Unit-2

Index Numbers
INTRODUCTION
Historically, the first index was constructed in 1764 to compare the Italian price index
in 1750 with the price level in 1500. Though originally developed for measuring the effect of
change in prices, index numbers have today become one of the most widely used statistical
devices and there is hardly any field where they are not used. Newspapers headline the fact
that prices are going up or down, that industrial production is rising or falling, that imports
are increasing or decreasing, that crimes are rising in a particular period compared to the
previous period as disclosed by index numbers. They are used to feel the pulse of the
economy and they have come to be used as indicators of inflationary or deflationary
tendencies, In fact, they are described as ‘barometers of economic activity’, i.e., if one wants
to get an idea as to what is happening to an economy, he should look to important indices like
the index number of industrial production, agricultural production, business activity, etc.
Some prominent definitions of index numbers are given below:
1. ‘Index numbers are devices for measuring differences in the magnitude of a group of
related variables. —Croxton &
Cowdert
2. “An index number is a statistical measure designed to show changes in a variable or a
group of related variables with respect to time, geographic location or other
characteristics such as income, profession, etc.
—Spiegel
3. “In its simplest form an index number is the ratio of two index numbers expressed as a per
cent. An index number is a statistical measure—a measure designed to show changes in
one variable or in a group of related variables over time, or with respect to geographic
location, or in terms of some other characteristics.” —Patternson

Definition:
Index numbers are statistical devices designed to measure the relative change in the
level of variable or group of variables with respect to time, geographical location etc.
In other words these are the numbers which express the value of a variable at any
given period called “ current period “as a percentage of the value of that variable at some
standard period called “base period ”.

Here the variables may be

1. The price of a particular commodity like silver, iron or group of commodities like
consumer goods, food, stuffs etc.
2. The volume of trade, exports, imports, agricultural and industrial production, sales in
departmental store.
3. Cost of living of persons belonging to particular income group or profession etc.
 Ex: suppose rice sells at Rs.9/kg at BBSR in 1995 as compare to Rs. 4.50/Kg in 1985, the
index number of price in 1995 compared to 1985.
Therefore the index number of price of rice in 1995 compared to 1985 is calculated as

This means there is a net increase of 100% in the price of rice in 1995as compared to
1985 [the base year’s index number is always treated as 100]
Suppose, during the same period 1995 the rice sells at Rs. 12.00/kg in Delhi. There fore,
the index number of price at Bhubaneswar compared to price at Delhi is

This means there is a net decrease of 25% in the price of rice in 1995as compared to
1985
The above index numbers are called ‘price index numbers’.

To take another example the production of rice in 1978 in Orissa was 44, 01,780
metric c tons compare to 36, 19,500 metric tons in 1971. So the index number of the
quantity produced in 1978 compared to 1971 is

That means there is a net increase of 21.61% in production of rice in 1978 as compared to
1971.
The above index number is called ‘quantity index number’

Univariate index: An index which is calculated from a single variable is called univariate
index.

Composite index: An index which is calculated from group of variables is called Composite index
Characteristics of index numbers:

1. Index numbers are specialized averages:

As we know an average is a single figure representing a group of figures. How ever to
obtain an average the items must be comparable. For example the average weight of man,
woman and children of a certain locality has no meaning at all. Further more the unit of
measurement must be same for all the items. How ever this is not so with index numbers.
Index numbers also one type of averages which shows in a single figure the change in two or
more series of different items which can be expressed in different units. For example while
 constructing a consumer price index number the various items which are use in construction
are divided into broad heads namely food, clothing, fuel, lighting, house rent, and
miscellaneous which are expressed in different units.
2. Index numbers measures the net change in a group of related variables:
Since index numbers are essentially averages, they describe in one single figure the
increase or decrease in a group of related variables under study. The group of variables
may be prices of set of commodities, the volume of production in different sectors etc.
3. Index numbers measure the effect of changes over period of time:
Index numbers are most widely used for measuring changes over a period of time. For
example we can compare the agricultural production, industrial production, imports,
exports, wages etc in two different periods.

Uses of index numbers:

Index numbers are indispensable tools of economics and business analysis. Following
are the main uses of index numbers.
1) Index numbers are used as economic barometers:
Index number is a special type of averages which helps to measure the economic
fluctuations on price level, money market, economic cycle like inflation, deflation etc.
G.Simpson and F.Kafka say that index numbers are today one of the most widely used
statistical devices. They are used to take the pulse of economy and they are used as
indicators of inflation or deflation tendencies. So index numbers are called economic
barometers.
2) Index numbers helps in formulating suitable economic policies and planning etc.
Many of the economic and business policies are guided by index numbers. For
example while deciding the increase of DA of the employees; the employer’s have to
depend primarily on the cost of living index. If salaries or wages are not increased
according to the cost of living it leads to strikes, lock outs etc. The index numbers provide
some guide lines that one can use in making decisions.
3) They are used in studying trends and tendencies.
Since index numbers are most widely used for measuring changes over a period of
time, the time series so formed enable us to study the general trend of the phenomenon
under study. For example for last 8 to 10 years we can say that imports are showing
upward tendency.
4) They are useful in forecasting future economic activity.
Index numbers are used not only in studying the past and present workings of our
economy but also important in forecasting future economic activity.
5) Index numbers measure the purchasing power of money.
The cost of living index numbers determine whether the real wages are rising or
falling or remain constant. The real wages can be obtained by dividing the money wages by
the corresponding price index and multiplied by 100. Real wages helps us in determining
the purchasing power of money.
6) Index numbers are used in deflating.
Index numbers are highly useful in deflating i.e. they are used to adjust the wages for cost
of living changes and thus transform nominal wages into real wages, nominal income to real
income, nominal sales to real sales etc. through appropriate index numbers.

Classification of index numbers:

According to purpose for which index numbers are used are classified as below.
i) Price index number
ii) Quality index number
iii) Value index number
iv) Special purpose index number
Only price and quantity index numbers are discussed in detail. The others will be
mentioned but without detail.

