THE INSTITUTE OF FINANCE MANAGEMENT (IFM)

Department of Mathematics and Actuarial Studies

Business Statistics 1

INDEX NUMBERS

To measure the growth and progress of an economy, economists and scientists use many
statistical tools. One such very important tool are index numbers. They help reveal the trends
and tendencies of the economy and help in the formulation of economic policies and laws.

Definition:
 An index number is, in part, a ratio of a measure taken during one time frame to that
same measure taken during another time frame. Or
 An Index number is a number that expresses the relative change in price, quantity, or
value compared to a base period.
 An index number is a statistical measure, designed to measure changes in a variable, or a
group of related variables. It is a single ratio (or a percentage) which measures the
combined change of several variables between two different times, places, or situations.

Examples of specific indexes are

a. Employment cost index
b. Price index for construction
c. Index of manufacturing capacity
d. Producer price index
e. Consumer price index
f. Dow Jones industrial average
g. Index of output etc.
Types of Index Numbers
Index numbers can be differentiated using different measures.
a) Number of variables involved. This includes:
1. Simple Index Number: This measures a relative change in a single variable with respect to
a base. Or if the index number is used to measure the relative change in just one variable,
such as hourly wages in manufacturing, it is referred to as a simple index.
2. Composite Index Number: measures average relative change in a group of variables with
respect to a base. In other words, when an index number is used to measure changes in the
value of the group of variables such as prices of specified list of Commodities, volume of
production in different sectors of an industry, production of Various agricultural crops, cost
of living etc, it is referred to as composite index.

b) Type of variable involved. This includes:

1. Price index numbers: The determination of the worth of money using price index
numbers is the most significant application of index numbers. It portrays inflation or
deflation and efficiently illustrates the shift in price levels. Prices can be either retail or
wholesale. Price index number are useful to comprehend and interpret varying economic
and business conditions over time, they are used to determine distinct regions' standards
of living. Government and businesses utilize price index figures as a tool to formulate
policies.

2. Value index numbers: This is used to determine the ratio of the aggregate value of a
given commodity in the current year and its value in the chosen base year. The value
index is utilized for inventories, sales, and foreign trade.

3. Quantity index numbers: used to measure changes in the volume or quantity of goods
that are produced, consumed, and sold within a stipulated period. Index of Industrial
Production (IIP) is an example of Quantity Index. They are used to measure changes in
the physical quantity of goods produced, consumed or sold of an item or a group of items.
 c) Assignment of Weight. Here we have:
1. Simple or Unweighted Index Numbers: this accord all objects the same weight,
regardless of their relative proportions. It treats each item equally in relation to the
specified variable. It is therefore a simple average and less precise than the other class of
index numbers.
2. Weighted Index Numbers: These weigh items according to their importance with
respect to the concerned variable. It is more realistic in comparison to simple index
number because it accurately reflects the change over time.

Characteristics of index numbers:

i) Index numbers are specialised averages.
ii) Index numbers measure the change in the level of a phenomenon.
iii) Index numbers measure the effect of changes over a period.
iv) Index numbers measure changes which are not directly measurable. For example the
cost of living, the price level or the business activity in a country are not directly
measurable but it is possible to study relative changes in these activities by measuring
the changes in the values of variables/factors which affect these activities.
v) Index numbers are related to a base year.
vi) Most economic index numbers are reported to the nearest whole number or to the
nearest 10th of a percent e.g., 8.3, 118.6.
vii) Index numbers are a special type of average that provides a measurement of relative
changes in the level of a certain phenomenon from time to time. It is a special type of
average because it can be used to compare two or more series which are composed of
different types of items or even expressed in different types of units.
viii) Index numbers are expressed in terms of percentages to show the extent of relative
change.
ix) Index numbers measure relative changes. They measure the relative change in the value
of a variable or a group of related variables over a period or between places.
Uses of Index Number

Index numbers are descriptive measures that are used to

• Compare phenomena from one time period to another (comparison between two different
periods).
• Relate information about stock markets, inflation, sales, exports and imports, agriculture
etc.

