Index Numbers Introduction Index numbers are designed to measure the magnitude of economic changes over time. Because they work in a similar way to percentages they make such changes easier to compare. ‘An index number is a statistical device for comparing the general level of magnitude of a group of related variables in two or more situation. If we want to compare the price level of 2012 withi what it was in 2011, we shall have to consider a group of variables such as price of wheat, rice, vegetables, cloth, house rent etc., if the changes are in the same ratio and the same direction; we face no difficulty to find out the general price level. But practically, if we think changes in different variables are different and that too, upward or downward, then the price is quoted in different units ie milk in litre, rice or wheat in kilogram, rent in square feet, etc. Definitions ‘An index number is a specialized average designed to measure the change in a variable with respect to time, geographical location or characteristics such as income, profession etc. In other words index number is defined as a measure over a time designed to show average changes in prices, quantity or value over a period of time. “Index numbers are used to measure the changes in some quantity which we cannot observe directly’. 2 “An index number is a statistical measure designed to show changes in variable or a group of related variables with respect to time, geographic location or other characteristic". —M.Splege?ipdex Numbers 219 characteristics of index numbers On the basis of study and analysis of the definition given above, the following guacteristics of index numbers are apparent. 1. Index numbers are specified averages. 2. Index numbers are expressed in percentage, 3. Index numbers measure changes which are not capable of direct measurement. 4, Index numbers are for comparison. 5. Index numbers measure the net changes in a group of related variables 6. Index numbers measure the effect of changes over a period of time. Uses of Index numbers Index numbers are indispensable tools of economic and business analysis. They are pricularly useful in measuring relative changes. Their uses can be appreciated by the following points. | 1, They measure the relative change. .. They are of better comparison. They are good guides. They are economic barometers. They are the pulse of the economy. . They compare the wage structure. They compare the standard of living. They are a special type of averages. ). They provide guidelines in policy making. . They help to measure the purchasing power of money. froblems in the construction of index numbers No index number is an all purpose index number. Hence, there are many problems ‘volved in the construction of index numbers, which are to be tackled by an economist or Si Ss ‘atistician. They are . Defining clear and concrete terms, the objective or the purpose of the index numbers. 2. Selection of base period which should be a period of normal and stable economic conditions. Selection of items or commodities to be used for construction of index numbers. Selection of reliable and unbiased source of data for construction of index numbers . Collection of data of prices of selected commodities. . Selection of the average to be used for the construction of index numbers. . System of weighing different commodities according to their relative importance. . Choice of Formula to be used for construction of index numbers. ea aHaw220 Index Numbers Index Numbers are called Economic Barometers Index numbers are called as Economic Barometers. Because, they are used to check the economic growth of a nation. They measure the influence of economic activities of the country. They are also useful in projecting trends in future and preparing policies. Types or classification of Index Numbers Index numbers may be classified in terms of the variables that they are intended to measure. In business, different groups of variables in the measurement of which index number techniques are commonly used are (i) price, (ii) quantity, and (iii) value The classifications are as follows: 1. Price