Price index number:

Price index number measures the changes in the price level of one commodity or
group of commodities between two points of time or two areas.
Ex: Wholesale price index numbers
Retail price index numbers
Consumer price index numbers.
Quantity index number:
Quantity index numbers measures the changes in the volume of production, sales, etc
in different sectors of economy with respect to time period or space.

Note: Price and Quantity index numbers are called market index numbers.
Problems in constructing index numbers:
Before constructing index numbers the careful thought must be given into following
problems
i. Purpose of index numbers.
An index number which is properly designed for a purpose can be most useful and
powerful tool. Thus the first and the foremost problem are to determine the purpose of index
numbers. If we know the purpose of the index numbers we can settle some related problems.
For example if the purpose of index number is to measure the changes in the production of
steel, the problem of selection of items is automatically settled.
ii. Selection of commodities
After defining the purpose of index numbers, select only those commodities which are
related to that index. For example if the purpose of an index is to measure the cost of living of
low income group we should select only those commodities or items which are consumed by
persons belonging to this group and due care should be taken not to include the goods which
are utilized by the middle income group or high income group i.e. the goods like cosmetics,
other luxury goods like scooters, cars, refrigerators, television sets etc.
iii. Selection of base period
The period with which the comparisons of relative changes in the level of phenomenon are
made is termed as base period.The index for this period is always taken as 100. The following
are the basic criteria for the choice of the base period.

i) The base period must be a normal period i.e. a period frees from all sorts of
abnormalities or random fluctuations such as labor strikes, wars, floods, earthquakes
etc.
ii) The base period should not be too distant from the given period. Since index numbers
are essential tools in business planning and economic policies the base period should
not be too far from the current period. For example for deciding increase in dearness
allowance at present there is no advantage in taking 1950 or 1960 as the base, the
comparison should be with the preceding year after which the DA has not been
increased.
iii) Fixed base or chain base .While selecting the base a decision has to be made as to
whether the base shall remain fixing or not i.e. whether we have fixed base or chain
base. In the fixed base method the year to which the other years are compared is
constant. On the other hand, in chain base method the prices of a year are linked with
those of the preceding year. The chain base method gives a better picture than what is
obtained by the fixed base method.
● How a base is selected if a normal period is not available?
Ans: Some times it is difficult to distinguish a year which can be taken as a normal year
and hence the average of a few years may be regarded as the value corresponding to the
base year.

iv. 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 reliable sources such as standard trade
journals, official publications etc. for example for the construction of retail price index
numbers, the price quotations for the commodities should be obtained from super bazaars,
departmental stores etc. and not from wholesale dealers.
v. Selection of appropriate weights
A decision as to the choice of weights is an important aspect of the construction of
index numbers. The problem arises because all items included in the construction are not of
equal importance. So proper weights should be attached to them to take into account their
relative importance. Thus there are two type of indices.
i) Un weighted indices- in which no specific weights are attached
 ii) Weighted indices- in which appropriate weights are assigned to various
items.
vi. Choice of average.
Since index numbers are specialized averages, a choice of average to be used in their
construction is of great importance. Usually the following averages are used.
i) A.M
ii) G.M
iii) Median
Among these averages G.M is the appropriate average to be used. But in practice G.M is not
used as often as A.M because of its computational difficulties.
vii. Choice of formula.
A large variety of formulae are available to construct an index number. The problem
very often is that of selecting the 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 constructing index numbers:

A large number of formulae have been derived for constructing index numbers. They can
be
1) Unweighted indices
a) Simple aggregative method
b) Simple average of relatives.
2) Weighted indices
a) Weighted aggregative method
i) Lasperey’s method
ii) Paasche’s method
iii) Fisher’s ideal method
iv) Dorbey’s and Bowley’s method
v) Marshal-Edgeworth method
vi) Kelly’s method
b) Weighted average of relatives

Unweighted indices:
i) Simple aggregative method:
This is the simplest method of constructing index numbers. When this method is used to
construct a price index number the total of current year prices for the various commodities in
question is divided by the total of the base year prices and the quotient is multiplied by 100.

`Symbolically
Where P0 are the base year prices
 P1 are the current year prices
P01 is the price index number for the current year with reference to the base year.
Problem:
Calculate the index number for 1995 taking 1991 as the base for the following data
Commodity Unit Prices 1991 (P0) Prices 1995 (P1)
A Kilogram 2.50 4.00
B Dozen 5.40 7.20
C Meter 6.00 7.00
D Quintal 150.00 200.00
E Liter 2.50 3.00
Total 166.40 221.20

Price index number =

There is a net increase of 32.93% in 1995 as compared to 1991.

Limitations:
There are two main limitations of this method
1. The units used in the prices or quantity quotations have a great influence on the
value of index.
2. No considerations are given to the relative importance of the commodities.

ii) Simple average of relatives

When this method is used to construct a price index number, first of all price relatives
are obtained for the various items included in the index and then the average of these
relatives is obtained using any one of the averages i.e. mean or median etc.

When A.M is used for averaging the relatives the formula for computing the index is

When G.M is used for averaging the relatives the formula for computing the index is

Where n is the number of commodities

and price relative =

Problem:
Calculate the index number for 1995 taking 1991 as the base for the following data
 Commodity Prices 1991 (P0) Prices 1995 (P1)
I=
A 50 70
= 140
B 40 60 150
C 80 90 112.5
D 110 120 109.5
E 20 20 100
Total

Price index number =

There is a net increase of 22.4% in 1995 as compared to 1991.

Merits:
1. It is not affected by the units in which prices are quoted
2. It gives equal importance to all the items and extreme items don’t affect the index number.
3. The index number calculated by this method satisfies the unit test.

Demerits:
1. Since it is an unweighted average the importance of all items are assumed to be the same.
2. The index constructed by this method doesn’t satisfy all the criteria of an ideal index
number.
3. In this method one can face difficulties to choose the average to be used.

