DBB2102 Unit-07

DBB2102: Quantitative Techniques for Management Manipal University Jaipur (MUJ)
BACHELOR OF BUSINESS
ADMINISTRATION
SEMESTER 3
DBB2102
QUANTITATIVE TECHNIQUES FOR
MANAGEMENT
Unit 7: Index Numbers 1

Unit 7
Index Numbers
Table of Contents
SL Topic Fig No / Table SAQ / Page No

No / Graph Activity
1 Introduction
3-4
1.1 Objectives
2 Meaning of index number 5
3 Types of index number 6
4 Uses of Index Numbers 7
5 Methods of constructing Index Numbers 1 1 8 - 22
6 Test For Adequacy of Index Number 23
Formulae
7 Consumer Price Index Number 24
7.1 Uses of Consumer Price Index Numbers
8 Assumptions of cost-of-living index number 25
9 Methods of constructing Consumer Price 2 26 - 29
Index
10 Limitations of Index Numbers 30
11 Summary 31
12 Glossary 32
13 Terminal Questions 32 - 33
14 Answers 34 - 35

1. INTRODUCTION
In our day-to-day life, we come across different statements like the following:
a) The index of industrial production in India (Base 1980-81=100) shows a growth rate is
around 8% per year for the year 1984-1985 and 1985-86.
b) The index of rice yield in India (Base 1969-70=100) rises to 258.7 for the year 1985-
1986.
c) The general level of prices has registered an increase of 2%.
When we talk of industrial production, it is obvious that we are referring to the production
of all those commodities that are produced by the industrial sector. Now, production of some
of these commodities may be increasing while others may be stagnant or falling. Similarly,
the prices of some commodities increase, and others decrease. Example, the price of rice,
wheat, sugar has increased, and the price of mobile phones, computers, and laptops has
decreased compared to the previous years. Thus, we require a system to know how much f
change occurs over a period of time. We may want to know how much the price of
petrol/diesel has increased, or how much the price of our favorite pizzas, burgers have
increased so that we can spend accordingly. Similarly, companies require the past sales,
transportation cost, cost of raw materials, etc and compare it with those of the present year.
We can also take the example of the educational institutions comparing the fees of different
courses charged in the previous years and deciding about the amount to be charged in the
coming year. In all of the above cases the degree of change must be determined and defined
in order to know about the amount the change that needs to be made. Let us take another
real-life example of where index number is used. Suppose the index number of the year 2010
in comparison to the year 2009 is 115. (We will learn the calculation later in the chapter).
This signifies that there is an increase of 15% in the goods and services which are taken into
consideration while calculating the index number of the year 2010 based on 2009. This
information tells the government and other employers about the percentage of hike in the
salary in order to ensure the same living standard of their employees.
Such differences of changes like the 15% change(increase)which gave a basis for the
government in above example is one of the area where Index Numbers are applied. In the

following section, we will study the meaning of index numberstheir use, importance,
methodology, and application.
1.1 Objectives:
After studying this unit, you should be able to:
❖ Describe the meaning & importance of index numbers

❖ Discuss about different types of index numbers
❖ Explain the different methods of construction of index numbers
❖ Identify the uses of index numbers
❖ Discuss Consumer Price Index

2. MEANING OF INDEX NUMBER
Index numbers are a specialized type of average. It measures how much a variable changes
over time. They are designed to measure the relative change in the level of the phenomenon
with respect to time, geographical locations, or some other characteristic. It is an indicator
that reflects the relative changes in the level of certain phenomena in any given period called
the current period with respect to its value in some fixed period called base period selected
for comparison.
For example, if we want to measure the relative change in the price level, we would not be
able to do so by using the averages because price of different commodities ise expressed in
different units, such as kilogram, litre, meter etc. In such cases, we require some special types
of average which will enable us to measure changes in the price level. Index numbers are
such an average.
The following are the characteristics of index numbers:
a) They are expressed in percentages: Index numbers is calculated as the ratio of the
current value to the base year value expressed as a percentage. The index for the base
year is taken to be 100 and the change in the current year is always calculated in
comparison to the base year.
b) They are specialized averages: An index number is a specialized average. As discussed
above, it is used for comparison in cases where the items to be compared have different
units like a consumer price index number would consist of Rice, Sugar, Milk, Tea,
Kerosene Oil which have different units like kilogram, litre, etc. The index number is
obtained as a result of an average of all these items which are expressed in different
units. Thus, index number is a specialized average which takes into consideration all
the different items measured in different units taken together.
c) Relative Measure: Index number measures changes which are not capable of direct
measurement.
d) They are for comparison: The index number by their nature is comparative. They
compare changes taking place over time or between places

