1

Index Number:
Index numbers: Index numbers are statistical devices designed to measure the relative
change in the level of phenomenon (variable or a group of variables) with respect to time,
geographical location or other characteristics, such as income, production, expenditure,
export, import, etc.
Uses of index numbers:
Index number plays an important role in economics and business. Though originally
developed for measuring the effect of change in prices, there is hardly any field today where
index numbers are not used. They are used to feel the pulse of the economy and they come to
be used as an indicators of inflationary or deflationary tendencies. In fact they are described
as barometers of economic activity i.e. if one wants to get an idea as to what is happening to
an economy, he should look to important indices like the index number of industrial
production, agricultural production, business activity etc. In short, the followings are the
different important fields of business and economics where index numbers can be widely
used.
i) Index number can help in framing suitable policies: many of the economic and business
policies are guided by index numbers. For example, for deciding the increase in dearness
allowance (DA) of the employees, the employer has to depend upon primarily the cost of
living index. If wages and salaries are not adjusted in accordance with the cost of living, very
often it leads to strikes and lock-out which in turn cause considerable waste of resources.
ii) Index number reveals trends and tendencies of the data: Since index numbers are most
widely used for measuring changes over a period of time, the time series so formed enable us
to study the general trend of the phenomenon under study. For example, by examining index
numbers of imports for Bangladesh for the last 5-10 years, we can say that our imports are
showing an upward tendency i.e. they are rising year after year.
iii) Index numbers as Economic Barometers: Index numbers are used to take the pulse of
the economy and they have come to be used as indicators of inflationary or deflationary
tendencies. They are indispensible tools for the management personnel and in business
planning and formulation of executive decisions.
iv) Index numbers are very useful in deflating: index numbers are used to adjust the
original data for price changes or to adjust wage for cost of living changes and thus transform
nominal wages into real wages.
Problems in the construction of index number: The construction of index numbers
involves the following problems.
a) The purpose of the Index Number.
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b) Selection of the Commodities.

c) Data for Index Numbers
d) Selection of the Base period
e) Types of Average to be used.
f) Selection of appropriate weights.
g) Choice of Formulae
Classification of index numbers: Index numbers may be classified in terms of what they
measure. In economics and business, the classifications are:
i) Price index number
ii) Value index number
iii) Quantity index number
iv) Special purpose index number
Price index number: In price index number, it is tried to measure the relative change of
price of phenomenon for a given year (period/time) with respect to base year (period/time).
Quantity index number: In quantity index number, it is tried to measure the relative change
of quantity (/production) of phenomenon for a given year (period/time) with respect to base
year (period/time). Quantity index numbers study the changes in the amount (volume) of
goods (commodities) produced (manufactured), consumed or distributed, like the indices of
agricultural production, industrial production, imports and exports etc. They are extremely
helpful in studying the level of physical output in an economy.
Value index number: In value index number, it is tried to measure the relative change of
value of phenomenon for a given year (period/time) with respect to base year (period/time).
Where, value is the multiplication of unit price and quantity (v=pq). Value index is given by

V01=
pq
1 1
 100
p q
0 0

Special purpose index number: for example, cost of living index number. It will be discuss
later.
Methods of constructing index numbers: A large number of formulae have been devised
for constructing index numbers. They can be grouped under two heads:
a) Un-weighted indices and b) Weighted indices
In un-weighted indices, weights are not assigned whereas in the weighted indices weights are
assigned. Each of these types may further be divided into two types:
a) Simple (un-weighted) aggregative method and b) Simple (un-weighted) average of price
relative method
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Simple (un-weighted) Aggregative method: This is the simplest method of constructing

index numbers. In this method, the total of current year prices for various commodities is
divided by the total of base year prices and the quotient is multiplied by 100. Symbolically,

P01 
P 1
 100 .
P 0

Where, Po1= price index.

p 1 =total of current year prices for various commodities

P 0  total of base year prices for various commodities.