Weighted indices:
i) Weighted aggregative method:
These indices are same as simple aggregative method. The only difference is in this method,
weights are assigned to the various items included in the index.
There are various methods of assigning weights and consequently a large number of
formulae for constructing weighted index number have been designed.
Some important methods are

i. Lasperey’s method: This method is devised by Lasperey in year 1871.It is the most
important of all the types of index numbers. In this method the base year quantities are
taken weights. The formula for constructing Lasperey’s price index
number is
 P01La=

ii. Paasche’s method: In this method the current year quantities are taken as weights and the
formula is given by

P01=

iii. Fisher’s ideal method: Fishers price index number is given by the G.M of the Lasperey’s and
Paasche’s index numbers.
Symbolically

P01=

iv. Dorbey’s and Bowley’s method

Dorbey’s and Bowley’s price index number is given by the A.M of the Lasperey’s and
Paasche’s index numbers.
Symbolically

P01DB=
Quantity index numbers:
i. Lasperey’s quantity index number: Base year prices are taken as weights

Q01La=
ii. Paasche’s quantity index number : Current year prices are taken as weights

Q01Pa=
iii. Fisher’s ideal method: Q = 01
F
=

Fisher’s index number is called ideal index number. Why?

The Fisher’s index number is called ideal index number due to the following
characteristics.
1) It is based on the G.M which is theoretically considered as the best average of
constructing index numbers.
2) It takes into account both current and base year prices as quantities.
3) It satisfies both time reversal and factor reversal test which are suggested by Fisher.
4) The upward bias of Lasperey’s index number and downward bias of Paasche’s index
number are balanced to a great extent.

Example: Compute price index numbers for the following data by

Comparison of Lasperey’s and Paasche’s index numbers:-
In Lasperey’s index number base year quantities are taken as the weights and in
Paasche’s index the current year quantities are taken as weights.

From the practical point of view Lasperey’s index is often proffered to Paasche’s for
the simple reason that Lasperey’s index weights are the base year quantities and do not
change from the year to the next. On the other hand Paasche’s index weights are the current
year quantities, and in most cases these weights are difficult to obtain and expensive.

Lasperey’s index number is said to be have upward bias because it tends to over
estimate the price rise, where as the Paasche’s index number is said to have downward bias,
because it tends to under estimate the price rise.

When the prices increase, there is usually a reduction in the consumption of those
items whose prices have increased. Hence using base year weights in the Lasperey’s index,
we will be giving too much weight to the prices that have increased the most and the
numerator will be too large. Due to similar considerations, Paasche’s index number using
given year weights under estimates the rise in price and hence has down ward bias.

If changes in prices and quantities between the reference period and the base period
are moderate, both Lasperey’s and Paasche’s indices give nearly the same values.

Demerit of Paasche’s index number:

Paasche’s index number, because of its dependence on given year’s weight, has
distinct disadvantage that the weights are required to be revised and computed for each
period, adding extra cost towards the collection of data.
What are the desiderata of good index numbers?
Irving Fisher has considered two important properties which an index number should satisfy.
These are tests of reversibility.
1. Time reversal test
2. Factor reversal test
If an index number satisfies these two tests it is said to be an ideal index number.

Weighted average of relatives:

Weighted average of relatives can be calculated by taking values of the base year (p0q0) as
the weights. The formula is given by
 When A.M is used

When G.M is used

Where and i.e. base year value

Test of consistency or adequacy:

Several formulae have been suggested for constructing index numbers and the
problem is that of selecting most appropriate one in a given situation. The following teats are
suggested for choosing an appropriate index.
The following tests are suggested for choosing an appropriate index.
 1) Unit test
2) Time reversal test
3) Factor reversal test
4) Circular test
1) Unit test:
This test requires that the formula for construction of index numbers should be such,
which is not affected by the unit in which the prices or quantities have been quoted.

Note: This test is satisfied by all the index numbers except simple aggregative method.
2) Time reversal test
This is suggested by R.A.Fisher. Time reversal test is a test to determine whether a
given method will work both ways in time i.e. forward and backward. In other words, when
the data for any two years are treated by the same method, but with the bases reversed,
the two index numbers secured should be reciprocals to each other, so that their product
is unity. Symbolically the following relation should be satisfied.

Where P01 is the index for time period 1 with reference period 0.
P10 is the index for time period 0 with reference period 1.
Note: This test is not satisfied by Lasperey’s method and Paasche’s method. It is satisfied by
Fisher’s method.
When Lasperey’s method is used

P01La=

P10La=
Now,

P01La× P10La = ≠1
Therefore this test is not satisfied by Lasperey’s method

When Paasche’s method is used

P01Pa=

P10Pa=
Now,
 P01Pa ×P10Pa = ×
Therefore this test is not satisfied by Paasche’s method
When Fisher’s method is used

P01F=

P10F=
Now,

P01F ×P10F= =1

Value index:
The value of a single commodity is the product of its price and quantity. Thus a value
index ‘V’ is the sum of the values of the commodities of given year divided by the sum of the
value of the base year multiplied by 100.

i.e.
3) Factor reversal test:
This is also suggested by R.A.Fisher. It holds that the product of a price index number
and the quantity index number should be equal to the corresponding value index. In other
words the test is that the change in price multiplied by the change in quantity should be
equal to change in value.

If & represents prices and & the quantities in the current year and base
year respectively and if P01 represents the change in price in the current year 1 with
reference to the year 0 and Q01 represents the change in quantity in the current year 1
with reference to the year 0.

Symbolically
Note: This test is not satisfied by Lasperey’s method and Paasche’s method. It is satisfied by
Fisher’s method.
When Lasperey’s method is used
 P01La=

Q01La=
Now,

P01La× Q01La =
Therefore this test is not satisfied by Lasperey’s method
When Paasche’s method is used

P01Pa=

Q01Pa=
Now,

P01Pa × Q10Pa = ×
Therefore this test is not satisfied by Paasche’s method
When Fisher’s method is used

P01F=

Q01F=

P01La× Q01La =

=
Therefore this test is satisfied by Fisher’s method

4) Circular test:
This is another test of consistency of an index number. It is an extension of time
reversal test. According to this test, the index should work in a circular fashion.
Symbolically
 Note:
This test is not satisfied by Lasperey’s method, Paasche’s method and Fisher’s method.
This test is satisfied by simple average of relatives based on G.M and Kelly’s fixed base
method.