Problems in Index Number Construction

i. Collection of data

The availability and comparability of data to get the correct data is very difficult as we know that
the primary data which are always the appropriate ones is costly and time consuming

ii. Selection of Base time Period

In the calculation of index number we have two important periods;

a. The base period where the reference is to be made

b. The current period – period whose data compared to those of base year

iii. The choice of the suitable formula

There are several methods in which the index number can be derived. Different method gives
different index numbers. The choice among the different formulae should depend on the
particular use to be made on it

iv. Selection of component commodity

For the single item or commodity it is easier to get a price index, but if the index is of general
purpose i.e. to compare the cost of link, here the selection of item to be included should be
properly made considering the place, habit and time.

Importance of index Numbers

Index numbers are indispensable tools of economics and business analysis They are important
in economics for the following reasons:
 Permits Observation of Intangible Changes: The study the change factors and
variables which cannot be measured or observed directly.
 Enables Comparison: With the support of index numbers, the average price of several
articles in one year may be compared with the average price of the same quantity of the
same articles in several years within and across different countries.
 A measure of Change: Index numbers track changes in economic variables. For
instance, the Consumer Price Index is important because it measures the change in the
price of a large group of items consumers purchase. The Producer Price Index, on the
other hand measures price fluctuations at all stages of production. The ruling authorities
need knowledge of these fluctuations to stabilize the economy.
 Economic barometers: Index numbers act as economic indicators that enable timely
analysis of economic trends in a country. They measure the level of business and
economic activities; and are therefore helpful in gauging the economic status of the
country or to judge the health of an economy.
 Policy Formulation: Index numbers helps in formulating suitable economic policies and
for economic planning. Many of the economic and business policies are guided by index
numbers. For example, while deciding whether to increase the wages of employees, the
employers have to depend primarily on the cost-of-living index. If salaries or wages are
not increased according to the cost of living it will lead to a fall in workers standard of
living, strikes, unrest, poor productivity levels, etc. Thus, index numbers provide some
guidelines that one can use in making decisions.
 Trend Analysis: Index numbers are used in studying trends and tendencies. Since index
numbers are most widely used for measuring changes over time, the time series so
formed enables us to study the general trend of the phenomenon under study.
 Forecasting: Index numbers 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.
 Determination of the Value of Money: Index numbers measure the purchasing power of
money. The cost-of-living index numbers determine whether the real wages are rising or
 falling or are constant. Real wages help us in determining the purchasing power of
money.

❖ The real wages can be obtained by dividing the money wages by the corresponding

price index and multiplied by 100.

Construction of Index Numbers

Conventionally, index numbers are expressed in terms of percentage, and they are computed
using the two periods.
1. The Base Year: the period with which the comparison is to be made. It serves as the
reference to which we compare or determine the change in the value of the variable of
interest. The value of the index number in the base period is 100.
Example:

Suppose year 2000 is the base year, and we are interest in the relative change in price in 2022 if
the price index for the year 2022 is 135, it means that there was an increase of 35% in the general
price in 2022 as compared to the price level in year 2000. While price index numbers measure
and permit comparison of the prices of certain goods, quantity index numbers measure the
changes in the physical volume of production, construction or employment

The base period can be:

a) Fixed Base (A Single-Period): In a fixed base, the base period must be a normal period.
A normal period means that the period must be free from all sorts of abnormalities of
random causes such as financial crisis, floods, famines, earthquakes, strikes of labourers,
wars, etc.
b) Fixed Base (An Average of Selected Periods): When it is difficult to choose one single
period as a normal, then a better choice is to take an average of several periods as a base.
c) Chain Base: If the comparison is a required year on year, a system of chain base is

2. The Current year: the year for which we aim to find index number for.
Method of Constructing Method
 Unweighted Index Numbers: Here as earlier indicated, weights are not assigned to the
various items used for the calculation of index number. Examples are:
a) Simple Index Number: Here relative change in just one variable is considered.