Example-1. Construct index number of prices of 1990 taking 1985 as the base year from the
following data using simple aggregative method.
Commodity Price in1985 (in TK.) Price in 1990 (TK.)
Rice 10.5/kg 15.5/kg
Wheat 5.5/kg 6.5/kg
Cloth 5.5/metre 7.0/metre
Sugar 20.5/kg 27.5/kg
Milk 8.0/litre 14.5/kg

Solution: Construction of index number

Commodity Price in1985 Price in 1990
P0 P1
Rice 10.5 15.5
Wheat 5.5 6.5
Cloth 5.5 7.0
Sugar 20.5 27.5
Milk 8.0 14.5
Total  P0  50  P1  71.0
Therefore, the price index of 1990 using 1985 as base is

P01 
 P 100  71 100  142
1

P 0 50

This means that as compared to 1985, in 1990 there is a net increase in price of commodities
included to the extent of 42.0%
Limitation of this method:
i) The prices of various commodities may be in different units e.g. per liter,
per kg etc.
ii) The relative importance of various commodities are not considered.

b) Simple (un-weighted) average of price relative method: This method consists of finding
price relatives and averaging them expressed in percentage. For the purpose of averages, any
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one measure of central tendency, such as, mean, median, mode, geometric mean may be used.
P1
P
When A.M. is used, the simple average of price relative index number is P01  0
 100 ,
N
Where, P1 is the price of current year, P0 is the price of base year. P1/p0 = price relative =
ratio of price of the commodities in the current year as on the base year.
When Geometric mean is used, the simple average of price relative is
P1
P
P01  Anti log[ 0
 100]
N
Example-2: The prices of four commodities for 1986 and 1990 are given below. Calculate
the index for 1990 with 1986 as base year using simple average of price relative method.
Commodity Price in 1986 (in TK.) Price in 1990 (in TK.)
Rice 11/kg 15.5/kg
Wheat 5/kg 6.5/kg
Cloth 5.5/meter 7.0/meter
Sugar 22.o/kg 27.5/kg

Solution:
Calculation table:
Commodity Price in 1986 (in TK.) Price in 1990(in TK.) Price relative
p1/p0
Rice 11/kg 15.5/kg 1.409
Wheat 5/kg 6.5/kg 1.300
Cloth 5.5/metre 7.0/metre 1.273
Sugar 22.o/kg 27.5/kg 1.222
Total  p1 / p0 = 5.204
P1
 P0 5.204
Therefore, simple average of price relative is P01  1
 100   100  130.1
N 4
Merits and limitation of this method: The method has the following two advantages
i) Extreme items do not influence the index. Equal importance is given to all the
items
ii) The index is not influenced by the units in which prices are quoted or by the
absolute level of individual prices.
The method has the following disadvantages:
i) Difficulty is faced with regard to the selection of an appropriate average.
ii) The prices of various commodities may be in different units i.e. per liter, per
meter, per quintal etc.
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iii) The relatives are assumed to have equal importance./the relative importance of
various commodities is neglected.
Weighted index numbers are of two types:
a) Weighted aggregative index number and b) Weighted average of relative index number.
Weighted aggregative index number: These index numbers are of the simple aggregative
type with the fundamental difference that weights are assigned to the various items included
in the index. Usually, the quantity consumed, sold or marketed in the base/given year is
considered as weights. This method consists of the following indices:
i) Laspeyre’s method
ii) Paasche’s method
iii) Dorbish and Bowley’s method
iv) Fisher’s ideal method
v) Marshall-Edgeworth method
vi) Kelly’s method/Fixed Weight Method.
Laspeyre’s method: In this method, the base year quantities are taken as weights. The

formula for constructing the index is P01 

Pq 1 0
 100 …………(i)
P q0 0

Equation (i) is called Laspeyre’s aggregative price index.