Index Numbers: Price index numbers measure the relative changes in prices of commodities between two periods. They are further sub-divided into two classes. They are: a) Wholesale Price Index Numbers and b) Retail Price Index Numbers. The wholesale price index reveals the changes into general price level of a country, but the retail price index reveals the changes in the retail price of commodities such as consumption of goods, bank deposits, etc. 2.Quantity Index Numbers : Price index numbers measure and permit comparison of the price of certain goods. On the other hand, the quantity index numbers measure the physical volume of production, employment etc. The most common type of the quantity index is that of quantity produced. 3. Value Index Numbers: Value index numbers compare the total value of a certain period with total value in the base period. Here total value is equal to the price of commodity multiplied by the quantity consumed. For any index number, two time periods are needed for comparison, These are called the Base period and the Current period. The period of the year which is used as a basis for comparison is called the base year and the other is the current year. Base Year: A base year is the year used for comparison for the level of a particular economic index. The arbitrary level of 100 is selected so that percentage changes (either Fising or falling) can be easily depicted. Any year can be chosen as a base year, but typically recent years are chosen. Point to be considered while selecting base year _ The Base year (Base period) should be normal. (In that year there should not be any incidents like war, earthquakes, inflation etc.) 2. The Base year should not be too distant. (It should be recent year). 3, We have to see that whether the base year shall be remained fixed or not. Current Year: The year for which comparisons are required is called as current year. The various notations used are as given below:| des Numbers : 221 p= Price of current year Py = Price of base year Q, = Quantity of current year Q = Quantity of base year P= Price relatives [Bs 100 for each item 0 NETHODS OF CONSTRUCTING INDEX NUMBERS , Simple or Unweighted Index 1. Simple Aggregative Method 2. Simple Average of Price Relatives Method g. Weighted Index Numbers 1, Weighted Aggregative Method 2. Weighted average of price relatives Method Simple or Unweighted Index: Under this method all the commodities are given equal iqportance while calculating index numbers. There are two methods of constructing simple pethod. 1. Simple Aggregative Method 2. Simple Average of Price Relatives Method Simple Aggregate Method: This is the simplest of all the methods of constructing index «ambers and consists in expressing the total price in the current year as a percentage of the sggregate of prices in the base year. Thus, the price index for the current year with reference pthe base year is: =P, Formula: Simple aggregate price index = Po = on x 100 0 Where , Por = Index Number EP, = total prices of the current year EPo= Total prices of the base year Ulustration 1 ; Calculate index numbers from the following data by simple aggregate ethod taking prices,of 2008 as base. 7 Price per unit (in Rupees) Commodity Ty San 4 $ P 180 195 ° 150 160 R 190 220 Ss 130 175222 Index Numbers Computation of index number under simple aggregate method: Price per unit (in Rupees) Commodity 2008 (Po) 2011 (Pi) P 180 195 Q 150 160 _® 190 220 s 130 175 EP = 650 =P; =750 Po, = ZL x 100 =P = 22 x 100 650 = 115.3846 Simple Average of Price Relatives Method: Under this method the actual price of each variable will be converted into percentage of the base period. These percentages are. called relatives because they are relative to the value of the base period. The index number is the average of all such relatives. In this method, first we have to calculate the price relative for the various commodities and then average of these relative is obtained by using arithmetic mean and geometric mean. When arithmetic mean is used for average of price relative: =P Formula: Po) = y Where, Poi = Index Number P= Price relatives [2 100 foreach ie] 0 N = Number of items Py Po= Prices of base year When geometric mean is used for average of price relative: Poy = Antilog [Pee] Illustration 2 : From the following data, construct an index for 2011 taking 2040 as base by the average of price relative using (a) arithmetic mean and (b) Geometric mean Prices of current year ‘Commodity Price in 2010 Price in 2011 P 180 195 Q 150 160index Numbers a = i 190 220 _ S 130 175 (a) Calculation of Price relative index number (using arithmetic mean) Calculation of price relatives (P) rT 1 | Commodity Price in 2010(P5) Price in 2011(P) (2 . 