HANDOUT # 04

INDEX NUMBER

An Introduction:

Index Number is such a relative measure which is used for measuring the relative
changes from time to time or from place to place.

Some important definitions of Index Number:

Some prominent definitions of Index Numbers are given below:

• In its simplest form, an Index Number is nothing more than a relative number
which expresses the relationship between the two figures is used as base.
• Index Number is the single ratio (usually in percentage) with measures the
combined (i.e. average) change of several variable between two different times,
places or situations.
• An Index Number is the statistical measurement designed to show changes in
variables or a group of related variables with respect to time, geographic location
or other characteristics.
• Index Numbers are the devices for measuring differences in the magnitude of a
group of related variables.

Characteristics of Index Number:

On the basis of the study and analysis of the definitions of Index Numbers given above,
the following characteristics can be defined as:

• Index Number is the relative measure of expressing percentage changes in

variable or a group of variables.
• Index Number compares the situations prevailing at two different points of time
by means of ratio.
• Index number is an average measure and it represents average changes in the
value of variable or a group of variables.
• Index Number is a weighted average.
• Index Number is the relative measure independent of units of measurements. SO
it is comparative measure.

Issues involved in construction of Index Number:

The following points should be considered as issues while constructing the index
number:

(1) Purpose: It is absolutely necessary to clarify the purpose for which the index
number is to be constructed. Every index number is of limited and particular use.
(2) Selection of base year: Whenever index numbers are constructed, a reference
is made to some base period. It may be a year, a month or a day. The base
period should be the period of normal and stable economic condition. The base
period should not be too distinct from the given period. The index number of the
base period always equals to 100. If the period of comparison is kept fixed for all
current year, it is known as FIXED BASE PERIOD. If the comparison is made with
the preceding period, it is known as CHAIN BASE PERIOD.
(3) Selection of item: The item included in a index number should be determine
keeping in mind the purpose of index number. The number of items selected
should not be too large or too small.

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(4) Availability of price of items: After the items are selected, the next problem
is to obtain prices of these items. The retail prices of items of consumption by
families are collected from retail shops located in the area where the families of
the class of people reside. Such retail shops should be government recognized or
approved shops. The simple averages of retail prices of different items collected
at different items are considered as the current prices for the construction of
index number for the class of people under study.
(5) Selection of average: It is necessary to obtain a common price index number
by combining percentage price relatives of all items. The appropriate average
should be used for this purpose. The geometric mean is the better averaging
relatives, but for the most if the indices arithmetic mean is used because of its
simplicity. Also median is used.
(6) Selection of weight: In construction of index number all commodities included
are not of equal importance. Hence the measure of importance attached to the
group of items according to their importance is known as weight.
(7) Selection of formula: There are many formulas for constructing the index
number. The selection of the formula depends on the purpose of index number
and also on the availability of the data.

Uses of Index Number:

The index numbers are very useful statistical tools to study the changes occurring in
the economic and business activities with time. The uses of index numbers are as
follows;

(1) Index number is used to determine the purchasing power of money at a given
point of time. For example, if the price index number for the year 2010 is 250 then
taking the price index number of the base year as 100, then the purchasing power
of the money is 100/250=0.4.

(2) Index numbers are indispensable tools for the management of any organization
for efficient planning and formulation of the policies. For example, the cost of living
index number helps in deciding the dearness, allowance, bonus etc.

(3) Index number enables us to study the general trend for a group phenomenon in
a time series data. SO index number can also be used to forecast the future events.
For example, by examining the agricultural index number of Pakistan for the last
5-years one can observe that agriculture yield having downward trend.

(4)Index numbers measure the level of economic and business behavior. So it is

termed as ECONOMIC BAROMETER.

(5)Index numbers are highly useful in deflating. For example, the real wages can
be obtained from the given wages using the cost of living index number.

Limitations of Index Number:

Despite the many use of the index numbers, there are various limitation of index
number:

• Index numbers are based on simple data. They are only approximate indicators
and may not exactly represent the changes in the relative level of a phenomenon.
• There are chances that error may creep of any stage of the construction of the
index numbers.
• The customs, habits and tastes of people change with time and they make the
weighting not suitable for the present data.

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• Every index number is constructed for a specific objective. It cannot be used for
other objectives.
• Index number is the special type of the average so it has all limitations the
average bears.
• If a wrong base has been selected, or if weights are not assigned rationally or if
the appropriate formula is not used then the result could be misleading.
• Different formulas of index number give different results. Thus there can be a
formula error.

Types of Index Number:

There are various types of index numbers. They can broadly classify into three types
of principal indices. They are as discussed follows:

1. Price Index Number

2. Quantity Index Number
3. Value Index Number

Price Index Number: It is the most frequently used form of index number. A price
index measures the changes in from one period to another. By constructing the price
index number, we are summarizing the price movements of each item or a group of
items. The Wholesale Price Index (WPI) and Consumer Price Index (CPI) are some of
the popular used of price indices.

Quantity Index Number: The quantity index number measures the changes in
quantity from one period to another. This measures changes in the quantity of goods
produced, purchased or consumed. The Index of Industrial Production (IIP) and Index
of Agriculture Production (IAP) are some of the popular used quantity index number.

