The Institute of Chartered Accountants of Sri Lanka

Postgraduate Diploma in Accounting, Business and Strategy

Quantitative Methods for Business Studies

Handout 05: Business use of price indices

Introduction
An index number measures how much a variable changes over time. We calculate an index number
by finding the ratio of current value to a base value and multiply the resulting number by 100 to
express the index as a percentage. Index number for the base point in time is always 100.

Types of index numbers.

 Price index number

Price index numbers are used to measure relative changes in the price of a product, or commodity,
from one period to another. They may be used within a wholesale price index or a consumer price
index. Usually the present, or current, price level is compared to a specific period in a previous
month, year, decade, etc. This is known as the base period.

 Quantity index number

The quantity index numbers are used to measure the changes relating to the physical quantities of
how many of an item or group of items were produced, sold or consumed.

Value index
The value index, measures changes in total monetary worth. That is it measures changes in Rupee
worth of a variable. The value index combines price and quantity changes to present a more
meaningful index.

Uses of Index Numbers

Management uses index numbers as part of an intermediate computation to understand other
information better.
(i) Index numbers measure the level of business and economic activities and are therefore helpful
in gauging the economic status of the country.
(ii) Index numbers measure the relative change in a variable or a group of related variables under
study.
(iii) Consumer price indices are useful in measuring the purchasing power of money, thereby used
in compensating the employees in the form of increase of allowances.
Methods of constructing index numbers
 Simple index
Simple index numbers measure relative changes of a single variable in relation to a specific base.
 Unweighted aggregate index
Unweighted aggregate index numbers measure average relative changes within a group of several
relative variables in relation to a certain base.
 Weighted aggregate index
This is an aggregate index with different weights attached to the items in the index.

Simple price index

Simple price index = Pi x 100
P0

Where,
Pi- price for each element of each year in which we want the index
P0- price for each element in the base year.
Qi- quantity for each element of each year in which we want the index
Q0- quantity for each element in the base year

Exercise
The price and quantity data of four commodities for the two years 2000 and 2018 are given blow.
Find the simple price index for each commodity for 2018 taking 2000 as the base year.
Prices Quantities
Commodity
2000 2018 2000 2018
A 10 12 20 22
B 8 8 16 18
C 5 6 10 11
D 4 5 7 8

Simple aggregate price index

Aggregate index is calculated by adding all elements in the composite for the given period and
then dividing this result by the sum of the elements during the base period.
Aggregate price index is a simple method for constructing index numbers. In this, the total of
current year prices for various commodities is divided by the corresponding base year price total
and the result is multiplied by 100.

Simple aggregate price index = ∑Pi x 100

∑P0
Where,
Pi- price for each element of in the current year
P0- price for each element in the base year.

Simple aggregate quantity index = ∑Qi x 100

∑Q0
Where,
Qi- quantity for each element in the current year
Q0- quantity for each element in the base year.

Exercise
In an effort to get a measure of economic hardship, the IMF collected data on the price behaviour
of five major products imported by a group of less developed countries. Using 2010 as the base
period, express the 2018 prices in terms of unweighted aggregated index.
Product A B C D E
2010 price (Rs) 127 532 2290 60 221
2018 price (Rs) 152 651 2314 76 286

The advantage of un-weighted aggregate indices is its simplicity. Major disadvantage is, it does
not attach importance or weight to the price change of a high use item than it does to a low volume
item.

Weighted aggregate price index

As discussed above, to attach greater importance to changes in some products than others, a weight
is attached to an index. This allows us to include more information than just the change in the
variable over time.

Weighted aggregate price index = ∑PiQ x 100

∑P0Q
Where,
Pi- price for each element of each year in which we want the index
P0- price for each element in the base year.
Q –quantity weighting factor.

This leads to an important question; what quantities to use, ie base year quantities, current year
quantities or quantities of other chosen period.
When base year quantities are used, the index is termed the Laspeyre’s price index, and when
current year quantities are used the index is termed the Paasche’s price index. If any other
quantities are specified, it is termed a fixed aggregate price index.

Laspeyre’s price index = ∑PiQo

∑P0Q0
Paasche’s price index = ∑PiQi
∑P0Qi
where,
Q0 base period quantities
Qi current period quantities

Exercise
1. Refer the data in example 1
a Construct a Laspeyres price index for 2018 using 2000 as the base period.
b Use the data to calculate a Paasch’s price index for 2018 using 2000 as the base period.
2. The price and quantity sold of pocket electronic calculators has changed dramatically in a
short period of time. Table below indicates the prices of four different kinds of pocket
electronic calculators at two time periods eight years apart and the quantities at the initial year
and eight years later.