Xt
It = × 100
X0
Where; X0 is the quantity, price, or cost in the base year
Xt is the quantity, price, or cost in the year of Interest
It is the index number for the year of interest

Price Relative (PR)

Price Relative is the ratio of the price of the single commodity in a given period called current
period to its price in another period called base period.
Pt
PI = × 100
P0

where, Pt is the price for current period

Po is the price for base period

Example:
The price of a standard lot at the shady rest cemetery in 2011 was Tsh 6000. The price rose to
Tsh 10000 in 2015 . What is the price index for 2015 using 2011 as the base period?
Pt
PR = × 100
P0

10000
× 100
6000

PR = 166.7
Interpreting this result, the price of a cemetery lot increase 66.7 percent from 2011 to 2015

Example:
The following table shows the average price of one liter of petrol in Dar es Salaam from 2005 to
2010
 Year 2005 2006 2007 2008 2009 2010
Tshs 450 560 750 900 1000 1100

Using the 2006 - 2007 as the base year, find the price relatives of one liter of petrol
compounding to all the given years

Solution
The arithmetic mean of the price for the year 2006 – 2007,
Year Tshs Price relative

2005 450 450⁄

655 × 100 = 68.7
2006 560 560⁄
655 × 100 = 65.5
2007 750 750⁄
655 × 100 = 114.5
2008 900 900⁄
655 × 100 = 137.4
2009 1000 1000⁄
655 × 100 = 152.7
2010 1100 1100⁄
655 × 100 = 167.9

This method has limited use due to the following reasons:

 This method doesn’t consider the relative importance of various commodities used in the
calculation of index number since equal importance is given to all the items.
 The different items are required to be expressed in the same unit. In practice, however,
the different items may be expressed in different units.
 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

b) Aggregate Price Index:

This becomes useful and necessary when there is need to compare the index number of a group
of items. This can be done using the following methods:
Simple Average of Relative Price Index
This method is an improvement over the previous method as it is not affected by the unit in
which the prices of various commodities are quoted. The price relatives are pure number and
therefore are independent of original units in which these are quoted. The price index number
using price relatives can be determined using arithmetic mean and geometric mean.
Procedure in computation of simple average of relative index
1. Calculate a separate index for each item
2. Average all of relative indexes calculated
3. Relative price index is given as
Pt
∑(
P0 × 100)
I=
n

Where, n is the total number of commodities

Note: The arithmetic mean is the average of a sum of numbers, which reflects the central
tendency of the position of the numbers. It is often used as a parameter in statistical distributions
or as a result to summarize observations or a group of numbers.

Example 3:
The price for five commodities for two years, 2000 and 2010 and their consumed quantities by a
certain family is given by the following table below

Item 2000 2010

Price Po (Tshs) Price Pt (Tshs)
Eggs(dozen) 185 298
Milk (liter) 88 198
mangoes (500g) 146 175
Orange juice (355ml) 158 170
Tea bags (500g) 440 475

Calculate the simple average of relative price index use 2000 as a base period
Solution:
Item 2000 2010 Simple Index
Price Po (Tshs) Price Pt (Tshs)
Eggs(dozen) 185 298 298
× 100 = 161
185
Milk (liter) 88 198 198
× 100 = 161
88
mangoes (500g) 146 175 175
× 100 = 161
146
Orange juice (355ml) 158 170 170
× 100 = 161
158
Tea bags (500g) 440 475 475
× 100 = 161
440
Total pt
∑ × 100 = 746.5
p0

pt
∑
p0 × 100 = 746.5
I= = 149.3
5

Simple Aggregate Index (SAI)

Simple Aggregate Index is the ration of the sum of price of all commodities in a given period
called current period to the sum of price in another period called base period.
Simple aggregate index also is called unweighted aggregate index given by
∑ Pt
SAI = ( × 100)
∑ P0

Characteristics of Simple Aggregate Index

Simple Aggregate Index

i. Is the sum the prices (rather than the indexes) for the two periods
ii. Determine the index based on the totals.
iii. Is constructed by collecting a number of similar items
Example 4
The average price in Tshs (‘000’) for stone, cement, sand and building block for the two years
2005 and 2010 are given in table below
Item 2005 2010
1ton Stone 87 160

1ton cement 56 125

1ton building block 98 200

1 ton sand 67 135

Calculate the simple aggregate price index for the year 2010 using 2005 as a base.