3. TYPES OF INDEX NUMBER
There are basically three principal types of indices, the price index, the quantity index and
the value index.
3.1 Price index number: When the comparison is made with respect to prices it is
called price index number. Here the price index compares changes in the prices of certain
commodities in the current year compared to the base year. Suppose the price index number
of a group of commodities for the year 2010 base year 2007 is 125. We would conclude that
for the same commodities we will have to pay 25% extra to purchase the same amount of
commodities in the year 2010 which could be bought at 2007.
3.2 Quantity index number Similarly when the comparison is in respect of quantity, it
is called quantity index number. A quantity index number measures the changes in the
quantity from one period to another period .In this index number the focus is on the quantum
of production and not on the price. We compare how many units of commodities of a group
of products are manufactured during the current year and compare whether it has increased
or decreased in comparison to the base year. The most popular index of this type is the index
of industrial production which measures the increase or decrease in the level of industrial
production in a given period compared to the base year.
3.3 Value index number: It’s the number where the comparison is made based on the
value which is the product of both price and quantity. It combines both price and quantity to
give a combined or mutual effect in making comparisons. The value index is usually used in
sales and inventories where effects of both quantity and price are required. However, this
index number is unable to distinguish the effect of the price and quantity separately.

4. USES OF INDEX NUMBERS
1. It acts as a barometer for measuring the value of money. Index numbers help us to find
the value of money over different years; for example, if Rs. 7,000 a month was
considered sufficient for a middle standard of living during 2007 but that same 7000
will not be able to sustain that person to live in the same standard during the year 2010.
Here we can say that the value of money has decreased. Index numbers help us to find
how much decrease has taken place. It is also used for evaluating the purchasing power
of money.
2. This change in the value of money has a direct effect on the public. It is used by the
government to frame policies related to taxes, imports, exports, interest rates, subsidies
etc.
3. It is useful in comparing changes in production and prices.
4. It is also used by businesses in production planning, inventory level and pricing of their
goods & services.
5. Consumer Price Index, a type of index number guides the authorities and the
government for the fixation and revision of wages.
6. They help in comparing the economic conditions of a particular group at two different
periods or between different groups of people in the same period.
7. Index numbers serves as a guide for making relevant investment decisions for example
the investment index like Sensex and Nifty give a lot of information to the investors
about the performance of the market and help them take rational decision.

5. METHODS OF CONSTRUCTING INDEX NUMBERS
The different methods of constructing index numbers are as follows: They are Unweighted
Index Numbers & Weighted Index Numbers.
Unweighted Index Numbers consists of Simple aggregative method and Simple average of
relative method.
Similarly Weighted Index Numbers consists of weighted aggregative method & weighted
average of relative method.
Fig. 7.1: Methods of Constructing Index Numbers
We will now study each of the methods in detail.
1. Unweighted Index Numbers: An unweighted index number is one where weights are
not assigned or equal importance is given to all the commodities taken for computing
index number.
a) Simple aggregative method: This is the simplest method of constructing Index
Numbers. To find a price index number by this method we divide the total of current
year prices by the total of base year prices and multiply it by 100. To make it easier
the steps to be followed for calculating Price Index by simple aggregative Method are
given below:
Step 1. Add the current year prices for different commodities or find ∑ 𝑃1
Step 2. Add the base year prices for same commodities of Find ∑ 𝑃0

Step 3. Divide the total of current year prices by the total of base year prices and
multiply the quotient by 100 that is
∑ 𝑃1
𝑃01 = × 100
∑ 𝑃0
Where 𝑃01 is the simple price index of current year “1” based on base year“0”
Merits
➢ It is very simple to calculate.
Demerits
➢ The relative importance of different commodities is not taken into consideration.

➢ This method does not reflect the real situation as the changes in prices are not linked
to changes in quantity consumed.
➢ Large-numbered figures greatly affect the index numbers. We will understand it better
with the help of an example
Example 1: Find the unweighted simple aggregative price index for the year 2011 taking
2005 as the base year and also interpret the results.
Commodity Unit 2005( P0 ) 2011 ( P1 )
Rice (1Kg) Kilogram 15 25

Mustard Oil (1Kg) Litre 50 65
L P G (1Kg) Kilogram 250 350
Bengal Gram (1Kg) Kilogram 20 42
Sugar (1Kg) Kilogram 18 48
Total 353 530
We have taken the base year as 2005 and current year as 2011. Substituting the values in the
formula we get
∑ 𝑃1
𝑃01 = × 100
∑ 𝑃0

530 × 100
Therefore 𝑃01 =
353
=150.14
Interpretation:
A comparison between the changes in prices of the year 2011 based on the year 2005 has
been made. Thus, we can conclude that the price index number is 150.14 which means that
price has increased by 50.14 % in the year 2011 as compared to the year 2005. However,
this price index cannot reflect the price changes of all goods and services, as this is only a
rough estimate. Secondly, on inclusion of other commodities and varying weights in the list
of the commodities taken, there is a possibility that that the price index number would
change. As we have already said that this method does not reflect the real situation as the
changes in prices are not linked to changes in quantity consumed. We will again evaluate it
with the same example but increase the consumption of a commodity say Sugar to 10 kgs
from 1 kg.
Commodity Unit 2005 (P0) 2011 (P1)
Rice (1Kg) Kilogram 15 25