Paasche’s method: In this method, the current year quantities are taken as weights. The

formula for constructing the index is P01 

Pq 1 1
 100
P q0 1

Dorbish and Bowley’s method: Dorbish and Bowley have suggested simple A.M. of
Laspeyre’s and Paasche’s price indices, the formula for constructing the index is

pq 1 0

pq
1 1

P01 
LP
(
p q 0 0 p q
0 1
)  100 , Where L = Laspeyres index and P = Paasche’s
2 2
index
Fisher’s Ideal index: The geometric mean of Laspeyre’s and Paasche’s formula is known as

Fisher’s ideal price index and is given by P01  L  P 

pq pq
1 0 1 1
 100
p q p q
0 0 0 1

Fisher’s methods is called ideal method of constructing index number because of the
following reasons:
i) It is based on geometric mean which is theoretically considered to be the best
average for constructing index number.
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ii) It takes into account both current year as well as base year prices and quantities
iii) It satisfies both time reversal test as well as factor reversal test.
iv) It is free of bias.
Marshall Edgeworth method: in this method, the A.M. of base year quantities and current
year quantities are taken as weight. The formula for constructing index is
q0  q1
p (
1
2
)
 p1q0   p1q1 )  100
P01   100  (
q q
 p0 ( 0 2 1 )  p0 q0   p0 q1
Kelly’s method/Fixed Weight Method: In this method, the base/current year quantities are
taken as weights. In other words, if q is the base year as well as current year quantity i.e if the
quantity of base year and current year are same (fixed), then the formula for constructing the

price index is P01 

 P q 100
1

P q 0

Example-3: Construct index number of prices from the following data applying a)
Laspeyre’s method, b) Paasche’s method c) Bowley’s method, d) Fisher’s method and e)
Marshall Edgeworth method.
Commodity Price in 1987 Quantity in1987 Price in 1988 Quantity in 1988
A 2 8 4 6
B 5 10 6 5
C 4 14 5 10
D 2 19 2 13

Solution:
Calculation table:
Commodity Price(p0) Quantity(q0) Price (p1) Quantity(q1) P1q0 P0q0 P1q1 P0q1
A 2 8 4 6 32 16 24 12
B 5 10 6 5 60 50 30 25
C 4 14 5 10 70 56 50 40
D 2 19 2 13 38 38 26 26
Total 200 160 130 103

a) Laspeyres index: P01 

Pq 1 0
100 
200
100  125
P q 0 0 160

b) Paasche’s index: P01 

Pq 1 1
 100 =
130
 100  126.21
P q 0 1 103
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pq 1 0

pq 1 1

c) Bowley’ index: P01 

LP
(
p q 0 0 p q 0 1
)  100 = 125.605
2 2

d) Fisher’s ideal index: P01  L  P 

pq pq1 0 1 1
 100 = 125.6
p q p q
0 0 0 1

q0  q1
p (
2
1 )
 p1q0   p1q1 )  100 =
e) Marshall-Edgworth: P01   100  (
q q
 p0 ( 0 2 1 )  p0 q0   p0 q1
125.475
Weighted average of relative index number: If W is the weight given to commodity, then
the general formula of index numbers obtained on taking the weighted average of price

relative becomes: P01 

 PW , where, W  p q and P 
p1
 100 . Here A.M. is used.
W
0 0
p0

If G.M. is used, the index becomes P01  e

 W log P
W
=Antilog(
W log P )
W
Example 4: From the following data, compute price index number by applying weighted
average of price relative method.
Commodity p0 q0 p1
Sugar 3.0 20kg 4
Flour 1.5 40kg 1.6
Milk 1.0 10ltr 1.5

Solution: Index number using weighted A.M. of price relative.

Commodity P0 Q0 P1 W=p0q0 P=p1/p0. PW
100
Sugar 3.0 20kg 4 60 8000
Flour 1.5 40kg 1.6 60 6400
Milk 1.0 10ltr 1.5 10 1500
Total 130 15,900

Therefore, P01 
 PW 
15900
100
W 130

This means that there has been a 22.31% increase in price compare to the base year.
Chain indices: The various formulae discussed so far assume that base period is fixed at
some previous period. Some authors, however, feel that index numbers should satisfy the
homogeneous test, i.e. the data for the two periods being compared should be as
homogeneous as possible and this is best attained by taking two adjacent periods. Hence
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instead of fixed base method they suggested the use of chain (sequence/series) base method
which consists in calculating a series of index numbers for each year with the preceding year
as base, i.e. p01, p12, p23…,pk-1,k. where prs represents the price index number of ‘s’ year
compare to ‘r’ base year. The basic index number is obtained by the successive
multiplications of the index numbers so obtained to give
P01  first link