Solution
Item P (2005) P (2010)
0 t
1 ton Stone 87 160

1 ton cement 56 125

1 ton building block 98 200

1 ton sand 67 35

1 ton sand ∑ Po = 308 ∑ Pt = 620

∑ Pt
SAI = × 100
∑ Po
620
× 100
308
SAI = 201.3
Disadvantage of the Simple Aggregate Index
The method does not put in considerations the unity used to give the weight of the difference
commodities,

It assumes equal qualities have been used on each commodity

Weighted Index Number:
Here rational weights are assigned to all the items or commodities. Such weights indicate the
relative importance of the items included in the calculation of the index. In most cases quantity
of usage is the best measure of importance.
 There two main types of weighted aggregate indexes we will discuss in this course
i. Laspeyre’s
ii. Paasche’s
 The two methods of computing a weighted price index they differ only in the period used
for weighting.

Laspeyre’s index
This an index formula used in price statistics for measuring the price development of the basket
of goods and services consumed in the base period.
The Laspeyres method uses base-period weights that is, the original prices and quantities of the
items bought to find the percent change over a period of time in either price or quantity
consumed depending on the problem.

Example:

The question it answers is how much a basket that consumers bought in the base period would
cost in the current period. Thus, it uses the base year quantity as the weight. It is defined as a
fixed-weight, or fixed-basket index that uses the basket of goods and services and their weights
from the base period. It is also known as a “base-weighted index”

i. Laspeyre’s Price Index

Laspeyre’s Price Index is the weighted aggregate index formed by considering the quantity of the
base period as weight. It is defined as;

∑ Pt Q 0
LPI = × 100
∑ Pt Q 0

ii. Laspeyre’s Quantity Index

Laspeyre’s Quantity Index is the weighted aggregate index formed by considering the price of
the base period as weight. It is defined as;

∑ Q t P0
LQI = × 100
∑ Q 0 P0
Where LPI = Price Index
Pt = price of variable in current period or stated period
qo = Quantity in the base period
Po = Price in the base period.

Example 5
The price for six commodities for two years, 2000 and 2010 and their consumed quantities by a
certain family is given by the following table below.

Item 2000 2010

Price Po Quantity (qo) Price Pt Quantity (qn)

(Tshs) (Tshs)
Brown bread (loaf) 77 50 198 55
Eggs(dozen) 185 26 298 20
Milk (liter) 88 102 198 130
mangoes (500g) 146 30 175 40
Orange juice 158 40 170 41
(355ml)
Tea bags (500g) 440 12 475 12

Use 2000 as a base year to calculate Laspeyre’s Price Index and Laspeyre’s Quantity Index

Solution
Item 2000 2010 poqo ptqo p q
o t
Price Po Quantity price Pt Quantity
(Tshs) (qo) (Tshs) (qt)
Brown bread (loaf) 77 50 198 55 3850 9900 4235
Eggs(dozen) 185 26 298 20 4810 7748 3700
Milk (liter) 88 102 198 130 8976 20196 11440
mangoes (500g) 146 30 175 40 4380 5250 5840
Orange juice 158 40 170 41 6320 6800 6478
(355ml)
Tea bags (500g) 440 12 475 12 5280 5700 5280
Total 33616 55594 36973
 Laspeyre’s Price Index
∑ Pt Q 0
LPI = × 100
∑ P0 Q 0

55594
LPI = × 100 = 165.4
33616
Based on this analysis we conclude that the price of this group of items has increased
65.4 percent in the ten year period.

