3.

8 INDEX NUMBERS

3.8.1 Objectives

By the end of this lecture, you should be able:

 To define a simple index number;

 To calculate an Index relative;
 To compute Laspeyres and Paasches indices;
 To discuss the challenges of index number construction;
 To give examples of indexes

3.8.2 Introduction

In one way or the other if you are living in Zimbabwe, you hear people of all walks of life
talking about prices of goods and services going up at an alarming rate from 2014. As
students you actually discussed at great length about the Tuition fees increases charged by
many universities in Zimbabwe this year. Even your company or yourself, if you trade some
goods and/or provide services, you have a way of keeping an eye on price changes or
inflation to remain viable. It is not to say these price increases cannot be studied, no. They
come under the study of index numbers.

By definition an Index number (IN) is defined as a summary measure of the change in the
level of activity of either a single or a basket of related items from one period (base period) to
another (current period). An IN is actually a ratio employing the current period value over the
base period value expressed as a percentage.

IN = Current Period Value x 100%

Base Period Value

The base period IN = 100%. Suppose the price of bread is $25,00 and we are in the same year
of say 2017, then IN = 25/25*100% = 100%. The price can also drop to $20,00.

Other examples of IN are for : Share prices on the Zimbabwe Stock Exchange (2010-2020);
Exchange rate of the Zimbabwe dollar (2017-2020); industrial output (2018-2020);
Happiness Index; the Acc102 pass rate from 2010 to 2019 etc.

3.8.3 Types of IN

Basically, we have two major categories of IN where for each type one can have an index for
a single item or for a basket of related items.

 Price Indexes for a single price index and composite price index.
 Quantity Indexes for a single price index and composite price index.

Hence, price and quantity are the two ways we measure IN.
The notation used in our calculations are:

 P0 = base period price

 P1 = current period price
 Q0 = base period quantity
 Q1 = current period quantity

3.8.4 Price Indexes

A price index thus measures the percentage change in price between two time periods for
either a single item or a basket of items.

A price relative measures the percentage change for a single item from the base period to the
current period.

Price Relative = P1/ P0 * 100%

So, the price change we are interested here is from 2017 , $25.00 for the bread example above
say to 2020 of $51,00.

Price relative for bread =51/25*100% = 204. However, we do not say the price of bread went
up by 204% but 204-100= 104%.

The price of bread has gone up by 104% with 2017 as base period.

If we consider the price of a barrel of oil on the international market from 2018 to 2020 for
example we find the following: In 2018 it was $68,00 (USD) but in May 2020 its now
$32,00.

The Price Relative = 32/68*100% =4706. So the price of a barrel of oil fell by 52,94% with
2018 as the base year.

3.8.5 Composite price index

This is the average price change for a basket of items from the base period to the current
period. The various items in the basket are weighted basing on the importance attached to it
especially considering its price and quantity of it consumed. Obviously, food items may
supersede entertainment because nobody can do without food but can minimize on
entertainment. We saw this play out when the government started relaxing “Stay at home”
restrictions. Agriculture related activities got relaxed before say going for watching sports
activities.

We have weights based on the Laspeyres Approach and the Paasche Approach.

Laspeyres Approach advocates holding quantities constant at base period levels to allow the
aggregates of the changes in prices to be compared. The equation used to compute the price
change is:
Laspeyres Price Index (LPI) = ∑ (P1*Q0) x100%

∑ (P0*Q0)

Note that quantities are constant at base period levels but prices are the ones being compared.
Also, take note that we are summing up the total of the items in the basket.

Paasche Approach advocates holding quantities constant at current period levels to allow the
aggregates of the changes in prices to be compared.

Paasche Price Index (PPI) = ∑ (P1*Q1) x100%

∑ (P0*Q1)

Note that quantities are constant at current period levels but prices are the ones being
compared.

3.8,6 Worked example

The share portfolio problem.

In 2016 an investor bought a small portfolio of shares on the Zimbabwe Stock Exchange
(ZSE). She has purchased and sold from this portfolio over time. Her current 2019 portfolio
is given below:

Table 3.8.1 Portfolio of shares for an investor on the ZSE.

Base year 2016 Current year 2019

Share P0 Q0 P1 Q1
A 65c 350 115c 300
B 200c 240 120c 60
C 1 260c 50 1 890c 100

Qn 1 Calculate the Laspeyres Price Index.

Table 3.8.2 Laspeyres Price Index.

Base year 2016 Current year (2019) Value in

Base Current

Share P0 Q0 P1 Q1 P0*Q0 P1*Q0

A 65c 350 115c 300 22 750 40 250
B 200c 240 120c 60 48 000 28 800
C 1 260c 50 1 890c 100 63 000 94 500
Total 133 750 163 550

L.P.I. = 163 550/133 750 *100% = 122, 28

The prices of shares rose by 22,28% if the quantities are held constant at base period levels.
Qn 2 Calculate the Paasche Price Index

Table 3.8.3 Paasche Price Index.

Base year 2016 Current year (2019) Value in

Base Current
Share P0 Q0 P1 Q1 P0*Q1 P1*Q1
A 65c 350 115c 300 19 500 34 500
B 200c 240 120c 60 12 000 7 200
C 1 260c 50 1 890c 100 126 000 189 000
Total 157 500 230 700

P.P.I. = 230 700/ 157 500 * 100% = 146, 48

Therefore, if quantities are held constant at current 2019 levels, the share prices increased by
46,48% from the base period of 2016.

3.8.7 Quantity Indexes

A quantity index measures the percentage change in consumption level of an individual item
or a basket of items from the base period to the current period.

Quantity Relative measures the consumption of an item from the base period to the current
period..

Quantity relative = Q1/ Q2 * 100%.

If we pick on share A above, the Quantity relative = 300/350*100% = 85,7

Therefore, the amount of shares consumed decreased by 14,3 % for share A from the base
year 2016 to the current year 2019.

3.8.8 Computation of Laspeyres and Paasche Quantity Indexes

Composite quantity index measures the average quantity change for a basket of items from
the base period to the current period.

Laspeyres Approach advocates holding prices constant at base period levels.

Laspeyres Quantity Index (LQI) = ∑ (P0*Q1) x100%

∑ (P0*Q0)

Paasche Quantity Index (PQI) approach advocates holding prices at current period levels
constant.

Paasche Quantity Index (PQI) = ∑ (P1*Q1) x100%

∑ (P1*Q0)
Table3.8.4. Laspeyres Quantity Index (LQI) Computation.

Base year 2016 Current year (2019) Value in

Base Current
Share P0 Q0 P1 Q1 P0*Q0 P0*Q1
A 65c 350 115c 300 22 750 19 500
B 200c 240 120c 60 48 000 12 000
C 1 260c 50 1 890c 100 63 000 126 000
Total 133 750 157 500

LQI= 157500/133750 * 100 = 117, 8’

Therefore, the number of units of shares held increased by 17, 8% if prices are held constant
at base period levels.

Table 3.8.5 Paasche Quantity Index (PQI)

Base year 2016 Current year (2019) Value in

Base Current
Share P0 Q0 P1 Q1 P1*Q0 P1*Q1
A 65c 350 115c 300 40 250 34 500
B 200c 240 120c 60 28 800 7 200
C 1 260c 50 1 890c 100 94 500 189 000
Total 163 550 230 700

PQI = 230700/163550* 100 = 141,1

If prices are held constant at current period levels the number of unit of shares increased by
41,1%.

3.8.9 Self assignment

Find out the problems of index number construction and the limitation on the interpretation of
index numbers.