EDUCATION FOR EXCELLENCE

Statistical Methods

Study Material
Prepared By:
SHANKARAIAH.P
Lecturer
 INDEX NUMBERS
Introduction:
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. The base value of the
index number is usually 100, which indicates price, date, a level of production, and more.
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 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.’
Definition:
According to Croxton and Cowden: “the index numbers are devices for measuring
differences in the magnitude of a group of related variables.”
According to Spiegal: “an index number is a statistical measure designed to show changes in a
variable or a group of related variables with respect to time, geographical locations, or other
characteristics.”
To understand the meaning of the term index number, three points are to be noted.
First, an average figure relates to a single group of commodities. But the various items in the
group are expressed in different units. For example, a consumer price index contains such
diverse items as food, clothing, fuel and lighting, house rent, and miscellaneous things. Food
consists of wheat, ghee, etc. expressed in kgs. cloth is expressed in metres, and lighting in kws.
An index number expresses the average of all such diverse items in different units. Second, an
index number measures the net increase or decrease of the average prices for the group under
study. 
Types of Index Numbers:
1. Price index number: It evaluates the relative differences in costs between two particular
points in time.
2. 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.
3. Value Indices: Value indices actually measure the combined effects of price and quantity
changes. For many situations either a price index or quantity index may not be enough for the
purpose of a comparison.
Characteristics of Index Numbers:
1. Expressed in percentage: Index numbers are expressed in percentage, so they remove this
barrier. Although, we do not use the percentage sign. It is possible to compare the
agricultural production and industrial production and at the same time being expressed in
percentage, we can also compare the change in prices of different commodities.
2. measures of net changes: Index numbers measure a net or relative change in a variable or a
group of variables. For example, if the price of a certain commodity rises from ₹10 in the
year 2007 to ₹15 in the year 2017, the price index number will be 150 showing that there is
a 50% increase in the prices over this period.

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3. Measure change over a period of time or in two or more places:  Index numbers measure
the net change among the related variables over a period of time or at two or more places.
For example, change in prices, production, and more, over the two periods or at two places.
4. Special type of average:  Index numbers are specialised average, expressed in percentage,
and help in measuring and comparing the change in those variables that are expressed in
different units. For example, we can compare the change in the production of industrial
goods and agricultural goods.
5. Measuring changes that are not directly measurable: Cost of living, business activity,
and more are complex things that are not directly measurable.  With the help of index
numbers, it is possible to study the relative changes in such phenomena.
Importance/Uses:
1. It helps 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. And to make any policy related to the industrial or agricultural
production, the government refers to their respective index numbers.
2. It helps 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. It Helps 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. It facilitates for 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.
5.It Measures the purchasing power of money to maintain standard of living:  Index
numbers, such as cost inflation index help in measuring the purchasing power of money at
different times between different regions. Such analysis helps the government to frame
suitable policies for maintaining or raising the standard of living of the people.
6. It acts as Economic Barometer: Index numbers are very useful in knowing the level
of economic and business activities of a country. So, these are rightly known as economic
barometers.
7. Changes in Cost of Living: Index numbers highlight changes in the cost of living in the
country. They indicate whether the cost of living of the people is rising or falling. On the
basis of this information, the wages of the workers can be adjusted accordingly to save the
wage earners from the hardships of inflation.
8. BSE and SENSEX are the index of share prices for shares traded in the Bombay Stock
Exchange. This helps the authorities in regulating the stock market. This index is also an
indicator of general business activity and is used in framing various government policies.
Problems/Steps in the Construction of Index Numbers:
1.  Purpose of the Index Number:
Before constructing an index number, it should be decided the purpose for which it is
needed. An index number constructed for one category or purpose cannot be used for others. A
cost-of-living index of working classes cannot be used for farmers because the items entering
into their consumption will be different.