● Prove that AM of Lasperey’s index numbers and Paasche’s index number is greater than or
equal to Fisher’s index number.
Let
 Lasperey’s index number = P01La
Paasche’s index number= P01Pa
Fisher’s index number= P01F

And we have P01F=

Now we have to show that

The Chain Index Numbers

In fixed base method the base remain constant through out i.e. the relatives for all the
years are based on the price of that single year. On the other hand in chain base method, the
relatives for each year is found from the prices of the immediately preceding year. Thus the
base changes from year to year. Such index numbers are useful in comparing current year
figures with the preceding year figures. The relatives which we found by this method are
called link relatives.

Thus
And by using these link relatives we can find the chain indices for each year by using the
below formula

Note: The fixed base index number computed from the original data and chain index number
computed from link relatives give the same value of the index provided that there is only one
commodity, whose indices are being constructed.
Example: from the following data of wholesale prices of wheat for ten years construct index
number taking a) 1998 as base and b) by chain base method
Note: the chain indices obtained in (b) are the same as the fixed base indices obtained in (a).
in fact chain index figures will always be equal to fixed index figure if there is only one
series.

Example-2: Compute the chain index number with 2003 prices as base from the following
table giving the average wholesale prices of the commodities A, B and C for the year 2003 to
2007
Conversion of fixed based index to chain based index

Conversion of chain based index to fixed base index.

Example: Compute the chain base index numbers

Example: Calculate fixed base index numbers from the following chain base index numbers

Note: It may be remembered that the fixed base index for the first year is same as the
chain base index for that year.

Merits of chain index numbers:

1. The chain base method has a great significance in practice, because in economic and
business data we are often concerned with making comparison with the previous
period.
2. Chain base method doesn’t require the recalculation if some more items are introduced
or deleted from the old data.
3. Index numbers calculated from the chain base method are free from seasonal and
cyclical variations.

Demerits of chain index numbers:

1. This method is not useful for long term comparison.
 2. If there is any abnormal year in the series it will effect the subsequent years also.

Differences between fixed base and chain base methods:

Chain base Fixed base
1. Here the base year changes 1. Base year does not changes
2. Here link relative method is used 2. No such link relative method is used
3. Calculations are tedious 3. Calculations are simple
4. It can not be computed if any one year 4. It can be computed if any year is
is missing missing
5. It is suitable for short period 5. It is suitable for long period
6. Index numbers will be wrong if an 6. The error is confined to the index of
error is committed in the calculation of that year only.
link relatives

Base shifting:
One of the most frequent operations necessary in the use of index numbers is
changing the base of an index from one period to another with out recompiling the entire
series. Such a change is referred to as ‘base shifting’. The reasons for shifting the base are
1. If the previous base has become too old and is almost useless for purposes of
comparison.
2. If the comparison is to be made with another series of index numbers having different
base.
The following formula must be used in this method of base shifting is

Index number based on new base year =

Example:
The following are the index numbers of prices with 1998 as base year

2003 410
year Index 2004 400
1998 100 2005 380
1999 110 2006 370
2000 120 2007 340
2001 200
2002 400
Shift the base from 1998 to 2004 and recast the index numbers.
Solution:
Index number based on new base year =
 Index number for 1998 = =25
………………………………………….

Index number for 2007= =85

Year Index number Index number Year Index number Index number
(1998as (2004 as base) (1998as base) (2004 as base)
base)
1998 100 2003 410
=25
=102.5
1999 110 2004 400
=100
=27.5
2000 120 2005 380
=30 =95
2001 200 2006 370
=50 =92.5
2002 400 2007 340
=100 =85

Splicing of two series of index numbers:

The problem of combining two or more overlapping series of index numbers into one
continuous series is called splicing. In other words, if we have a series of index numbers with
some base year which is discontinued at some year and we have another series of index
numbers with the year of discontinuation as the base, and connecting these two series to
make a continuous series is called splicing.
The following formula must be used in this method of splicing

Index number after splicing =

Example: The index A given was started in 1993 and continued up to 2003 in which year
another index B was started. Splice the index B to index A so that a continuous series of
index is made
Deflating:
Deflating means correcting or adjusting a value which has inflated. It makes
allowances for the effect of price changes. When prices rise, the purchasing power of money
declines. If the money incomes of people remain constant between two periods and prices of
commodities are doubled the purchasing power of money is reduced to half. For example if
there is an increase in the price of rice from Rs10/kg in the year 1980 to Rs20/kg in the year
1982. then a person can buy only half kilo of rice with Rs10. so the purchasing power of a
rupee is only 50paise in 1982 as compared to 1980.

Thus the purchasing power of money =

In times of rising prices the money wages should be deflated by the price index to get
the figure of real wages. The real wages alone tells whether a wage earner is in better
position or in worst position.
 For calculating real wage, the money wages or income is divided by the corresponding
price index and multiplied by 100.

i.e. Real wages =

Thus Real Wage Index=

Example: The following table gives the annual income of a worker and the general Index
Numbers of price during 1999-2007. Prepare Index Number to show the changes in the real
income of the teacher and comment on price increase

The method discussed above is frequently used to deflate individual values, value series or
value indices. Its special use is in problems dealing with such diversified things as rupee
sales, rupee inventories of manufacturer’s, wholesaler’s and retailer’s income, wages and the
like.