100) ® | 0 P 180 195 (2 3.100) = 108.33 {| | Q 150 160 (122-100) - = 106.67 “4 1 R 190 220 (Z2-100)- 115.79 1 { s 130 175 (B10) = 134.62 [ P | Commodity Price in 2010 Price in 2011 (2 100) P) 7 0 { P 180 195 108 Q 150 160 107 [ R 190 220 116 | s 130 5 135 i =P = 466 =P Pa= ae aie Po)= “se =116.5 (b) Price relative index number using Geometrie Mean Calculation of price relatives (P) = P Commodity Po P, (B10) ) Log P 195 2.0334 ——*100 |= 108 P 180 195 (3 = 160 2.0294 —=x100 |= Q 150 160 (2 ) 107224 Index Numbers 2.0645 R 190 220 (122-100)- 16 175 2.1303 s 130 | 175 — «100 |= 135 (eam) E Log P= 8.2576 Po.= Antilog [742] a ae Po) =Antilog Poi = Antilog 2.0644 Po = 116.0 : Weighted Index Numbers Under this method appropriate weights are assigned to various commodities to reflect their relative importance in the group. (a) Weighted Aggregative Method: In this method, commodities are assigned weights on the basis of quantities purchased. +: Some of the important methods of constructing weighted index numbers are: [1] Laspeyre’s method [2] Paasche’s method [3] Dorbish andd Bbowley method [4] Fisher’s ideal method [5] Marshall-Edgeworth method, and [6] Kelly’s method [1] Laspeyre’s method : The most commonly used index formula is the Laspeyres index which measures the change in cost of purchasing the same basket of goods and services in the current period as purchased in a specified base period. The prices are weighted by quantities in the base period, The Laspeyres Index is practical and easy to interpret. A variant of the basic calculation known as the Laspeyres price relative is used by many statistical agencies for the calculation of consumer price indexes. This method was adopted by New Zealand in the major revision of 1993 and is used in all aggregations above the calculation of regional price data. It produces the same results as the basic Laspeyres formula but offers greater flexibility in handling ongoing practical problems in the compiling of the index. The main advantage of this method is that quantities do not need to be calculated. Instead, expenditure data can be used directly in the index formula, Laspeyre’ s price index = Po Foe 100tedex Numbers 225 [2] Paasche’s method: In this method current year quantities are used as weights. ZPQi . 100 EPoQi (3) Dorbish & Bowleys Method: This method is a combination of Laspeyre’s and Paasche’s methods. If we find out the arithmetic average of Laspeyre’s and Paasche’s index wwe get the index suggested by Dorbish & Bowley. [4] Fisher’s ideal method: Fisher’ s Price index number is the geometric mean of the Laspeyres and Paasche indices. Paasche’ s price index number = Po, EP;Qo “ . P; Formula: Fisher” s ideal index number,= Pp: 121. 100 It is known as ideal index number because (a) It is based on the geometric mean (®) Itis based on the current year as well as the base year (c) It confirms certain tests of consistency (@) Itis free from bias. Mlustration 3 : Compute Fishers ideal index number (52010) Items Base year Current year Price Quantity, Price Quantity P 5 6 6 7 Q 7 12 6 13 R 6 15 8 15 Ss 8 10 8 12 Htems | Po | Qo | Pi | Q PiQo PoQo PQ PQ Pp [5|6/6|7 36 30 42 35 e@f{[7{2fe]s 2 84 8 91 R ; 6 15 8 15 120 90 120 90 s [s]wfs] 2 80 80 96 06 | EPiQo= 308 | E PoQe=284 | EPQ=336 | TP QH312 seems snes nneesennsnencetntnesen ss .226 Index Numbers Poi= V1.0845 x 1.0769 x 100 Po= V1.1678 x 100 Poi= 1.0807x 100 . Fisher's index number = 108.07 Tests of Consistency of index numbers Several formulae have been studied for the construction of index