Mustard Oil (1Kg) Litre 50 65
L P G (1Kg) Kilogram 250 350
Bengal Gram (1Kg) Kilogram 20 42
Sugar (10kgs ) Kilogram 180 480
Total 515 962
Here Price Index =186.79
Just by changing the consumption of Sugar the index number changed from
150 to 186.70. As equal importance is given to all commodities this aggregate method of
calculation did not get much acceptance.
a) Simple average of relative methods:
In this method the price relative of each commodity is calculated separately and
averaged.

The steps to construct a price index by the method of simple average of relative method
are as follows:
Step 1. Obtain the price relative for each commodity which is calculated as
Price of item in current year

Price Relative for current year = × 100
Price of item in base year
𝑃1
𝑃= × 100
𝑃0
Step 2. a. Calculating using the arithmetic mean
Calculate the arithmetic mean for the price relative obtained in step 1 and denote it
by𝑃01
𝑃1
∑(
𝑃0 × 100)
𝑃01 =
𝑁
Step 2. b. Calculation by the geometric mean
Calculate the geometric mean for the price relative obtained in step 1 and denote it
by𝑃01
𝑝
𝑃01 = anti log ∑ (𝑙𝑜𝑔 𝑝1 × 100)
0
We will solve a problem to understand it
Example 2: The Prices of wheat, rice and corn for the year 2005 and 2010 are given below.
The prices given are for per ton of the commodity. Calculate the price index by using the
simple average of relative method by using both arithmetic mean and geometric mean taking
base year as 2005.

Year 2005 2010

Wheat 900 1400
Rice 560 670
Corn 700 1235
Here Base year = 2005; N =3
We will calculate the price relative first

Year 2005 2010 Price
𝑃1Relative log R
P0 P1 𝑅= × 100
𝑃0
Wheat 900 1400 155.56 2.19

Rice 560 670 119.64 2.08
Corn 700 1235 176.43 2.25
Total ∑ 𝑃0 = 2160 ∑ 𝑃1 = 3305 ∑ 𝑅= 451.63 ∑ 𝑙𝑜𝑔R=6.52
Simple average of relatives by using arithmetic mean
𝑃1
∑(
𝑃0 × 100)
𝑃01 =
𝑁
451.6
=
3
𝑃01 = 150.54
Simple average of relatives by using geometric mean
𝑃1
∑ (𝑙𝑜𝑔
𝑃0 × 100)
𝑃01 = 𝑎𝑛𝑡𝑖 log
𝑁
= anti log=(6.52 / 3)
= 149.05

Merits
➢ Equal importance is given to all items

➢ Extreme items do not unduly affect the index
Demerits
➢ The use of geometric mean involves difficulties of computation.

➢ It fails to give any consideration to the relative importance of different items just like
the simple aggregate method
2. Weighted Index Numbers
In this method weights are assigned to various commodities according to their

significance and consequently weighted index improves the accuracy of the index
number as compared to the unweighted one. Usually, the quantity consumed during
the base year or the current year is taken as the weights to obtain the weighted
aggregate index numbers.
There are different methods to find each of which are discussed below:
a) Laspeyre’s Price Index: The Laspeyre’s price index is a weighted aggregate price
index where the weights are the base year’s quantities. The formula given by Laspeyre
is as follows:
∑ 𝑃1 𝑄0
Laspeyre’s Price Index 𝑃01 = × 100
∑ 𝑃0 𝑄0
Where P1 =current year price; P0 = base year price; Q0 = Base year quantity
Similarly, the Laspeyre’s Quantity Index is given by the formula
∑ 𝑄1 𝑃0
Laspeyre’s Quantity Index 𝑄01 = × 100
∑ 𝑄0 𝑃0

Where P1 = current year price; P0 = base year price; Q0 = Base year quantity
Q1 = Current year quantity
Merits
➢ Simple to calculate and can be computed once the current year’s prices are known.
Demerits
➢ Laspeyre’s method tends to overestimate the rise in prices or has an upward bias. As
we know that a considerable price increase would result in a slight decrease in the
consumption of those commodities. When base year quantities are used as weights, it
will result in assigning too much weight to prices that have increased the most. Thus,
the numerator of the Laspeyre’s index would be high. Similarly, when the prices
decrease, consumers tend to increase their demand of those commodities whose prices
have decreased and hence the usage of the base year period quantities would result in
too low weight to prices that have decreased the most. This is the major disadvantage
of Laspeyre’s method.
b) Paasche’s Method: Paasche’s method is based on current year’s quantities. Current
year’s quantities are used as weights. Paasche’s price Index is given as
∑ 𝑃1 𝑄1
Paasche’s Price Index 𝑃01 = × 100
∑ 𝑃0 𝑄1
Where P1= current year price; P0 = base year price; Q0 = Base year quantity
Paasche’s Quantity index number is given by the formula:
∑ 𝑄1 𝑃1
Paasche’s Quantity Index 𝑃01 = × 100
∑ 𝑄0 𝑄1
Where P1 = current year price; P0 = base year price; Q0 = Base year quantity
Q1 =Current year quantity