Cost of living index numbers (or) Consumer price index numbers:

The cost of living index numbers measures the changes in the level of prices of
commodities which directly affects the cost of living of a specified group of persons at a
specified place. The general index numbers fails to give an idea on cost of living of different
classes of people at different places.
 Different classes of people consume different types of commodities, people’s
consumption habit is also vary from man to man, place to place and class to class i.e. richer
class, middle class and poor class. For example the cost of living of rickshaw pullers at BBSR
is different from the rickshaw pullers at Kolkata. The consumer price index helps us in
determining the effect of rise and fall in prices on different classes of consumers living
in different areas.
Main steps or problems in construction of cost of living index numbers
The following are the main steps in constructing a cost of living index number.
1. Decision about the class of people for whom the index is meant
It is absolutely essential to decide clearly the class of people for whom the index is
meant i.e. whether it relates to industrial workers, teachers, officers, labors, etc.
Along with the class of people it is also necessary to decide the geographical area
covered by the index, such as a city, or an industrial area or a particular locality in a
city.
2. Conducting family budget enquiry
Once the scope of the index is clearly defined the next step is to conduct a sample
family budget enquiry i.e. we select a sample of families from the class of people for
whom the index is intended and scrutinize their budgets in detail. The enquiry should
be conducted during a normal period i.e. a period free from economic booms or
depressions. The purpose of the enquiry is to determine the amount; an average family
spends on different items. The family budget enquiry gives information about the
nature and quality of the commodities consumed by the people. The commodities are
being classified under following heads i)Food
ii) Clothing
iii)Fuel and Lighting
iv)House rent
v) miscellaneous
3. Collecting retail prices of different commodities
The collection of retail prices is a very important and at the same time very difficult
task, because such prices may vary from lace to place, shop to shop and person to
person. Price quotations should be obtained from the local markets, where the class of
people reside or from super bazaars or departmental stores from which they usually
make their purchases.

Uses of cost of living index numbers:

1. Cost of living index numbers indicate whether the real wages are rising or falling. In
other words they are used for calculating the real wages and to determine the change
in the purchasing power of money.
 2. Cost of living indices are used for the regulation of D.A or the grant of bonus to the
workers so as to enable them to meet the increased cost of living.
3. Cost of living index numbers are used widely in wage negotiations.
4. These index numbers also used for analyzing markets for particular kinds of goods.
Methods for construction of cost of living index numbers:
Cost of living index number can be constructed by the following formulae.
1) Aggregate expenditure method or weighted aggregative method
2) Family budget method or the method of weighted relatives

1) Aggregate expenditure method or weighted aggregative method

In this method the quantities of commodities consumed by the particular group
in the base year are taken as weights. The formula is given by

consumer price index =

Steps:
i) The prices of commodities for various groups for the current year is multiplied by the
quantities of the base year and their aggregate expenditure of current year is obtained .i.e.

ii) Similarly obtain

iii) The aggregate expenditure of the current year is divided by the aggregate expenditure of
the base year and the quotient is multiplied by 100.

Symbolically

2) Family budget method or the method of weighted relatives

In this method cost of living index is obtained on taking the weighted average of
price relatives, the weights are the values of quantities consumed in the base year i.e.

. Thus the consumer price index number is given by

consumer price index =

Where for each item

, value on the base year

Note: It should be noted that the answer obtained by applying the aggregate expenditure
method and family budget method shall be same.
Example: Construct the consumer price index number for 2007 on the basis of 2006 from the
following data using (i) the aggregate expenditure method, and (ii) the family budget method.

Thus, the answer is the same by both the methods. However, the reader should prefer the
aggregate expenditure method because it is far more easier to apply compared to the family
budget method.
Possible errors in construction of cost of living index numbers:
Cost of living index numbers or its recently popular name consumer price index
numbers are not accurate due to various reasons.
1. Errors may occur in the construction because of inaccurate specification of groups for
whom the index is meant.
2. Faulty selection of representative commodities resulting out of unscientific family
budget enquiries.
 3. Inadequate and unrepresentative nature of price quotations and use of inaccurate
weights
4. Frequent changes in demand and prices of the commodity
5. The average family might not be always a representative one.

Problems or steps in construction of wholesale price index numbers (WPI):

Index numbers are the best indicators of the economic progress of a community, a
nation and the world as a whole. Wholesale price index numbers can also be constructed for
different economic activities such as Indices of Agricultural production, Indices of Industrial
production, Indices of Foreign Trade etc. Besides some International organizations like the
United Nations Organization, the F.A.O. of the U.N., the World Bank and International Labour
Organization, there are a number of organizations in the country who publish index numbers
on different aspects. These are (a) Ministry of Food and Agriculture, (b) Reserve Bank of
India, (c) Central Statistical Organization, (d) Department of Commercial Intelligence and
Statistics, (e) Labour Bureau, (f) Eastern Economist. The Central Statistical Organization of
the Government of India publishes a Monthly Abstract of’ Statistics which contains All India
index numbers of Wholesale Prices (Revised series : Base year 1981-82) both
commodity-wise and also for the aggregate.
i. Purpose or object of index numbers.
A wholesale price index number which is properly designed for a purpose can be most
useful and powerful tool. Thus the first and the foremost problem are to determine the purpose
of index numbers. If we know the purpose of the index numbers we can settle some related
problems.
ii.Selection of commodities
Representative items should be taken into consideration. The items may be grouped into
relatively homogeneous heads to make the calculation. The construction of WPI of a region
or country we may group the commodities as (1) Primary Articles — (a) Food Articles (b)
Non-food Articles (c) Minerals (ii) Fuel. Power, Light and Lubricants (iii) Manufactured
Products (iv) Chemicals and Chemical Products (v) Machinery and Machine Equipments (vi)
Other Miscellaneous Manufacturing Industries.
Selection of base period
iii.
1. The base period must be a normal period i.e. a period frees from all sorts of
abnormalities or random fluctuations such as labor strikes, wars, floods, earthquakes
etc.
 2. The base period should not be too distant from the given period. Since index numbers
are essential tools in business planning and economic policies the base period should
not be too far from the current period. For example for deciding increase in dearness
allowance at present there is no advantage in taking 1950 or 1960 as the base, the
comparison should be with the preceding year after which the DA has not been
increased.
3. Fixed base or chain base .While selecting the base a decision has to be made as to
whether the base shall remain fixing or not i.e. whether we have fixed base or chain
base. In the fixed base method the year to which the other years are compared is
constant. On the other hand, in chain base method the prices of a year are linked with
those of the preceding year. The chain base method gives a better picture than what is
obtained by the fixed base method.

iv. 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 wholesale rice index numbers. The data should be collected from reliable sources such as
standard trade journals, official publications etc.
v. Selection of appropriate weights
A decision as to the choice of weights is an important aspect of the construction of
index numbers. The problem arises because all items included in the construction are not of
equal importance. So proper weights should be attached to them to take into account their
relative importance. Thus there are two type of indices.
1. Un weighted indices- in which no specific weights are attached
2. Weighted indices- in which appropriate weights are assigned to various items.
vi. Choice of average.
Since index numbers are specialized averages, a choice of average to be used in their
construction is of great importance. Usually the following averages are used.
iv) A.M
v) G.M
vi) Median
Among these averages G.M is the appropriate average to be used. But in practice G.M is not
used as often as A.M because of its computational difficulties.
vii. Choice of formula.
The selection of a formula along with a method of averaging depends on data at hand and
purpose for which it is used. Different formulae developed for the purpose have already been
discussed in earlier sections.