Value Index Number: The value index number is the COMBINATION INDEX NUMBER.
It combines price and quantity changes to present a more spatial comparison. The
value index measure changes in the monetary value. It is useful in very few selected
cases like sales, inventories, foreign trade, etc. Its use is limited because of the
inability to distinguish the effects of price and quantity separately.

INDEX
NUMBER

PRICE QUANTITY VALUE

INDEX INDEX INDEX
NUMBER NUMBER NUMBER

Methods of Constructing the Index Number:

There are two approaches for constructing of the index number namely the
Aggregates Method and Average of Relative Method. The index number
constructed in either of these methods could be a weighted or an un-weighted.
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AGGREGATES METHODS

• Un-Weighted Aggregate Index

• Weighted Aggregate Index

An Un-Weighted (Simple) Aggregate Index is the ratio of the aggregate price of

the various items in a given year to the same in the base year. It is expressed in
percentage.

P0n = (ΣPn / ΣP0) x 100

Where ΣPn : Aggregate Price Index of the current year

And ΣP0 : Aggregate Price Index of the base year

In a Weighted Aggregate Index, weighs are assigned according to their

significance. The weighted index number improves the accuracy of the general price
level estimate based on the calculated index. Usually, the quantities consumed are
used as weights.

If W be the weight attached to an item then the price index number is given by:

P0n = (ΣPnW / ΣP0W) x 100

By considering the different weights, many formulas have been given as below:

1. Laspeyres Formula
2. Paasche’s Formula
3. Fisher’s Formula or Fisher Ideal Formula
4. Marshall-Edgeworth Formula
5. Dorbish and Bowley Formula
6. Walsch’s Formula
7. Kelley’s Formula

Laspeyres Formula considers the quantities consumed in the base period as weights.
It can be computed as:

P0n = (ΣPnQ0 / ΣP0Q0) x 100

Paasche’s Formula considers the quantities consumed in the current period as

weights. It can be computed as:

P0n = (ΣPnQn / ΣP0Qn) x 100

Fisher’s Formula is the Geometric Mean of the Laspeyres and Paasche’s indices. It
can be computed as:

P0n = √(ΣPnQ0 / ΣP0Q0) x (ΣPnQn / ΣP0Qn) x 100

OR P0n = √ L x P

Note: The Fisher’s Formula is the best average for constructing the index number
because its uses the Geometric Mean as an average and both quantities of base period
and current period and also it satisfies all the consistency tests which we shall discuss
further in this handout.

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Marshall-Edgeworth Formula considers the simple Arithmetic Mean of the
quantities of the base and current period as weights. It can be computed as:

P0n = (ΣPn(Q0 + Qn)/2 / ΣP0(Q0 + Qn)/2) x 100

OR P0n = (ΣPn(A.M of Qn and Q0) / ΣP0(A.M of Qn and Q0)) x 100

Dorbish and Bowley Formula is the simple Arithmetic mean of Laspeyres and
Paasche’s Formulas. It can be computed as:

P0n = ½(L + P)
OR P0n = 1/2[(ΣPnQ0 / ΣP0Q0) + (ΣPnQn / ΣP0Qn)] x 100

Walsch’s Formula considers the Geometric Mean of the quantities of base and
current periods as weights. It can be computed as:

P0n = (ΣPn√(Q0 . Qn) / ΣP0√(Q0 . Qn)) x 100

OR P0n = (ΣPn(G.M of Qn and Q0) / ΣP0(G.M of Qn and Q0)) x 100

Kelley’s Formula also known as FIXED WEIGHT AGGREGATE INDEX NUMBER

considers quantities from any period (not necessary for base or the current) as weight.
It can be computed as:

P0n = (ΣPnQ / ΣP0Q) x 100

Note: In the Kelley’s Formula, the A.M or G.M can be used as an average of more than
one quantities of the current or base year as weights.

Average of Relatives Method

The price of the each item in the current year is expressed as the percentage of the
price in the base year kept as fixed. This is known as Price Relatives or Simple Price
Index Number and is computed as:

Price Relatives = (Price of the current year)/(Price of the fixed base period) x 100

When the base year period is not fixed (i.e. the price of base year is changed not fixed)
then Link Relatives are computed which are further converted to Chain Indices.
Link Relatives = (Price of the current year)/(Price of the changed base period) x 100

The Purchasing Power

The purchasing power of the rupee is the reciprocal of the consumer price index
number (is also defined as Layspere's Formula) and then multiplied by 100.

PURCHASING POWER OF RUPEE = (1/CPI) x 100

NOTE; The Consumer Price Index Number (CPI) is a price index number which is based
on the goods and transportation etc to determine the real purchasing power money.
CPI is the measure of the standard of living of a particular class.

Deflation of per capital rupee

The relationship between the real and current per capita income is defined as the effect
of the changing price on per capita income which has to be removed dy deflating the
income expressed in the current money. It can be computed as;

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 Real per capita income = [(current per capita income)/(CPI)]x100

OR Real per capita income = (Current per capita income)x(Purchasing

power of rupee)

Lecture Delivered and Compiled by:

ASIF SUMEER