Chapter 8: Index numbers

Meaning: Index numbers is a statistical tool for measuring relative change in a group of related
variables over two or more different times.
Features of an Index Number
a. They are expressed in percentages.
b. They are special types of averages.
c. They measure the effect of change over a period of time.
Problems in construction of Index Numbers
a. Defining the purpose of index numbers
b. Selection of items
c. Selection of base period
d. Selection of prices
e. Selection of weights
f. Choice of an average
g. Choice of the formulae
Advantages of Index Number
1. Measurement of change in the price level or the value of money: Index number can be used
to know the impact of the change in the value of money on different sections of the society.

2. Knowledge of the change in standard of living: Index number helps to ascertain the living
standards of people. Money income may increase but if index number show a decrease in the
value if money. Living standard may even decline.

3. Adjustment in salaries and allowances: Cost of living index number is a useful guide to the
government and private enterprises to make necessary adjustment in salaries and allowances
of the workers.

4. Useful to business community: Price index numbers serve as a useful guide to the business
community in planning and decision. Trend of prices significantly influence their production
policies.
5. Information regarding foreign trade: Index of exports and imports provides useful information
regarding foreign trade. Accordingly export-import policies are formulated.
6. Information regarding Production: Index numbers of production shows whether the level of
agricultural and industrial production in the economy is increasing or decreasing. Accordingly
agricultural and industrial development policies are formulated.

Price index are of two types

a. Simple Index Number
b. Weighted price Index numbers

Construction of simple Index Numbers:-

There are two methods
a. Simple aggregate Method
It calculates the percentage ratio between the aggregate of the prices of all commodities
in the current year and aggregate prices of all commodities in the base year.

P= (∑P1÷∑P0)×100

Here, ∑P1= Summation of the prices of all commodities in current year and ∑P0=
Summation of prices of all commodities in base year.
b. Simple Average of price relative method
In this method, we find out the price relative of individual items and average out the individual
values. Price relative refers to the percentage ratio of the value of a variable in the current year
to its value in the year chosen as the base.

Price relative (R) = (P1÷P0) × 100

Here, P1= Current year value of item with respect to the variable and P0= Base year value of
the item with respect to the variable. Effectively, the formula for index number according to this
method is:

P = ∑ [(P1÷P0) × 100] ÷N

Here, N= Number of goods and P= Index number.

Construction of Weighted Index Numbers
There are two methods:-
1]Weighted Aggregate method:- Here different goods are assigned weight according to the
quantity bought. There are three well-known sub-methods based on the different views of
economists as mentioned below:

A] Laspeyre’s Method

Laspeyre was of the view that base year quantities must be chosen as weights. Therefore the
formula is :

P= (∑P1Q0÷∑P0Q0)×100

Here, ∑P1Q0= Summation of prices of current year multiplied by quantities of the base year taken
as weights and ∑P0Q0= Summation of, prices of base year multiplied by quantities of the base year
taken as weights.

B] Paasche’s Method

Unlike the above mentioned, Paasche believed that the quantities of current year must be taken as
weights. Hence the formula:

P=(∑P1Q1÷∑P0Q1) ×100

Here, ∑P1Q1= Summation of, prices of current year multiplied by quantities of the current year
taken as weights and ∑P0Q1= Summation of, prices of base year multiplied with quantities of the
current year taken as weights.

C] Fisher’s Method

Fisher combined the best of both above-mentioned formulas which resulted in an ideal method.
This method uses both current and base year quantities as weights as follows:

P = √[ (∑P1Q0÷∑P0Q0) × (∑P1Q1÷∑P0Q1) ] ×100

NOTE: Index number of base year is generally assumed to be 100 if not given

2] Weighted Average or Price Relatives Method

Here we calculate the ratio between the summation of the product of weights with price relatives
and summation of the weights.

P=∑RW÷∑W
Here, R= Price relative and W= weight.

A Solved Example For You

Q: Construct index numbers of prices of items in the year 2012 from the following data by:

Laspeyres method

Paasche’s method

Fisher’s method

Items Price (2004) Quantity(2004) Price(2012) Quantity (2012)

A 10 10 5 25

B 35 4 35 10

C 30 3 15 15

D 10 25 20 20

E 40 3 40 5
Ans:
Items P0 Q 0 P 1 Q 1 PQ0 0 PQ 0 1 PQ
1 0 PQ
1 1

A 10 10 5 25 100 250 50 125

B 35 4 35 10 140 350 140 350

C 30 3 15 15 90 450 45 225

D 10 25 4 20 250 200 100 80

E 40 3 40 5 120 200 120 200

∑=700 ∑=1450 ∑=455 ∑=980

1. Laspeyre’s method= (455/700) × 100 = 65

2. Paasche’s method= (980/1450) × 100= 67.58
3. Fisher’s method= √0.43927 × 100 = 66.27
Types of Index Numbers
 Consumer Types of Index Numbers (CPI)
 Whole Sale Index (WPI)
 Index of Industrial (IIP)
 SENSEXPrice
a. Consumer Price Index:- (CPI) The methods of constructing CPI are
Consumer Price Index:- (CPI) The methods of constructing CPI are

• Aggregate Expenditure Method = This method is based on Laspeyres formula as can be

seen below:

CPI = (∑P1Q0 ÷ ∑P0Q0) ×100

Here, ∑P1Q0= Summation of, prices of current year multiplied by respective quantities
consumed in base year taken as weights
∑P0Q0= Summation of, prices of base year multiplied by respective quantities consumed in
base year taken as weights