Wholesale price index numbers (Vs) consumer price index numbers:

 1. The wholesale price index number measures the change in price level in a country as
a whole. For example economic advisors index numbers of wholesale prices.
Where as cost of living index numbers measures the change in the cost of living
of a particular class of people stationed at a particular place. In this index number we
take retail price of the commodities.
2. The wholesale price index number and the consumer price index numbers are
generally different because there is lag between the movement of wholesale prices
and the retail prices.
3. The retail prices required for the construction of consumer price index number
increased much faster than the wholesale prices i.e. there might be erratic changes in
the consumer price index number unlike the wholesale price index numbers.
4. The method of constructing index numbers in general the same for wholesale prices
and cost of living. The wholesale price index number is based on different weighting
systems and the selection of commodities is also different as compared to cost of
living index number

Importance and methods of assigning weights:

The problem of selecting suitable weights is quite important and at the same time quite
difficult to decide. The term weight refers to the relative importance of the different items in
the construction of the index. Generally various items 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 their relative importance. Thus there are two types of indices.
1) Unweighted indices – in which no specific weights are attached to various
commodities.
2) Weighted indices – in which appropriate weights are assigned to various
commodities.
The Unweighted indices can be interpreted as weighted indices by assuming the
corresponding weight for each commodity being unity. But actually the commodities included
in the index are all not of equal importance. Therefore it is necessary to adopt some suitable
method of weighting, so that arbitrary and haphazard weights may not affect the results.
There are two methods of assigning weights.
i) Implicit weighting
ii) Explicit weighting
In implicit weighting, a commodity or its variety is included in the index a number of
times. For example if wheat is to be given in an index twice as much times as rice then the
weight of wheat is two. Where as in explicit weighting two types of weights can be assigned.
i.e. quantity weights or value weights.
A quantity weight symbolized by q means the amount of commodity produced,
distributed or consumed in some time period. A value weight in the other hand combines
price with quantity produced, distributed or consumed and is denoted by v=pq.
For example quantity weights are used in the method of weighted aggregative like
Lasperey’s, Paasche’s index numbers and value weights are used in the method of weighted
average of price relatives.
Limitations or demerits of index numbers:
Although index numbers are indispensable tools in economics, business, management
etc, they have their limitations and proper care should be taken while interpreting them.
Some of the limitations of index numbers are
1. Since index numbers are generally based on a sample, it is not possible to take into
account each and every item in the construction of index.
2. At each stage of the construction of index numbers, starting from selection of
commodities to the choice of formulae there is a chance of the error being introduced.
3. Index numbers are also special type of averages, since the various averages like
mean, median, G.M have their relative limitations, their use may also introduce some
error.
4. None of the formulae for the construction of index numbers is exact and contains the
so called formula error. For example Lasperey’s index number has an upward bias
while Paasche’s index has a downward bias.
5. An index number is used to measure the change for a particular purpose only. Its
misuse for other purpose would lead to unreliable conclusions.
6. In the construction of price or quantity index numbers it may not be possible to retain
the uniform quality of commodities during the period of investigation.

Question bank
Choose the most appropriate option (a) (b) (c) or (d):

1. A series of numerical figures which show the relative position is called

a) Index no. b) relative no. c) absolute no. d) none
2. Index no. for the base period is always taken as
a) 200 b) 50 c) I d) 100
3. _________ play a very important part in the construction of index nos.
a) Weights b) classes c) estimations d) none
4. ________ is particularly suitable for the construction of index nos.
a) H.M. b) A.M. c) G.M. d) none
5. Index nos. show _________ changes rather than absolute amounts of change.
a) relative b) percentage c) both d) none
6. The ________ makes index nos. time-reversible.
a) A.M. b) G.M. c) H.M. d) none
7. Price relative is equal to
a) b). c) d)
8. Weighted G.M. of relative formula satisfy_______ test
a) Time Reversal Test b) Circular test
c) Factor Reversal Test d) none
9. Factor Reversal test is satisfied by
a) Fisher’s Ideal Index b) Laspeyres Index
c) Paasches Index d) none
10. ___________ is an extension of time reversal test
a) Factor Reversal Test b) Time Reversal Test
c) Circular Test d) none
11. The _______ of group indices given the General Index
a) H.M. b) G.M. c) A.M. d) none
12. Circular Test is one of the tests of
a) index nos. b) hypothesis c) both d) none
13. Index no. is equal to
a) Sum of price relatives b) average of the price relatives
c) product of price relative d) none
14. Laspeyre formula does not obey
a) Factor Reversal Test b) Time Reversal Test c) Circular Test d) none
15. A ratio or an average of ratios expressed as a percentage is called
a) a relative no. b) an absolute no. c) an index no. d) none
16. The value at the base time period serves as the standard point of comparison
a)False b) true c) both d) none
17. An index time series is a list of _______ nos. for two or more periods of time
a) index b) absolute c) relative d) none
18. Index nos. are often constructed from the
a) frequency b) class c) sample d) none
19. ___________is a point of reference in comparing various data describing individual behavior.
a) Sample b) Base period c) Estimation d) none
20. The ratio of price of single commodity in a given period to its price in another period called the
(a) base period b) price ratio (c) relative price (d) none