Shankaraiah.P, Lecturer, R.G. Institute Of Commerce And Management, Davangere. 3

 2. Selection of Commodities:
Commodities to be selected depend upon the purpose or objective of the index number
to be constructed. But the number of commodities should neither be too large nor too small.
Moreover, commodities to be selected must be broadly representative of the group of
commodities. They should also be comparable in the sense that standard or graded items should
be taken.
3. Selection of Prices:
The next step is to select the prices of these commodities. For this purpose, care should
be taken to select prices from representative persons, places or journals or other sources. But
they must be reliable.   For a consumer price index, wholesale prices are required, while for a
cost of living index, retail prices are needed. But different prices should not be mixed up.
4. Selection of an Average:
Since index numbers are averages, the problem is how to select an appropriate average.
The two important averages are the arithmetic mean and geometric mean. The arithmetic mean
is the simpler of the two. But geometric mean is more accurate. However, the average prices
should be reduced to price relatives (percentages) either on the basis of the fixed base method
or the chain base method.
5. Selection of Weights:
While constructing an index number due weightage or importance should be given to
the various commodities. Commodities which are more important in the consumption of
consumers should be given higher weightage than other commodities. The weights are
determined with reference to the relative amounts of income spent on commodities by
consumers. Weights may be given in terms of value or quantity.
6. Selection of the Base Period:
The selection of the base period is the most important step in the construction of an
index number. It is a period against which comparisons are made. The base period should be
normal and free from any unusual events such as war, famine, earthquake, drought, boom, etc.
It should not be either very recent or remote.
7. Selection of Formula:
There are various formulas for construction of index numbers like Laspeyre’s’ method,
Paasche’s method, Fisher’s method, and more. No single formula is appropriate for all types of
index numbers. The choice of formula depends upon the purpose of the available data.

Methods of Construction of Index Numbers:

Melthods

Uweighted Index Weighted Index

Nmubers Numbers

Simple Aggregate Simple Average of Price Weighted Aggregate Weighted Average of

Method Relative Method Method Price Relative Method

Shankaraiah.P, Lecturer, R.G. Institute Of Commerce And Management, Davangere. 4

I. Unweighted Index Numbers:
This type of indices are also referred to as simple index numbers. In this method of
constructing indices, weights are not expressly assigned. These are further classified under two
categories: Unweighted Index Numbers This type of indices are also referred to as simple
index numbers. In this method of constructing indices, weights are not expressly assigned.
These are further classified under two categories:
1) Simple Aggregative Index
2) Simple Average of Relatives Index
1) Simple Aggregative Method:
In this method, the index number is equal to the sum of prices for the year for which index
number is to be found divided by the sum of actual prices for the base year.
Formula:
∑ P1
P10= X 100
∑ P0
This price index number calculated by using simple aggregative method has limited
use. The reasons are as follows:
(a) This method doesn’t take into account the relative importance of various
commodities used in the calculation of index number since equal importance is given to all the
items.
(b) The different items are required to be expressed in the same unit. In practice,
however, the different items may be expressed in different units.
(c) The index number obtained by this method is not reliable as it is affected by the unit
in which prices of several commodities are quoted.
2. Simple Average of Price Relatives Method:
In this method, the index number is equal to the sum of price relatives divided by the number
of items and is calculated by using the following formula:
Formula:
∑P
P10= X 100
N
The index number based on simple average of price relatives is not influenced by the
units in which the prices of the commodities are quoted. However, this method like simple
aggregative method gives equal importance to all the items and thus neglects their relative
importance in the group.
These formulas are very simple for the purpose of calculation and so provides a quick
measure of Index number when one has to obtain Index number for similar type of articles, e.g.
crop items like wheat. rice, bajra, gram etc. But if prices of commodities under study have
different units i.e. per kg, per meter, per ton, this formula is not of any use as different units
cannot be summed us directly.
II. Weighted Aggregative Method:
In this method, different weights are assigned to the items according to their relative
importance. Weights used are the quantity weights. Many formulae have been developed to
estimate index numbers on the basis of quantity weights.
Weighted Index Numbers:

Shankaraiah.P, Lecturer, R.G. Institute Of Commerce And Management, Davangere. 5

 In the earlier two methods each item received equal weight/importance in the
construction of an index, whereas in the weighted index methods, weights are expressly
assigned to each item which is included in an index construction. This weighting allows us to
consider more information than just the change in price/ quantity over time. The problem only
is to decide how much weight (importance) to consider for each of the items included in the
sample. This is further divided into two methods.
1) Weighted Aggregates Index, and
2) Weighted Average of Relatives Index.
1) Weighted Aggregates Index: In this method appropriate weights are assigned to different
commodities to make them comparable and thus compatible for summation. In this method the
commodities of higher importance are given higher weight and vice versa. In this way, each
commodity selected for obtaining the index number influence it according to its weight (i.e.,
importance, literally).
I. Laspeyre’s Index: Laspeyre’s Price Index or Base Year Method French economist
Laspeyere in 1871, suggested that quantities of commodities consumed in base year can be
taken as weights for the purpose of calculating index numbers.
In this method, weights assigned to each commodity are the quantities consumed in the
base year for price indices. For quantity index weights used are the prices of commodities in
the base year. It is given by:
¿
II. Paasche’s Index: Paasche’s Price Index or Given Year Method By taking year quantities
as weights, we get Paasche’s formula. This formula is suggested by German statistician
Paasche in 1874 and so it is named after him and while writing this formula, as in earlier case,
we add upper suffic ‘Pa’.
In this method, quantities consumed in the current year are used as weights in
construction of price indices, where as in construction of quantity index, weights used are the
prices of items in the current year. It is given by:

¿
Note: In general, Laspeyre’s price index is greater than Paasche’s Price Index. In other words,
Laspeyre’s Price Index has an upward bias in general, with rise in price.

III. Durbish & Bowley’s Index: “It is the simple arithmetic mean of both Laspeyre’s and
Paache’s Index numbers”. It is given by:

∑ p 1 q 0 ∑ p1 q1
+
∑ p0 q 0 ∑ p0 q1
P10=
2 X 100 ¿
¿
IV. Fisher’s Ideal Index: Irving Fisher used geometric mean of the Laspeyre’s and Paache’s
indices to overcome the shortcomings of both. “Fisher Index is the geometric mean of both
Laspeyre’s and Paache’s Index numbers”. It is given by:

¿
Ideal Index:
Fisher Index is called Ideal Index because of the following reasons:

Shankaraiah.P, Lecturer, R.G. Institute Of Commerce And Management, Davangere. 6

 1. Use of base year and current year quantity: Fisher index number takes into
consideration the price and quantities of both the base year and quantities off both the
base year or initial year and current year.
2. Based on Geometric Mean: Fisher’s index is based on geometric mean which is
supposed to be the best average for the construction of index numbers. 
3. Satisfaction of Reversal Tests: It satisfies the time-reversal as well as the factor
reversal tests.
4. No Bias: there is no bias, as in case of Laspeyre’s and Paasche’s index numbers.
Time Reversal Test:
Proposed by Prof. Irving Fisher. It requires the index number formula to possess time
consistency by working both forward and backward with reference to time.
Meaning: When time is reversed keeping other two factors price and quantity as constant the
product must be equal to unity.

Test: P01 X P10 = 1

LHS = RHS
Proof:
¿

¿ √1 X 1 X 1 X 1

¿ √1
= 1
= RHS
Hence, Fisher Index Satisfies Time Reversal Test
Factors Reversal Test:
When two factors Price and Quantity are reversed keeping time factor as constant the
product must be equal to Value Index.

∑ p1 q1
Test: P01 X Q01 = = Value Index
∑ p 0 q0
LHS = RHS
Proof:
¿

Shankaraiah.P, Lecturer, R.G. Institute Of Commerce And Management, Davangere. 7

¿

2
∑ p1q1
¿
√( ∑ p0q0 )
2
∑ p0q1
¿
√( ∑ p1q1 )
∑ p1 q1
¿
∑ p0 q 0

= RHS

Hence, Fisher Index satisfies Factors Reversal Test

Shankaraiah.P, Lecturer, R.G. Institute Of Commerce And Management, Davangere. 8