Merits
➢ This method attaches weight according to its significance.
Demerits
➢ Paasche’s index is not frequently used in practice when the number of commodities is
very large. This is because for Paasche’s index revised weights or quantities must be
computed for each year examined. Such information is either unavailable or hard to
gather adding to the data collection expenses which makes the index unpopular.
➢ Paasche’s method tends to underestimate the rise in prices and has a downward bias.
c) Dorbish and Bowley’s method
The third method to calculate the weighted aggregate index number is the Dorbish and
Bowley’s method. This can be found by finding the arithmetic mean of Laspeyre’s index
and Paasche’s index.
Dorbish and Bowley’s Index Number
LapeyresPr iceIndex + Paasche′ s PriceIndex

𝑃01 = ( ) × 100
2
∑𝑃 𝑄 ∑𝑃 𝑄
( 1 0) + ( 1 1)
∑ 𝑃0 𝑄0 ∑ 𝑃0 𝑄1
𝑃01 = × 100
2
Where P1 =current year price; P0 = base year price; Q0 = Base year quantity
Merits:
➢ It is free from bias upward as well as downward.

➢ This formula takes into account both current year and base year prices and quantities
Demerits:

➢ This index is not widely used owing to the practical limitations of collecting data
d) Fisher’s Ideal Index Method: In this method the price index is the geometric mean of
Laspeyre’s and Paasche’s Price Indices. The formula is as follows:
∑𝑃 𝑄 ∑ 𝑃1 𝑄1
𝑃01 = √∑ 𝑃1 𝑄0 + ∑ 𝑃0 𝑄1
× 100
0 0
Where P1 = current year price; P0 = base year price; Q0= Base year quantity
Merits:
Theoretically geometric mean is considered the best average for the construction of index
numbers and Fisher’s index uses geometric mean.
Both the current year and base year prices and quantities are taken into account by this
index. Thus, it is free from bias upward as well as downward.
Both the factor reversal and time reversal tests have been satisfied by this method.
Demerits:
This index is not widely used owing to the practical limitations of collecting data.
We will understand all the different types with the help of an example.
Example 3: Find the Price Index by all the methods of weighted aggregative method taking
1990 as the base year and 2000 as the current year.
1990 2000
Commodities
Price Quantity Price Quantity
A 30 8 50 6
B 75 10 100 5
C 50 15 75 15
D 25 20 30 25
Solution:
The four methods are

i) Laspeyre’s Price Index

ii) Paasche’s Method
iii) Dorbish and Bowley’s method
iv) Fisher’s Ideal Index Method
1990 2000
Commodities P0Q0 P0Q1 P1Q0 P1Q1
P0 Q0 P1 Q1
A 30 8 50 6 240 180 400 300
B 75 10 100 5 750 375 1000 500
C 50 15 75 15 750 750 1125 1125
D 25 20 30 25 500 625 600 750
Total 180 53 255 51 2240 1930 3125 2675
∑ 𝑃1 𝑄1
Laspeyre’s Price Index 𝑃01 = × 100
∑ 𝑃0 𝑄0
= 3125/2240
= 139.51
∑ 𝑃1 𝑄1
Paasche’s Price Index 𝑃01 = × 100
∑ 𝑃0 𝑄1
= 2675/1930
=138.60
Dorbish and Bowley’s Price Index
Lapeyres Price Index + Paasche′ s Price Index

𝑃01 =
2
( 1 0) + ( 1 1)
∑ 𝑃0 𝑄0 ∑ 𝑃0 𝑄1
𝑃01 = × 100
2
= (139.51+138.60)/2
= 139.05

Fisher’s Ideal Price Index =
( 1 0) + ( 1 1)
∑ 𝑃0 𝑄0 ∑ 𝑃0 𝑄1
𝑃01 = × 100
2
3125 2675
𝑃01 = √2240 + × 100
1930
P01 = 139.05
Weighted Average of Relative Method
Here the price index is constructed on the basis of price relatives. We have already seen what
a price relative is. Even in this case we can find it by the arithmetic mean and geometric
mean.
Case 1: By arithmetic mean
Step1: Find individual price relatives
𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑖𝑡𝑒𝑚 𝑖𝑛 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑒𝑎𝑟