21.
(a) Relative Price Index (b) Simple Aggregative Price Index (c) both (d) none,
22. Chain index is equal to
(a) link relative of current year x chain index of the current year/ 100
(b) link relative of previous year xchain index of the current year/100
(c) link relative of current year xchain index of the previous year/100
(d) link relative of previous year x chain index of the previous year/100
23. P01 is the index for time
(a) 1 on 0 (b) 0 on 1 (c) I on 1 (d) 0 on 0
24. P10 is the index for time
(a) 1 on 0 (b) 0 on 1 (c) 1 on 1 (d) 0 on 0
25. When the product of price index and the quantity index is equal to the corresponding value index then
(a) Unit Test (b) Time Reversal Test (c) Factor Reversal Test (d) none holds
26. The formula should be independent of the unit in which or for which price and quantities are quoted in
(a) Unit Test (b) Time Reversal Test (c) Factor Reversal Test (d) none
27. Laspeyre’s method and Paasche’s method do not satisfy
(a) Unit Test (b) Time Reversal Test (c) Factor Reversal Test(d) none
28. The purpose determines the type of index no. to use
(a) yes (b) no (c) may be (d) may not be
29. The index no. is a special type of average
(a) false (b) true (c) both (d) none
30. The choice of suitable base period is at best temporary solution
(a) true (b) false (c) both (d) none
31. Fisher’s Ideal Formula for calculating index nos. satisfies the _______ tests
(a) Units Test (b) Factor Reversal Test` (c) both (d) none
 32. Fisher’s Ideal Formula dose not satisfy _________ test
(a) Unit test (b) Circular Test (c) Time Reversal Test (d) none
33. ____________________ satisfies circular test
a) G.M. of price relatives or the weighted aggregate with fixed weights
b) A.M. of price relatives or the weighted aggregate with fixed weights
c) H.M. of price relatives or the weighted aggregate with fixed weights
d) none
34. Laspeyre’s and Paasche’s method _________ time reversal test
(a) satisfy (b) do not satisfy (c) are (d) are not
35. There is no such thing as unweighted index numbers
(a) false (b) true (c) both (d) none
36. Theoretically, G.M. is the best average in the construction of index nos. but in practice. mostly the A.M. is
used
(a) false (b) true (c) both (d) none
37. Laspeyre’s or Paasche’s or the Fisher’s ideal index do not satisfy
(a) Time Reversal Test (b) Unit Test (c) Circular Test (d) none
38. ___________ is concerned with the measurement of price changes over a period of years
when it is desirable to shift the base
(a) Unit Test (b) Circular Test (c) Time Reversal Test (d) none
39. The test of shifting the base is called
(a) Unit Test (b) Time Reversal Test (c) Circular Test (d) none

40. Shifted price Index = .

a) True b) false c) both d) none
42. The no. of test of Adequacy is
a)2 b)5 c)3 d)4
43. We use price index numbers
(a) To measure and compare prices (b) to measure prices (c) to compare prices (d) none
44. Simple aggregate of quantities is a type of
(a) Quantity control (b) Quantity indices (c) both (d) none
45. Each of the following statements is either True or False write your choice of the answer 1 writing T for
True
(a) Index Numbers are the signs and guideposts along the business highway that indicae to the
businessman how he should drive or manage.
(b) “For Construction index number. The best method on theoretical ground is not th best method from
practical point of view”.
(c) Weighting index numbers makes them less representative.
(d) Fisher’s index number is not an ideal index number.
46. Each of the following statements is either True or False. Write your choice of the answer by writing F for
false.
(a) Geometric mean is the most appropriate average to be used for constructing an index number.
(b) Weighted average of relatives and weighted aggregative methods render the same result.
(c) “Fisher’s Ideal Index Number is a compromise between two well known indices — not a right
compromise, economically speaking”.
(d) “Like all statistical tools, index numbers must be used with great caution”.
47. The best average for constructing an index numbers is
(a) Arithmetic Mean (b) Harmonic Mean (c) Geometric Mean (d) None of these.
48. The time reversal test is satisfied by
 (a) Fisher’s index number. (b) Paasche’s index number
(c) Laspeyre’s index number. (d) None of these.
49. The factor reversal test is satisfied by
(a) Simple aggregative index number.(b) Paasche’s index number. (c) Laspeyre’s index number. (d) None
50. The circular test is satisfied by
(a) Fisher’s index number. (b) Paasche’s index number. (c) Laspeyre’s index number. (d) None of
these.
51. Fisher’s index number is based on
(a) The Arithmetic mean of Laspeyre’s and Paasche’s index numbers.
(b) The Median of Laspeyre’s and Paasche’s index numbers.
(c) the Mode of Laspeyre’s and Paasche’s index numbers.
(d) None of these.
52. Paasche index is based on
(a) Base year quantities. (b) Current year quantities.
(c) Average of current and base year. (d) None of these
53. Fisher’s ideal index number is
(a) The Median of Laspeyre’s and Paasche’s index number
(b) The Arithmetic Mean of Laspeyre’s and Paasche’s.
(c) The Geometric Mean of Laspeyre’s and Paasche’s
(d) None of these.
54. Price-relative is expressed in term of

55. Paasehe’s index number is expressed in terms of:

56. Cost of living Index number (C. L. I.) is expressed in terms of:

57. If the ratio between Laspeyre’s index number Paasche’s Index number is 28 : 27. Then the Missing
figure in the following table P is:
 (a) 7 (b)4 (c)3 (d)9

58. Time reversal Test is satisfied by following index number formula is

(a) Laspeyre’s Index number. (b) Simple Arithmetic Mean of price relative formula
(c) Marshall-Edge worth formula. (d) None of these.
59. If the prices of all commodities in a place have increased 1.25 times in comparison to the base period,
the index number of prices of that place is now
(a) 125 (b) 150 (c) 225 (d) None of these.
60. If the index number of prices at a place in 1994 is 250 with 1984 as base year, then the prices have
increased on average
(a) 250% (b) 150% (c) 350% (d) None of these.
61. If the prices of all commodities in a place have decreased 35% over the base period prices,
then the index number of prices of that place is now
(a) 35 (b) 135 (c) 65 (d) None of these.
62. Link relative index number is expressed for period n is