Laspeyre’s Quantity Index

∑ Q t P0
LQI = × 100
∑ Q 0 P0

36973
LQI = × 100 = 110
33616
Based on this analysis we conclude that the quantity of this group of items has increased
10 percent in the ten year period

Paasche’s Index

The Paasche’s method uses current - year weights for the denominator of the weighted index.

i. Paasche Price Index:

The Paasche price index is an index formula used in price statistics for measuring the price
development of the basket of goods and services that is consumed in the current period. it is
defined as a fixed-weight, or fixed-basket, index, because it uses the basket of goods and services
and their weights from the current period. It is therefore also known as a “current weighted
index.”

Example:

The question it answers is how much a basket that consumers buy in the current period would
cost now if in the base period we were spending ₦100 on the basket. Current quantity is used
here as the weight

This is the type of weighted aggregate index number considering the quantity of the current
year’s period as weights. It is defined as
 ∑ Pt Q t
PPI = × 100
∑ P0 Q t

Paasche’s Quantity Index

A type of weighted aggregate index number formed by considering price of the current period as
weights. It is defined as
∑ Q t Pt
PQI = × 100
∑ Q 0 Pt

Example 6: Use example 5 to calculate

a) Paasche’s Price Index

b) Paasche’s Quantity Index

Example 6: Use example 5

Item 2000 2010 qopt Ptqt p q
o t
Price Po Quantity price Pt Quantity
(Tshs) (qo) (Tshs) (qt)
Brown bread (loaf) 77 50 9900 10890 3850 9900 4235

Eggs(dozen) 185 26 7748 5960 4810 7748 3700

Milk (liter) 88 102 20196 25740 8976 20196 11440

mangoes (500g) 146 30 5250 7000 4380 5250 5840

Orange juice 158 40 6800 6970 6320 6800 6478

(355ml)
Tea bags (500g) 440 12 5700 5700 5280 5700 5280

Total 55590 62260 36973

Paasche’s Price Index

∑ Pt Q t
PPI = × 100
∑ P0 Q t

62260
PPI = × 100 = 168.4
36973
Paasche’s Quantity Index
∑ Q t Pt
PQI = × 100
∑ Q 0 Pt

62260
PPI = × 100 = 112
55590

• The Paasche index is more reflective of the current situation. It should be noted that the
Laspeyres index is more widely used. The Consumer Price Index, the most widely
reported index, is an example of a Laspeyres index.

Advantage and disadvantages of Laspeyres’ and Paasche’s

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
overweight goods whose prices increase.

Paasche’s
Advantages Because it uses quantities from the current period, it reflects current buying
habits.
Disadvantages 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 whose prices

Advantage of Weighted over the Simple Aggregate

In weighted index the weight of each of the items is considered.
Fisher’s index
It is the geometric mean of the Laspeyres and Paasche indexes. It is determined by taking the
kth root of the product of k positive numbers

Fisher′sideal index = √(laspeyre′ s index) × (Paascher′sindex)

Fisher’s index combines the best features of both Laspeyres and Paasche. That is, it balances the
effects of the two indexes.

Exercises
1. Statistics Canada results show that the number of farms in Canada dropped from 276 548 in
1996, to an estimated 246 923 in 2001. What is the index for the number of farms in 2001
based on the number in 1996?
2. Suppose the whole sales price of maize, wheat flour and rice per bag varies as here below
Commodity 2000 2010
Price in Tshs per bag
Maize 2500 3500
Wheat flour 3000 4500
Rice 3500 5000

Calculate the simple average of relative price index use 2000

as base year.
3. The average price in Tshs for rice, maize and sugar for the two years 2000 and 2011 are
given in table

Item 2000 2011

1kg rice 650 1200

1kg maize 400 800

1 kg sugar 700 1000

Calculate the simple aggregate price index for the year 2011 using 2000 as a base