number. The question arises as to which formula is appropriate to a given problem. A number of tests been developed and the important among these are 1. Unit test 2. Time Reversal test 3. Factor Reversal test 1. Unit test: The unit test requires that the formula for constructing an index should be independent of the units in which prices and quantities are quoted. Except for the simple aggregate index (unweighted) , all other formulae discussed in this chapter satisfy this test. 2. Time Reversal test:Time Reversal test is a test to determine whether a given method will work both ways in time, forward and backward. In the words of Fisher, “the formula for calculating the index number should be such that it gives the same ratio between one point of comparison and the other, no matter which of the two is taken as base”. Proof of Time reversal Test: In the Time Reversal test, When we change the time (i.e., zero to one and one to zero), Then, it will be as under, Time reversal test: Po; x Pio = TAQ TPQ ang Po= ZP9Qo EPoQ Po = ZPoQ , ZPoQo =P}Q) ZP;Qo oon} EP Qo, ZPQu , ZPoQi , ZPoQ0 EP9Q9 EPpQ, ZP7Qy * SPQ Cancel the similar elements in the numerator and denominator, then we Pox Ppp =, [2A » SARL ,, Ho@r , Poo 01 X Pioindex Numbers 227 Porx Pio = Vi ¥ Por X Pio = Time reversal test is Proved (i.e., Po x Pio = 1) 3. Factor Reversal test:Another test suggested by Fisher is known s factor reversal test, itholds that the product of a price index and the quantity index should be equal to the corresponding value index. In the words of Fisher, “Just as each formula should permit the interchange of the two times without giving inconsistent results, so it ought to permit interchanging the prices and quantities without giving inconsistent result, ie, the two results multiplied together should give the true value ratio. Proof of Factor reversal test: In the Factor Reversal test if we change the factors price (P) to quantity (Q), Then it will teas under, EPQo Factor reversal test: Po, x Qo, = ZP9Qo = |2PiQo . ZPAQ Pa= |x and " VEPOQo EPQ, JEQuPo ZQuP, EQoPo XQoP, Qu= TPQ , FAQ , FOR , BOA ZPOQ — EP9Q TQoPo EQoP, Cancel the similar elements in the numerator and denominator, then we Bree TPQ Fer, FAA A, ZP9Qo SPyQr LQoPy - -BQoPr 2 Pox Qoy = PQ (2P9Qo) Now cancel Root and Square then we will get, =PiQ) ZP9Qo Por x Qoi = Por x Qos = Pox Qo = =P, Factor reversal test is satisfied: Pox Qo = 2H ZPoQo228 Index Numbers Illustration 4 : Compute the fisher’s ideal index number. (BU, 32009) Items M N ° P Q ice (i 10 2007 Price (in 2) 20 50 40 60 Quantity 8 10 3 20 6 Price (in %) 30 40 30 60 40 2008 - Quantity 10 8 12 16 10 Computation of fisher’s ideal index number. Items | Po | Qo | Pi | Q PiQo PoQo PQ PQ M 20} 8 | 30} 10 240 160 300 200 P 50} 10 | 40] 8 400 500 320 400 Q 40/ 5 | 50} 12 250 200 600 480 RK | 60| 20 | 60 | 16 1200 1200 960 960 s [10] 6 | 40] 10 240 60 400° 100 = P,Qo=2330 E PoQo=2120 | E P,Q,=2580 | Z PoQ\=2140 P=, [AAO ZL x 100 EPoQ0 EPoQi = [2:230 , 2,580 99 2,120 2,140 Poi= V1.0990 x1.2056 x 100 Poi= VI.32495 x 100 Poi= 1.151066x 100 Fisher’s index number = 115.11 Illustration Construct Fisher’s ideal index with the help.of the data given below. (BU, 32008) Items Base year Current year Price Quantity Price ~~ Quantity Wheat 8 75 15 80 Ghee 20 10 25 12 Firewood 20 4 25 | Sugar 4 10 6 4 Cloth 1 50 404 1 3 Index Numbers 229 Computation of fisher’s ideal index number. [ites TPT @ [TOT ra, Pode PQ PoQi Wheat s_ [75 |is }8o 1125 600 1200 640 [Ceo 20 [10 _}25 fia 250 200 300 240 (Prewood [2 [20 [a [as 30 40 100 50 {Sue 4 [io |e fia 60 40 84 56 [co [so [3 [ao 150 30. 120 40 EP\Qo=1665 | E PpQ.=930 | E PiQ.=1804 | EP.Qi=1026 =P, Poe JariQo FRA, 199 EPoQo EP, 1,665 1,804 Po= fx x 100 "4930 “1,026 * Poi= 1.7903 x1,7582 x 100 Po= V3.1477 x 100 Poi= 1.7741 x 100 Fisher's index number = 177.41 Ilustration 6 : Construct fisher’s index from the following: (BU, 32006) Items Base year Current year Base year Current year Quantity (kgs) _| Quantity (kgs)_| _ price per kg @) price per kg (®) Wheat 20 20 12 14 Rice 22 24 16 18 Gram 20 18 32. 36 Pulses 8 12. 