63. Fisher’s Ideal Index number is expressed in terms of:

64. Factor Reversal Test According to Fisher is

65. . Marshall Edge worth Index formula after interchange of p and q is impressed in terms of:

One mark questions:

 1. Define index number?
2. Define price index number?
3. Define quantity index number?
4. Define cost of living index numbers?
5. What is base year?
6. Write down the formula for Lasperey’s price index number?
7. Write down the formula for Lasperey’s quantity index number?
8. What is unit of measurement of index number of price?
9. Mention two uses of index numbers?
10. State the formula for Paasche’s index number?
11. “Index number of prices for 2001 taking 2000 as base year is 150”. Write the meaning
of this statement.
12. Give an example of weighted index number.
13. What is price relative?
14. Why a year nearer to current year is selected as base year?
15. Write down the formula for fisher’s index number.
16. How would you select a base year if a normal period is not available?
17. Name two systems of weighting for construction of weighted index number.
18. Which average is most appropriate for construction of an index number?
19. What is the value of index number for the base year?
20. State the relation between price index number and price relative.
21. Define value ratio or value index.
22. Define wholesale price index numbers?
23. Define chain index number.
24. Historically the first index number is constructed in the year_________.
25. What are the two tests suggested by fisher which a good index number should
satisfy?
26. The base period should be a normal period (T/F)
27. Bowley’s index is G.M of Lasperey’s and Paasche’s index number.(T/F)
28. What are the weights used in Lasperey’s method?
29. What are the weights used in Paasche’s method?
30. The circular test is an extension of time reversal test.(T/F)
31. The base year quantities are used as weights in Paasche’s method.(T/F)
32. If with the rise of 10% in prices the wages are increased by 20%, the real wage
increase by_____________%.
33. The A.M of Lasperey’s and Paasche’s index numbers is _______________.
34. What is unit test?
35. What is link relative?
Two marks questions:
1. What is an index number? What does it measure?
2. Distinguish between weighted and unweighted index numbers.
3. Mention three important weighted index numbers.
4. Show that the mean of Lasperey’s and Paasche’s index numbers is always greater than
fisher’s index number.
5. Why fisher’s index number is said to be an ideal index number?
6. Explain what is time reversal test?
7. What is factor reversal test?
8. What is circular test?
9. Define base shifting?
10. What is splicing?
11. What is deflating?
12. Why the cost of living index number for slum dwellers is different from that of I.A.S
officers?
13. Differentiate wholesale price index number with the cost of living index numbers.
14. Distinguish between Lasperey’s and Paasche’s index numbers.
15. What are the main considerations in the selection of base year?
16. What considerations are to be made for the selection of items for the construction of
price index numbers?
17. Distinguish between simple aggregative index and simple average of relatives.
18. What are the desiderata of good index number?
19. Show that fisher’s index number satisfies TRT.
20. Show that fisher’s index number satisfies FRT.
21. Verify whether Lasperey’s index satisfies TRT or not?
22. Verify whether Lasperey’s index satisfies FRT or not?
23. Verify whether Paasche’s index satisfies TRT or not?
24. Verify whether Paasche’s index satisfies FRT or not?
25. Explain how base year is selected.
26. State the major steps involved in the construction of wholesale price index numbers.
27. Explain what you mean by average family for the purpose of construction of
consumers price index numbers.
28. Describe a method of constructing price index number.
29. Explain the uses of index numbers.
30. A weighted index number is generally preferred to an unweighted index number. Why?
31. Why do you use weights in the index numbers?
32. Differentiate between fixed base and chain base.
33. Define chain index and explain its uses.
34. What are the disadvantages in using Paasche’s formula for the construction of a price
index number?
35. What is family budget enquiry?
36. What are the possible errors in the construction of an index numbers of prices?
37. Show that the G.M of price relatives in the construction of an index number satisfies
the time reversal test.
38. Find x if the value of Lasperey’s index is 1.5( with out multiplier 100)
Commoditie p0 q0 p1 q1
s
A 1.5 10 2 5
B 2.3 5 x 2
39. Name the methods of
constructing cost of living index umbers.
40. What are the uses of cost of living index numbers?
41. Describe briefly a method of constructing cost of living index numbers.
 42. Explain the meaning of upward bias and downward bias with reference to Lasperey’s
and Paasche’s price indices.
43. Index numbers are ‘economic barometers’. Explain this statement.
44. For a data Lasperey’s index number is 120 and fisher’s index number is 125. Calculate
Paasche’s index number.
45. What are the characteristics of an index number?
46. Explain what is formula error?
47. Explain simple aggregative method for the construction of index numbers. Explain its
merits and demerits.
48. Explain simple average of relatives for the construction of index numbers. Explain its
merits and demerits.
49. Write the formulae for Lasperey’s, Paasche’s and fisher’s quantity index numbers.
50. name the methods of constructing index numbers which satisfies i) TRT ii)FRT iii)CT
51. How do you convert chain index to fixed index?
52. What are the merits and demerits of chain base method?
53. Write two limitations of index numbers.
54.
Six marks questions:
1. Explain fisher’s ideal index number and discuss how far it is ideal?
2. Define fisher’s ideal index number. Show that it satisfies both time reversal and factor
reversal tests.
3. Define index number. Discuss various problems in the construction of index numbers.
4. Explain the need of weights in index numbers. Explain commonly used weighting
schemes.
5. Discuss different steps for the construction of wholesale price index numbers.
6. Define an index number. Distinguish between wholesale price index number and
consumer price index number. Describe the various steps involved in the construction
of consumer’s price index numbers.
7. i) Explain TRT, FRT, and CT.
ii) Describe what is meant by base shifting, splicing and deflating of index numbers.
8. Explain the concept and uses of index numbers. Discuss the conditions that a good
index number should satisfy.
9. What are the tests of a good index number? Explain Paasche’s, Lasperey’s and fisher’s
index numbers. Verify if they satisfy these tests?
10. What is the chain base method of constructing of index numbers and how does it differ
from fixed base method? Discuss the advantages and disadvantages of the two
methods.