Model Initial Price Eight Initial Year Ending Year

Year Price Rs Year Later Rs Quantity Quantity
Basic Four Functions 550 190 13 million 30 million
Single Memory 790 200 10 million 48 million
Scientific 1800 1400 3 million 27 million
Programmable 3900 1580 0.5 million 19 million

i. Compute the simple price index for each model of calculator.

ii. Compute a quantity-weighted index of the price change in calculators over the eight
years using base year quantities.
iii. Which type of index did you calculate, Laspeyres of Paasche?
iv. Using the ending year quantities, compute a quantity weighted index of the price change
in calculators over the eight year period.
v. Which type of index did you calculate, Laspeyres or Paasche?
vi. Compare your answer with the one given before. Which index indicates the greater price
change? Discuss the possible reasons for the change.
vii. Discuss the advantages and disadvantages of using Laspeyres price index

Adventages and disadvantages of Laspeyres’ and Paasche’s index numbers

Laspeyres’
Advantages: Requires quantity data from only the base period. This allows a more
meaningful comparison over time. The changes in the index can be
attributed to changes in the price.
Disadvantages: Does not reflect changes in buying patterns over time. Also, it may
over-weight goods whose prices increase.
Paasche’s
Advantages: Because it uses quantities from the current period, it reflects current
buying habits.
Disadvantages: It requires quantity data for each year, which may be difficult to obtain.
Because different quantities are used each year, it is impossible to attribute
changes in the index to changes in price alone. It tends to overweight the goods
in which prices have declined. It requires the prices to be recomputed each year.

Basket of goods concept.

When presenting index numbers, statisticians sometimes simplify index concepts referring to the
cost of a fixed basket of goods over many year. This refers to a quantity weighting of prices. For
example, if the basket consists of 2Kg of sugar ad 4l of milk then the numbers 2 and 4 are used
to weigh the prices of sugar and milk of each year and the price index is calculated in the normal
way.
Consumer price index (CPI)
The consumer price index is a measure of the overall cost of the goods and services bought by a
typical consumer. CPI is one way of measuring the price level.
It is used to monitor changes in the cost of living over time. When the CPI increases, the average
family has to spend more money to maintain the same standard of living.
Calculating CPI

1. Fix the basket. Determine the quantity of each good that the average consumer buys.
 Identify a basket of goods and services the typical consumer buys.
 Conduct monthly consumer surveys to determine the quantities of those
goods and services.
2. Find the prices. Find the prices of each of the goods and services in the basket for each period
(month or year).
3. Calculate the cost of the basket. Use the data on prices to calculate the cost of the basket of
goods and services at each period.
4. Choose a base year and compute the index.
 Choose one year as the base year, so that we can compare across years more
clearly.
 Compute the index by dividing the cost of the basket in one year by the cost
of the basket in the base year and multiplying by 100.

Current Cost of the basket

CPI   100
Base Year Cost of basket
The changes in consumer price index give an indication of changes in the value of money and they
are therefore used for example as a basis for establishing wage policies at national level and
negotiating wage settlements at the local level.

The index is however as an average taken over the whole country and therefore it doesn’t give an
accurate indication of changes for specific areas and specific groups of workers.

Using CPI to find the real income

Real income is determined by,
Real income = Money Income x 100
CPI
Exercise
A teacher earned the following salaries. Find the real value of the salaries.
Year Nominal CPI Real
Income Income
2000 24, 332 82.4
2001 32, 777 107.6
2002 41, 451 130.7
2003 53, 350 160.5
2004 59, 346 172.2
Calculating the rate of inflation with the CPI

Inflation is the rate at which the general level of prices for goods and services is rising and,
consequently, the purchasing power of currency is falling. Central banks attempt to control
inflation in order to keep the economy running smoothly. The inflation rate is the rate of change
in the consumer price index between years (or months).

CPI in Year 2  CPI in Year 1

Inflation Rate in Year 2= 100
CPI in Year 1

The changes in consumer price index give an indication of changes in the value of money and they
are therefore used for example as a basis for establishing wage policies at national level and
negotiating wage settlements at the local level.

Exercise
Using the data in the table below find the rate of inflation for the years 2001 to 2005
Year 2000 2001 2002 2003 2004 2005
CPI 130.7 136.2 140.3 144.5 148.2 152.4

Changing the base

To change an index with base period X into an index with base period Y, all you need to do is to
divide each value of the index with base period X by the values of the index with base period X at
period Y.

Index x (t )
IndexY (t )   100
Index x (Y )

Exercise
Change the base years of the following series from 1984 to 1995
Year 1990 1991 1992 1993 1994 1995 1996
Units sold (1984
=100) 126 135 147 159 165 182 187

Limitations of Index Numbers

1. Weighting factors can become obsolete.

2. If sampling had been done to obtain data, information might be incomplete or false.
3. They give only general indications of changes- minority groups or professions may not be
catered for.