and its quantities are used to
find all indices. The primary advantage of a fixed-weight aggregates price index is the
flexibility in selecting the base price and the fixed weight (quantity). This is known as Kelly’s
method.

Kelly’s Price index =

where p1 – prices of the current period; p0 – price in the base period and q – fixed weight.

Quantity index numbers are analogous to the price index numbers discussed earlier. Thus
(i) Laspeyre’s quantity index =

(ii) Paasche’s quantity index =

Example – 8: You are given the following information regarding four items.

1994 2001
Item Price Quantity Price Quantity
A $ 2.00 3 $ 5.75 8
B .80 20 1.25 10
C 22.00 4 35.00 3
D 7.00 2 15.00 1

Construct a weighted aggregate quantity index using 1994 as the base year and price as the
weight.

Time Reversal Test is used to test whether a given method will work both backwards and
forwards with respect to time. A price or quantity index for a given period with respect to the
preceding period should be equal to the reciprocal of the price or quantity index when periods
are interchanged. Thus we have

or
This test is not satisfied by the Laspeyre’s and Paasche’s index nymbers.

Factor Reversal Test

The change in the price when multiplied by the change in quantity should represent the total
change in the value. This relation should satisfy the following:

This test is satisfied only by Fisher’s ideal price index.

Advantages and Disadvantages
Index numbers are one of the most widely used statistical tools. Some of the advantages (or
uses) and disadvantages of index numbers are as follows:

Advantages
(1) Help in formulating policies - Most of the economic and business decisions and policies
are guided by the index numbers.
Example: To increase DA, the government refers to the cost-of-living index.

To make any policy related to the industrial or agricultural production, the government refers
to their respective index numbers.

(2) Help in study of trends - Index numbers help in the study of trends in variables like,
export-import, industrial and agricultural production, share prices, and more.

(3) Helpful in forecasting - Index numbers not only help in the study of past and present
behaviour, they are also used for forecasting economic and business activities.

(4) Facilitates comparative study - To make comparisons with respect to time and place
especially where units are different, index numbers prove to be very useful.
For example, change in ‘industrial production’ can be compared with change in ‘agricultural
production’ with the help of index numbers.

Disadvantages

(1) The first important issue/problem is to define the objective for which the index number is
to be constructed

(2) Selection of a suitable base period is a very crucial step.

(3) It should be of reasonable length and normal one, i.e., it should not be affected by any
abnormalities like, natural calamities, war, extreme business cycle situations.

(4) All the items do not have the same importance. So, it is necessary to adopt some suitable
measures to assign weight.

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