P02  P01  P12

P03  P01  P12  P23  P02  P23
.
.
P0 k  P0 ( k 1)  Pk 1k

Chain index number: Chain index number consists in calculating a series of index numbers
for each year with the preceding year as base, i.e. P01, P12 , P23.....Pk 1k . Where prs represents
the price index number of ‘s’ year compare to ‘r’ base year. The basic index number is
obtained by the successive multiplications of the index numbers so obtained to give
P01  first link

P02  P01  P12

P03  P01  P12  P23  P02  P23
.
.
P0 k  P0 ( k 1)  Pk 1k

Steps in the construction of chain indices:

i) Express the figures for each period as a percentage of the preceding period to obtain the
link relatives (LR).
ii) These LR’s are chained together by successive multiplication to get chain indices (CI) by
the following formula:
CYLR  PYCI
Chain index = , where CYLR =Current year LR and PYCI =Preceding year CI
100
Quantity index number: Price index numbers measures and permit comparison of the prices
of certain commodities (goods). Quantity index number, on the other hand, measure and
permit comparison of the physical volume of goods produced or distributed or consumed.
Though price indices are widely used, production indices are highly significant as indicators
of the level of the output in the economy. Quantity indices can be obtained easily by
changing p to q and q to p in the various formulae of price indices.
Thus, when Laspeyres method is used, the quantity index is
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Q01 
p q0 1
 100
P q0 0

When Paasches method is used, the quantity index is

Q01 
pq 1 1
 100
Pq 1 0

When Fisher’s formula is used, the quantity index is

Q01 
q p 1 0

q p
1 1
 100
q0 p0 q p
0 1

Example-5: Compute quantity index number from the following data

Commodity 1995 1996
Price Value Price Value
A 8 80 10 110
B 10 90 12 108
C 16 256 20 340
Solution: Since we are given value and price, we can obtain quantity by dividing value by
price for each commodity.
Commodity 1995 1996
P0 Q0 P1 Q1 Q1p0 Q0p0 Q1p1 Q0p1
A 8 10 10 11 88 80 110 100
B 10 9 12 9 90 90 108 108
C 16 16 20 17 272 256 340 320
Total 450 426 558 528
Laspeyres quantity index is

Q01 
p q0 1
 100 =
450
100 
P q0 0 426

Paasches quantity index is

Q01 
pq 1 1
 100 =
558
 100
Pq 1 0 528

Fisher’s quantity index is

Q01 
q p 1 0

q p
1 1
 100 = 105.6
q0 p0 q p
0 1

Value index number: The value of a single commodity is the product of its price and
quantity. Thus a value index is the sum of the values of a given year divided by the sum of
values of the base year. The formula for value index is
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V01 
v 1
 100 
pq 1 1
 100
v 0 p q 0 0

Where, sum(p1q1)= total value of all commodities in the given year and sum(p0q0) = total
value of all commodities in the base year.
Hw-1: Construct price index numbers for 2010 with 2005 as base year from the following
data by using i) simple aggregative method, ii) Laspeyer’s method. Also interpret the results.
Commodity 2005 2010
price Quantity Price Quantity
A 20 45 50 85
B 40 25 80 55
C 40 15 40 30
D 50 25 100 65
E 80 75 120 90

The criteria of a good index number:

1) Unit root test: Unit free
1
2) Time reversal test: p 
o1
p 10

3) Factor Reversal test: p q 01 01

 v01

4) Circular test: p  p  p 1
ab bc ca

Let us try to check for fisher’s index:

1

  p1q 0  p1q1  2

p01F      p q  p q 

 0 0 0 1
And
1

  p 0 q1  p 0 q 0  2

p F     

  p1q1  p1q 0 
10

1 1

  p1q 0  p1q1  2
  p0 q1  p0 q0  2

 p F   p F  =     
    p q  p q 
  p 0 q 0  p 0 q1 
10 01

 1 1 1 0
Hence,

p  p =1, which satisfies TRT.

10 01
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Hence we can say that Fisher’s index satisfies TRT.