𝑃𝑟𝑖𝑐𝑒 𝑅𝑒𝑙𝑎𝑡𝑖𝑣𝑒 𝑓𝑜𝑟 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑒𝑎𝑟 𝑃 = × 100
𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑖𝑡𝑒𝑚 𝑖𝑛 𝑏𝑎𝑠𝑒 𝑦𝑒𝑎𝑟
𝑃1
𝑃= × 100
𝑃0
Step 2. Compute the value V by finding the product of the base year price and base year
quantities of various commodities and obtain the sum as
∑ 𝑉 = ∑ 𝑃0 𝑄0
Step 3: Find the product of P and V and get the sum as ∑ 𝑃𝑉
Step 4: Compute the price index by the following formula

∑ 𝑃𝑉
𝑃01 =
∑𝑉
Where P is price relative and V is value weights
Case 2: By Geometric Mean
Step1: Find individual price relatives
𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑖𝑡𝑒𝑚 𝑖𝑛 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑒𝑎𝑟

𝑃𝑟𝑖𝑐𝑒 𝑅𝑒𝑙𝑎𝑡𝑖𝑣𝑒 𝑓𝑜𝑟 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑒𝑎𝑟 𝑃 = × 100
𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑖𝑡𝑒𝑚 𝑖𝑛 𝑏𝑎𝑠𝑒 𝑦𝑒𝑎𝑟
𝑃1
𝑃= × 100
𝑃0
Step 2: Compute the logarithm of each of price relatives i.e., log P
Step 3: Compute the value V by finding the product of the base year price
P0 and base year quantities Q0 of various commodities and obtain the sum as
∑ 𝑉 = ∑ 𝑃0 𝑄0
Step 4: Find the product of log P and V and get the sum as∑ 𝑉log P
Step 5: Compute the price index by the following formula
∑ 𝑉 𝑙𝑜𝑔 𝑃
𝑃01 = 𝑎𝑛𝑡𝑖 log ∑𝑉
We will solve a problem to understand it
From the data given below compute the index for the year 2008 taking 2007 as the base year
by weighted average method of price relatives using
(i) arithmetic mean (ii) geometric mean

price (Rs ) quantity price (Rs)

Commodity
2007 2007 2008
Rice 5 10 7
Wheat 7 5 8
Sugar 9 5 15
Pulses 6 4 8
Solution:
P0 Q0 P1 P1
price quantity price
P= 100
2007 2007 2008 V = P0Q0 P0 PV log P V log P
5 10 7 50 140.00 7000.00 2.15 107.31
7 5 8 35 114.29 4000.00 2.06 72.03
9 5 15 45 166.67 7500.00 2.22 99.98
6 4 8 24 133.33 3200.00 2.12 51.00
TOTAL 154 554.29 21700.00 8.55 330.32
(i) By using arithmetic mean
We have the formula
∑ 𝑃𝑉
𝑃01 =
∑𝑉
Substituting in the formula we get
21700
𝑃01 = 154
=140.9
(ii) By using geometric mean
We have the formula
∑ 𝑉 𝑙𝑜𝑔 𝑃
𝑃01 = 𝑎𝑛𝑡𝑖 log ∑𝑉
Substituting the values in the formula we get

330.32
𝑃01 = anti log ( )
154
= antilog (2.144)
= 139.315
Quantity Index Number: Price Index Numbers measure and permit comparison of the price
of goods. Quantity index numbers, on the other hand, measure the physical volume of
production, construction or employment. We calculate the changes in quantity. Quantity
index can be easily obtained from price index numbers just by interchanging P’s and Q’s in
the formulae used for calculating the price index numbers. All the four methods of calculating
Price index number is applicable while calculating Quantity index number.
Value Index Number: A value index measures general changes in the total value of some
variables. As value is the product of both price and quantity, a value index actually measures
the combined effect of price and quantity changes. It is used for measuring overall changes.
The formula for calculating value index number is as follows:
∑ 𝑃1 𝑄2
𝑉= × 100
∑ 𝑃0 𝑄0

Self-assessment questions -1
1. _______________is a statistical device designed to express changes or differences

in a variable or a group of related variables.
2. The three types of index numbers are _________________, ________________and
_____________ .
3. The following is the formula of which method of Index Number?
∑ V log P
𝑃01 = 𝑎𝑛𝑡𝑖 log ∑V
_____________
4. The weighted aggregate index number by Dorbish and Bowley’s method is

found by finding the geometric mean of Laspeyre’s index and Paasche’s index.
(True/False)
5. ______________measures the combined effect of price and quantity changes.
6. _______________is the ratio of a new (current year) price to the base year price.
7. The Laspeyre’s and Paasche’s index are examples of __________ . (Name the type
of index numbers)
8. The Laspeyre’s price index regards the__________ quantities as fixed.
9. A simple aggregate price index ignores relative quantities. (True/False)