• Family Budget Method

This method calculates CPI using price relatives method. Here, weight is defined as the product
of price and quantity consumed of the commodity, both with respect to the base year. Price
relative is the ratio of current year’s price to base year’s price multiplied by 100. The formula to
calculate CPI is as follows:
CPI = ∑RW÷∑W
Here, ∑RW= Summation of the product of price relative (R) and weight(P0Q0) of the commodity
∑W= Summation of the weights(P0Q0) of all the commodities
Uses of Consumer Price Index:- (CPI)
a. It is used in calculating purchasing power of money
b. It is used for grant of Dearness Allowance.
c. It is used by government for framing wage policy, price policy etc.
d. CPI is used as price deflator of income
e. CPI is used as indicator of price movements in retail market.

Wholesale Price Index (WPI):- As the name suggests, WPI simply measures the temporal
change in wholesale prices of commodities. Unlike CPI, which looks at the relative change in
prices from the consumption perspective, WPI looks at the relative change in price from
wholesale market’s perspective. Therefore it is an index of critical importance.
For the purpose of calculating WPI, commodities have been classified into the following three:

 Primary Articles- Includes eatables like rice, fruits, pulses etc. and non-food items like
cotton, jute etc.
 Fuel and Power- Includes items like petroleum products, coal, electricity etc.
 Manufactured Goods- Includes manufacturing items like paper, sugar, leather, chemicals
etc.

a. It measures the relative change in the price of commodities traded in wholesale market.
b. It indicates the change in the general price level.
c. It does not include services
Significance of WPI
a. The wholesale price index is an accurate measurement of predicting the demand and
supply of commodities in the economy. For example, an increase is WPI indicates an
increase in demand on an average.
b. WPI can be used to calculate the real and monetary values of aggregates like national
income.
Real value refers to the value of aggregate at base year prices. Monetary value refers to
the value of aggregate at current year prices. The two values are tied by WPI through
the following formula:
Real aggregate of the current year = monetary aggregate of current year × ( price index
of base year ÷ price of current year).
c. Additionally, WPI is used to calculate the rate of inflation. It is calculated as under:
Rate of inflation = [(P2 – P1) ÷P1]×100
Here, P2= Current WPI and P1= Previous WPI
Note: The annual rate of inflation is calculated as the average of WPI for all weeks of the
year.

Index Number of Industrial Production (IIP)

Apart from the two major indices, WPI and CPI, there is a third index IPI which also holds critical
importance. The index of industrial production measures the change of industrial production
relative to a base year.

Unlike WPI and CPI, this index number focuses on production rather than price. It is a useful
tool to measure the industrial growth of an economy. For calculating industrial production index,
the industries are divided into mining, manufacturing and electricity.
Constructing an IPI
A difference between the construction of an IPI and other indices is the approach towards how
weights are considered. For an IPI, weights are assigned according to the output of industries
and their contribution to the national income. The following formula is used:
Index number of industrial production = (∑RW÷∑W)×100
Here, R= (Q1/Q0*100)
Ratio of level of production in current year to the level of production in base year
W= Assigned weights
[Example will be given during the lesson]
The Relation between Inflation and Index Numbers
The term inflation is among the most frequently occurring terms in economics. Inflation denotes
the rise in the general price level in an economy over a long period of time. In simple words
under conditions of inflation, a particular commodity remains unchanged but it’s price still rises.
Such a constant rise in general price levels, with money income remaining same, erodes the
purchasing power of consumers. In addition to this, it also brings down the value of currency
slowly.
As wholesale price index represents the temporal change in general price level, inflation and
WPI are inter-related. The mathematical formula to find out inflation rate using WPI has already
been mentioned.
Another point worth noting is that a fall in the rate of inflation does not mean fall in price levels. It
simply indicates the fall in the incidence of inflation. In simpler words, it represents the fall in the
pace of increase in general price levels, which still continue to rise.
Uses of Index Numbers. (expand the points)
a. Helps us to measure changes in price level
b. Help us to know changes in cost of living
c. Help government in adjustment of salaries and allowances
d. Useful to Business Community
e. Information to Politicians
f. Information regarding foreign trade
SENSEX
SENSEX is the short form of Stock Exchange Sensitive Index with 1978-79 as base. It is a
useful guide for the investors in the stock market. It deals with 30 stocks represented by 13
sectors of the economy.

Solved Example for You

Q: Construct the cost of living index for 2014 on the basis of 2004 from the following data and give
your comments:

Item Prices in 2004 ( Rs.) Prices in 2014( Rs.) Weights

Food 40 55 5

Fuel 8 12 2

Clothing 25 37 4

Rent 15 22 3

Miscellaneous 25 30 1

Ans:
Items P0 P1 R=(P1÷P0)×100 Weights(W) RW

Food 40 55 137.5 5 687.5

Fuel 8 12 150 2 300

Clothing 25 37 148 4 592

Rent 15 22 146.7 3 440.1

Miscellaneous 25 30 120 1 120

∑RW =
∑W= 15
2139.6

Cost of living index number= ∑RW/∑W = 2139.6/15 = 142.64

As already mentioned, the index of the base year is generally taken to be 100. According to this
assumption, the increase in the cost of living index is 42.64% in 2014 relative to 2004 taken as the
base year.