For factor reversed test (FRT) we have to show that p  q =V 01

10 01

  p1q 0  p1q1  2

Fisher’s price index is, p F     


  p 0 q 0  p 0 q1 
01

  q1 p 0  q1 p1  2

Fisher’s quantity index is, q01F   

  q p  q p 

 0 0 0 1
1 1

  p1q 0  p1q1  2
  q1 p 0  q1 p1  2

 p  q =   
01 01   p q  p q    q p  q p 
 0 0 0 1  0 0 0 1

 p q 
pq  1 1
V
01 01
p q 0 0
01

Which implies that Fisher’s index satisfies FRT.

Since Fisher’s index satisfies both TRT and FRT, it is an ideal index.

**Show that Kelly’s index satisfies circular test.

Proof:

pq
p k   1

p q
01
0

p q
p k   2

pq
12
1

p q
p k   0

p q
20
2

pq p q p q
p  p  p  1
 1 2 0

p q pq p q
01 12 20
0 1 2

Which shows that Kelly’s index satisfies circular test.

Q) Check which of the following index satisfies TRT.
1)Laspeyer’s index
2) Paache’s index
 12

3)Fisher’s index
**Show that Simple (un-weighted) geometric mean of price relative index satisfies Circular
Test.
Proof: We know that simple G.M of price relative index is,
1

 p  n

p    1 
01

 p0 
1

 p  n

p    2 
12

 p1 
1

 p  n

p    0 
20

 p2 
1 1 1

 p   p   p  n n n

p  p  p    1     2     0   1
01 12 20

 p 0   p1   p 2 
Which implies that Simple (unweight) G.M of price relative satisfies CT.
**Show that the ratio of Laspeyer’s price and quantity index is equal to the ratio of Paache’s

price and quantity index or if L p  and pq  respectively Laspeyer’s price and Paache’s
quantity index number, show that

L p  p  p 

Lq  pq 
Proof: Here,
 13

pq
L p    100...........(1)
1 0

p q 0 0

q p
Lq    100...........(2)
1 0

q p 0 0

pq
p p    100...........(3)
1 1

p q 0 1

pq
pq    100...........(4)
1 1

pq 1 0

Dividing (1) by (2),

L p   p q q p
  100 / 1
 100
0 1 0

Lq   p q  q0
p 0 0 0

pq p q
  1 0 0 0

 p q p q
0 0 0 1

pq
  L.H .S
1 0

 p q 0 1

Dividing (3) by (4),

p p   p q q p
  100 / 1
 100
1 1 1

pq   p q  q0
p 1 0 1

pq pq
  1 1 1 0

p q pq0 1 1 1

pq
  R.H .S
1 0

p q 0 1

 L.H .S  R.H .S
**Show that Marshall Edgewarth index lies between Laspeyer’s and Paache’s index.
Proof: To prove the theorem, we have to apply the following lemma first.
Lemma, if a,b,c,d are positive number,then,
 14

a c a ac c
   
b d b bd d
a c
iff ,  , then
b d
ad  bc........(1)
Adding ab in both sides,
 ab  ad  ab  bc
 a(b  d )  b(a  c)
a ac
  ......(2)
b bd
Similarly adding cd in both sides of equation (1),

ac c
 ................(3)
bd d
From (2) and (3) we can write,

a ac c
 
b bd d
p L   p  p , then,
01 o1

Now ,if  p q pq pq pq

 1 0
1
...........(**)
0 1 1 1 1

p q p q p q p q
0 0 0 0 0 1 0 1

q q
p 0 1

Here, p ME  
2  p q p q
1
1 0 1 1
01
q q p q p q
p 0
0 1 0 0 0 1

2
Hence, p L   p ME   p  p .....(Proved )
01 01 01

Theorem: Show that Fisher’s index lies between Laspeyer’s and Paasche’s index.
Proof:
Let,
a<b
or, a2<ab ; a>0
or, a< ab
Also,
a<b
 15

or, ab< b2, b> 0

or, ab < b
Hence, a< ab < b
Which implies that the geometric mean of the two real positive number lies between them.
Since Fisher’s index number is the geometric mean of Laspayer’s and Paasche’s index
number.
 p L   p  pa 
o1 01

 p L   p F   p P 
o1 01 o1

(Showed)