6. TESTS FOR ADEQUACY OF INDEX NUMBER FORMULAE
1. Unit Test: This test requires that formula should be free of units. Except simple
aggregative index, all others satisfy this test.
2. Time Reversal Test: This test was proposed by Irving Fisher. According to him an
index number should be such that when the base year and current year are
interchanged (reversed), the resulting index number should be the reciprocal of the
earlier.
Suppose if P01 be the index number for the current period ‘1’ with the base year ‘0’ and
let P10 be another index number with the current period ’0’ and base year ‘1’, then the
particular index number satisfies time reversal test if
P01 × P10 = 1
Time reversal Test is not satisfied by Laspeyre’s and Paasche’s index number, but it is
satisfied by Fisher’s ideal index number.
3. Factor Reversal Test: factor reversal test requires that the product of the index
number of price (with quantities as weights) and the index number of quantity (with
price as weights) should indicate net change in value taking place in between the two
periods.
∑ 𝑃1 𝑄1
𝑃01 × 𝑄01 =
∑ 𝑃0 𝑄0
4. Circular Test: It is an extension of time reversal test. This test requires that if an index
is constructed for the year ‘a’ on base ‘b’ and for the year ‘b’ based on the year ‘c’, we
should get the same result when we calculate the index for the year a base on the year
c.
Symbolically
P01 ×P12 ×P20 =1
It is satisfied by index numbers with fixed weights by aggregate methods

7. CONSUMER PRICE INDEX NUMBER
Consumer Price Index Number is an index number of the cost met by a specified class of
consumers in buying a ‘basket of goods and services’. The “baskets of goods and services’’
mean goods and services needed in day-to-day life of the specified class of consumers. The
pattern of consumption of goods is different in different classes which differ due to their
income variation. And so, the general index numbers fail to indicate the changes in cost with
regard to various classes of consumers. The class of consumers means group of consumers
having almost identical pattern of consumption.
7.1 Uses of consumer price index numbers
1. It is useful to measure the changes in the purchasing power of currency.

2. As such, this index will help the government in formulating policies regarding control
of prices, taxation, imports and export duties etc.
3. They are used for comparing changes in the cost of living of different classes of people.
4. They are used in granting allowances and other facilities to employees.

8. ASSUMPTIONS OF COST-OF-LIVING INDEX NUMBER
Cost of living index is based on the following assumptions:
1. Similar Needs: The need of the people for which this index number is constructed is the
same.
2. Same goods: The goods taken under consideration in the base year and the current year
should remain the same
3. No change in quantity of goods: It is assumed that the quantity of goods consumed will
remain the same in the base year and current year.
4. It is assumed that the prices at different places are same, and they do not change
frequently.
5. Representative Goods: The commodities included in the cost of living index number
should represent the consumption of that class of people.

9. METHODS OF CONSTRUCTING CONSUMER PRICE INDEX
There are two methods of constructing consumer price index. They are:
1. Aggregate Expenditure method

2. Family Budget method
1. Aggregate Expenditure method: Here the quantities of the base year are taken as
weights. Thus, the consumer price index number by this method is
Total Expenditure in Current Year

𝑃01 = × 100
Total Expenditure in Base Year
∑ 𝑃1 𝑄0
𝑃01 = × 100
∑ 𝑃0 𝑄0
2. Family Budget Method: In this method the family budget of a large number of peopleis
carefully studied and the aggregate expenditure of the average family on various items
is estimated. These values are used as weights. Current year’s price is converted into
price relatives on the basis of base year’s prices and these prices relatives are
multiplied by the respective values of the commodities, in the base year. The total of
these products is divided by the sum of the weights and the resulting figure is the
required index numbers
∑ 𝑊𝐼 𝑃
𝑃01 = ∑𝑊
Where 𝐼 = 𝑃1 × 100; W =P0 Q0
0
We will take the help of an example to understand it Construct a consumer price index
by 2008 on the basis of 2007 from the following data using
(i) Aggregate expenditure method (ii) Family budget method.

Commo- dities Quantity consumed in Unit PRICES

2007 (Q0) 2007 (P0) 2008 (P1)
A 7 quintal 315.75 316.00

B 5 quintal 305.00 308.00
C 4 quintal 416.00 419.00
D 9 quintal 528.00 610.00
E 3 kg 12.00 11.50
F 5 quintal 1020.00 1015.00
Solution:
Consumer price index by 2008 on the basis of 2007 from the following data using
(i) Aggregate expenditure method:

P0 P1
quantity
P0Q0 P1Q0
Commodities Unit 2007 2008
2007(Q0)
A 7 quintal 300 310 2100 2170