29 29 Ghee 1 2 2 70 [Sugar 5 4 4 16 Computation of Fishers Index number. Htems | > | Qo] Pi | Q PiQo PoQo PQ PQ Wheat i2 | 20 | 14 | 20 280 240 280 240 4} Rice T 16 [22 | 18 | 24 396 352 432, 384 Gram | 32 | 20 | 36 | 18 720 640 648 576 ulses | 29 | 8 | 29 | 12 232 ae 348 348 [Ghee [62 [1 [70 | 2 70 6 140 124 Sugar a4 | 5 [16 | 4 80 70 64 36 E PiQo=1778 | ¥ PoQu=1596 | ¥ P,Qi=1912 | F PpQy=1728230 Index Numbers Po = JEHQ2 x ZR x 100 ZP9Qo EPoQr L778, 1,912 Poe feeb 5, L924 - y,596 “1,728 * 1 Poi= Vi.1140%1.1064 x 100 Poi= Vi.2325 x 100 Poi= 1.1101 x 100 Fisher's index number = 111.01 Illustration 7 : Construct price index number by applying Fisher’s ideal Method: Commodity 2007 2008 Price Quantity Price Quantity 2 8 4 5 5 12 6 10 4 15 5 12 2 18 4 20 Computation of Fishers Ideal Index number. Items | Po a | P| P.Qo PoQo PQ PQ a l2)8]4]5 32 16 20 10 B [5 | 12 {6 [ 10 2 60 60 30 C 4 [is | 5 12 | 15 60 60 a8 D 2 18 | 4 | 20 2 36 80 40 I ZPiQv=251_ | EPoQo=172 | EP,Q.=220 | EP,Q.=148 ZPQo , EPiQi x 100 Fisher’s index number =Po, EPoQo =PoQ Pos fre x 2% x 100 172 “148 Poi= V1.459x 1.487 x 100 ¥2.170 x 100 =.1.473 x 100 Fisher’s index number = 147.3 Illustration 8 : Compute Fishers ideal index number (BU, J 2011) iscas Base year Current year Value Quantity Value Quantity A 300 150 480 4paedipalvers 231 —— B 50 10 90 6 — 48 2 50 D 120 60 100 2 E 60 20 105 35 | Poriuens Computation of Fisher’s index number. Here, in the base year and current year value means, Product of price and quantity (PxQ). | fice per unit is not given. First we have to find the price per unit for Base year (Po) and Current year (P;). Price per unit = —Value_ Quantity Calculation of price per unit: Base year Current year Price per unit (Ps) price per unit (Pi) A 300.5 480 _ 129 150 4 B 30, 5 10 6 c a 50 19 12 5 D 120 14 100 _ 64 60 2 E . 105 49 20 35 tems | Po | Qo P, | @ PiQo PoQo PQ PoQ A | 2 | 150 | 120] 4 | 18000 300 480 8 B | 5] 10 | 15 | 6 150 50 90 30 oe A 120 8 30 20 _o [2] 6 | 50 | 2 3000 120 100 4 —eé [3 )20 | 30 | 35 | 600 60 105 10.5 = EPQ= | ERa- | =2Pa= | sr | 21870 578 825 725 Fisher’s index number =Por 71,870, 825 = [fx x100 Por W578 “72.5 *232 Index Numbers Poi= ¥37.8373 x 11.393 x 100 Po= ¥430.5619 x 100 Po= 20.7499 x 100 Fisher’s index number = 2074.99 Illustration 9 : Compute fisher’s ideal index number. (BU, A2003) Items Base year Current year Value ‘Quantity Value Price A 300 150 480 4 B 50 10 90 6 c 48 12 50 5 D 120 60 100 2 E 60 20 105 35 Computation of Fisher’s index number. Here, in the base year value means, Product of price and quantity (PxQ). Price per unit (Po) is not given. In the Current year Price per unit is given but Quantity(Q,) is not given. Now, First we have to find the price per unit for Base year (Po) and Current year quantity (Qi). Price per unit for Current year quantity Value Base year (P)) =v aue_ Q)= — Quantity Price , 300, $80 59 150 4 B 20. 2045 10 6 c 48 504 12 5 1 > 120, 100 59 60 2 5 o; 105 9 20 3.5 Computation of fisher’s ideal index number. Items | Po | Qo | Pi | Q PiQo PoQo PiQ PQ A 2 [150 | 4 | 120 600 300 480 240 B s [10 [6 [15 60 50 90 75, c 4 [12 [5 | 10 60 48 50 40 D 2 | 60 | 2 | so 120 120 100 100 E 3, | 20 | 35 | 30 70 60 105 90 EP:Qo=910 | EPcQ=578 | EP1Q:=825 | FP.Qi=545 || andes Numbers 233 Fisher's index number =Po,=, |2P1Q0 , ZQ x 190 EPQ DPQ 25 Po= VIS743X1.5137 x 100 Po= (2.3830 x 100 Poi= 1.5437 x 100 Fisher’s index number = 154.37 Mlustration 10 : Calculate Fisher’s Index Number. [BU, A2001} L Commodity Base Year Current Year Price Value Quantity Value A 2 10 4 20 B 3 12 5 30 c 1 8 2 16 D 4 20 8 24 Computation of Fisher’s index number. Here, in the base year Quantity (Qo) is not given. In the Current year Quantity is given but Price (P1) is not given. Now, first we have to find the quantity for Base year (Qy) and Current year price per unit for (P,). Quantity for Price for Value Value Base year (Qo)= So Current year (P,) Quantity 10 ==5 a 2 12 4 : 3 c 8 1 D Computation of fisher’s ideal index number. Items | Po | Qo | Pi | Q PiQo PoQo PQ PQs A ais s [4 25 10 20 8 B 3] 4 6 | 5 24 12 30 15 ic 1 8 8 2 64 8 16 2 D 4 5 3 8 15 20 24 32 EPiQo=128 | E PoQu=50 | EP,Q:=90 | F PoQ=57