B 5 quintal 305 308 1525 1540
C
4 quintal 416 419 1664 1676
D 9 quintal 530 625 4770 5625
E 3 kg 18 23 54 69
F 5 quintal 1050 1070 5250 5350
15363 16430
The formula for calculating Consumer price Index is
∑ 𝑃1 𝑄0
𝑃01 = × 100
∑ 𝑃0 𝑄0
16430
𝑃01 = × 100
15363
=106.94

(ii) Family budget method
The formula using Family budget is
∑ 𝑊𝐼 𝑃
𝑃01 = ∑𝑊
Where 𝐼 = 𝑃1 × 100; W =P0 Q0
0
P0 P1 P1
Commo- quantity2007
I= ×100 W =P 0 Q0
dities P0 WI
( Q0 )
Unit 2007 2008
A 7 quintal 300 310 103.33 2100 216993.00

B 5 quintal 305 308 100.98 1525 153994.50
C 4 quintal 416 419 100.72 1664 167598.10
D 9 quintal 530 625 117.92 4770 562478.40
E 3 kg 18 23 127.78 54 6900.12
F 5 quintal 1050 1070 101.9 5250 534975.00
TOTAL 652.63 15363 1642939.00
∑ 𝑊𝐼
𝑃01 =
∑𝑊
1642939
𝑃𝑂1
15363
= 106.941

Self-assessment questions -2
10. The cost-of-living index number is based on the assumption that group of
consumers have different needs. (True/False).
11. The methods of constructing consumer price index are ______________
and__________________ .
12. Consumer index number helps us in finding how much a consumer should
spend. (True/False)
13. Time reversal test requires that formula for constructing an index should be
independent of units. (True/False)
14. During the construction of consumer price index, it is assumed that the quantity
of goods consumed will remain the same in the base year and current year.
(True/False)
15. ______________is an index number of the cost met by a specified class of consumers
in buying a ‘basket of goods and services’.

10. LIMITATIONS OF INDEX NUMBERS
Although index numbers is a very useful tool for knowing the rate of changes, which is used
as a barometer or a basis for calculating other things like minimum wage, incentives, tax,
import & export duties, there are certain limitations which should also be borne in mind.
They are as follows:
1. Index numbers are not perfect. They are only approximated values.
2. There are a lot of difficulties in the construction of index numbers due to selection of
base year, commodities, changes in habits, and selection of average.
3. They have limited applications. An index number constructed for one purpose cannot
be used for other purposse.
4. Many formulae are used for the construction of index numbers. These formulae give
different values for the index.

11. SUMMARY
In this chapter, at first, we learnt the need for index number and also the meaning and types
of index number. We learnt that index number is an indicator which helps us to measure the
relative change between current year and base year. The three types of index number are
price, quantity and value index number. The primary purpose of index numbers is to provide
a value useful for comparing magnitude of aggregates of related variables to each other and
to measure the changes over time. It acts as an indicator just as the way a thermometer
measures the temperature. This indicator or index number then acts as a base to decide
about the various changes which need to take place such as decisions regarding tax rates,
minimum wages, and export import duties.
In the second stage, we studied the uses of index numbers and methods of constructing index
numbers. The two main types are the unweighted index numbers and the weighted index
numbers. Unweighted
index number does not take the weights into consideration whereas weighted index number
takes base year quantities and current year quantities into consideration. The fisher index
number is considered to be the ideal index number as it is free from any bia,s but the data
collection would be laborious.
In the third stage, we discussed the consumer price index, where we learnt that it is an index
number of the cost met by a specified class of consumers in buying a ‘basket of goods and
services’
Finally, we learnt about the limitations of index numbers wherein we saw that index
numbers are only approximate values. There are different methods to calculate, and each
method gives a different answer.

12. GLOSSARY
Base Year: It refers to the year used as the beginning or the reference year for constructing
an index, and which is usually assigned an arbitrary value of 100.
Relative: The value of a variable in a given (current) year divided by the value of the variable
in a specified (base) year. Thus, price relative is the ratio of a new (current year) price to the
base year price.
Incentives: It refers to something that incites or tends to incite action or greater effort, as a
reward offered for increased productivity; here it can be taken in terms of monetary benefit.
Purchasing Power: It refers to the number of goods/services that can be purchased with a
unit of currency.
13. TERMINAL QUESTIONS
1. Define index number. Discuss its importance

2. What is Consumer Price Index? What are its uses?
3. What are the limitations of index numbers?
4. Construct Fisher’s Ideal index for the data represented in the table
P0 Q0 P1 Q1
price (Rs ) quantity price (Rs) quantity
Commodity
2007 2007 2008 2008
Rice 4 6 6 8
Wheat 6 7 8 7
Sugar 9 8 16 6
Pulses 8 10 18 5
5. From the data given below compute the index for the year 2009 taking 2008 as the base
year by weighted average method of price relatives using (i) arithmetic mean (ii)
geometric mean

Price (Rs ) quantity Price (Rs)

Commodity
2008 2008 2009
A 9 15 14
B 8 6 9
C 6 9 18
D 7 8 9
6. Find the simple aggregative price index from the data taking 2008 as the base year and
2009 as the current year.
Commodity Unit 2008 2009
Ghee Per Kilogram 220 280
Eggs Per dozen 40 65
Tea Kilogram 250 330
7. Construct a consumer price index of 1988 on the basis of 1987 from the following data
using (i) Aggregate expenditure method (ii) Family budget method.
Commodities quantity 1987 Unit 1987 1988
A 6 quintal 365 390
B 8 quintal 321 371
C 9 quintal 425 452
D 4 quintal 598 625
E 5 kg 25 30
F 8 quintal 489 529

14. ANSWERS
Answers to Self Assessment questions
1. Index Numbers
2. Price, Quantity, Value
3. Price index by Weighted Average of Relative Method using geometric mean
4. False
5. Value Index Number
6. Price Relative
7. Weighted Index Numbers
8. Base year quantities
9. True
10. False
11. Aggregate expenditure method and Family budget method
12. False
13. False
14. True
15. Consumer Price Index Number
Answers to Terminal Questions:
1. 1.It is an indicator which reflects the relative changes in the current period with respect
to its value in base period. Refer Sec 2 & 3.
2. Consumer Price Index Number is an index number of the cost met by a specified class
of consumers in buying a ‘basket of goods and services’. Refer Section 6.
3. 2.Index numbers are only approximated values. There are a lot of difficulties in the
construction of index numbers due to selection of base year, commodities, changes in
habits, and selection of average. Refer Section 9.
4. 177.96
5. Arithmetic Mean 169.98 Geometric Mean 160.94
6. 106.59
7. 108.30

References
• Bharadwaj, R. Business Statistics, New Delhi: Excel Books, New Delhi

• Chandan, J., Jagjit Singh., & Khanna, K. Vikas Publishing House: New Delhi.
• Gupta, C., Vijay Gupta, An Introduction to statistical Methods. Vikash Publishing House:
New Delhi.
• Richard I. Levin., David S. Rubin, Statistics for management. Eastern Economy Edition.

DBB2102 Unit-07

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DBB2102: Quantitative Techniques for Management Manipal University Jaipur (MUJ)

Unit 7: Index Numbers 1

SL Topic Fig No / Table SAQ / Page No

Unit 7: Index Numbers 2

Unit 7: Index Numbers 3

After studying this unit, you should be able to:

❖ Describe the meaning & importance of index numbers

Unit 7: Index Numbers 4

2. MEANING OF INDEX NUMBER

The following are the characteristics of index numbers:

Unit 7: Index Numbers 5

3. TYPES OF INDEX NUMBER

Unit 7: Index Numbers 6

4. USES OF INDEX NUMBERS

Unit 7: Index Numbers 7

5. METHODS OF CONSTRUCTING INDEX NUMBERS

Fig. 7.1: Methods of Constructing Index Numbers

We will now study each of the methods in detail.

Unit 7: Index Numbers 8

➢ It is very simple to calculate.

➢ The relative importance of different commodities is not taken into consideration.

Rice (1Kg) Kilogram 15 25

Unit 7: Index Numbers 9

Rice (1Kg) Kilogram 15 25

Here Price Index =186.79

a) Simple average of relative methods:

Unit 7: Index Numbers 10

Price of item in current year

Step 2. a. Calculating using the arithmetic mean

Step 2. b. Calculation by the geometric mean

We will solve a problem to understand it

Unit 7: Index Numbers 11

Year 2005 2010

Here Base year = 2005; N =3

We will calculate the price relative first

Wheat 900 1400 155.56 2.19

Simple average of relatives by using arithmetic mean

Simple average of relatives by using geometric mean

Unit 7: Index Numbers 12

➢ Equal importance is given to all items

➢ The use of geometric mean involves difficulties of computation.

In this method weights are assigned to various commodities according to their

Similarly, the Laspeyre’s Quantity Index is given by the formula

Unit 7: Index Numbers 13

Q1 = Current year quantity

Q1 = Current year quantity

Paasche’s Quantity index number is given by the formula:

Q1 =Current year quantity

Unit 7: Index Numbers 14

➢ This method attaches weight according to its significance.

Dorbish and Bowley’s Index Number

LapeyresPr iceIndex + Paasche′ s PriceIndex

Q1 = Current year quantity

➢ It is free from bias upward as well as downward.

Unit 7: Index Numbers 15

Q1 = Current year quantity

The four methods are

Unit 7: Index Numbers 16

i) Laspeyre’s Price Index

Dorbish and Bowley’s Price Index

Lapeyres Price Index + Paasche′ s Price Index

Unit 7: Index Numbers 17

Fisher’s Ideal Price Index =

Weighted Average of Relative Method