Index Number

Index number occupy a place of great prominence in

business. It originally developed for measuring the
effect of change in prices. It is used to feel the pulse
of the economy and also the indicator of inflamatory
or deflationary tendencies. In fact, it is described as
the barometer of economic activity. So an index
number may be described as a specialised average
designed to measure the change in the level of a
phenomenon with respect to time, geographic
location or other characteristics such as income, sales
industrial production, prices of different commodities
etc. Thus when we say that index number of whole
sale prices is 125 for the period of June 2006
compared to June 2005, it means there is a net
increase in the prices of wholesale commodities to
the extent of 25%.
Classification of Index Number
Index number may be in terms of what they
measure. In economic and business the
classifications are i) price index number ii)
quantity index number & iii) value index number .
 Method of construction index number

The following is the chart gives the various methods

of index number.
Index number

Unweighted Weighted

Simple Aggregate Weighted aggregate

Simple average of price relative Weighted average of price

relative
 Simple aggregate method

This is the simplest method of constructing index

numbers. Under this method the aggregate of current
year prices for the various commodities is divided by
the aggregate of base year prices and the quotient is
multiplied by 100. Symbolically,
P01= ∑p1 x 100
∑p0
Where, P01= Index number of current year based on the base
year, ∑p1=Sum of the current year prices of various
commodities & ∑p0 =Sum of the base year prices of various
commodities.
 Simple average of price relative

We have used arithmetic mean for averaging the price

relatives. Other measures of central tendency can
also be employed. When arithmetic mean is used
for averaging the price relatives, the formula for
computing the index is P01= ∑(p1 p0 X 100)
N
When N= the no. of items whose price is to be averaged.
When geometric mean is employed for averaging the price
relatives the formula will be P01=Antilog ∑log(p1 p0 X 100)
= Antilog ∑logP N
N ; When P=( p1 p0 )X 100
 Weighted aggregate

1. Laspeyre’s 2. Paache’s 3. Dorbish and Bowlay’s 4.

Fisher’s 5. Marshall-Edgeworth & 6. Kelly’s.
Laspeyre’s method: In this method base year
quantities are taken as weights. The formula for
constructing index number is P01= ∑p1 q0 X100
∑p0 q0
Steps: i) Multiply current year prices for the various
commodities with base year weights to obtain
∑p1q0 . ii) Multiply base year prices for the various
commodities with base year weights to obtain
∑p0q0 .
iii) Divide ∑p1q0 by ∑p1q0 and multiply the quotient by
100. This gives required index number.
Paache’s method: In this method current year quantities
are taken as weights. The formula for constructing
index number is P01= ∑p1 q1 X100
∑p0 q1
Dorbish and Bowlay’s method: The Laspeyre’s formula
takes into account base year weights and Paache’s
formula current year weights. Dorbish and Bowlay
have suggested simple arithmetic mean of Laspeyre’s
and Paache’s formula. Thus it is intended to take into
account the impact of both
the base and current year. Symbolically,
P01= (∑p1q0 ∑p0 q0 )+(∑p1q1 ∑p0 q1 ) X100
2
Fisher’s method: This index number formula is
given by Irving Fisher which is
P01= √(∑p1q0 ∑p0 q0 )X(∑p1q1 ∑p0 q1 ) X100
This formula is the geometric mean of the
Laspeyre’s and Paache’s method. This is also
known as cross-weight formula.
Marshall-Edgeworth’s method: The formula to be
applied under this method is P01=∑(q0 +q1)p1 X100
∑(q0 +q1)p0
= ∑p1q0 + ∑p1 q1 X100
∑p0q0 + ∑p0 q1
Like the Fisher's method this formula also involves
the use of current year as well as base year prices
and quantities. There is a slight difference in
results between Fisher’s and this formula.
Kelly’s method: T.L. Kelly has suggested the
another method for constructing index number.
P01= (∑p1 q ∑p0 q) X 100
Where q refers to quantity of some period, not
necessarily the base or current year. It is possible
to use the average quantity of two or more years as
weight. This method is also known as the fixed-
weight aggregate index number. If in Kelly’s
formula the average of the quantities of two years
is used as weight q= q0+q1
2
 Weighted average of price relatives

The weighted average of price relatives can be

computed by introducing weights into the
unweighted price relatives. We may use arithmetic
mean or the geometric mean for the purpose of
averaging weighted price relatives.
a) When arithmetic mean is used-
P01= ∑(p1 p0 X 100)p0q0 = ∑PV ; P=(p1/p0)X100
∑p0q0 ∑V V= value weight
=p0q0
b) When geometric mean is used-
P01= Antilog ∑V logP
∑V
Where, P=(p1/p0)X100 , V = value weight =p0q0
* P01= √(∑p1q0 ∑p0 q0 )X(∑p1q1 ∑p0 q1 ) X100
The above formula (Fisher’s method) is known as
‘Ideal’ because of the following reasons-
i) It is based on the geometric mean which is
theoretically considered to be the best average for
constructing index number.
ii) It takes into account both current year as well as
base year prices and quantities.
iii) It satisfies both the time reversal test as well as
factor reversal test as suggested by Fisher.
iv) It is free from bias. The two formulae, Laspeyre’s
and Paache’s that embody the opposing types and
and weight biases are, in the ideal formula,
crossed geometrically i.e. by an averaging process
that of itself has no bias. This result is the
complete cancellation of biases of the kinds.
 Quantity index number

Index number also may be constructed by changing

prices (pij) to quantity(qij) and quantity(qij) to
prices (pij) in the various formula.
The Laspeyre’s method is used:-
Q01= ∑q1 p0 X100
∑q0 p0
Paache’ formula, Q01= ∑q1 p1 X100
∑q0 p1
Fisher’s formula,
Q01= √(∑q1p0 ∑q0 p0 )X(∑q1p1 ∑q0 p1 ) X100
These formulae represent the quantity index in
which the quantities of different commodities are
weighted by their prices.
Value index number
The value of a single commodity is the product of its
price and quantity. Thus a value index V is the
sum of the values of a given year divided by the
sum of the values of the base year. The formula
therefore, V= ∑p1 q1 X100
Where, ∑p0 q0
∑p1 q1= Total value of all commodities in the given period.
∑p0 q0 = Total value of all commodities in the base period.
 Index number tests

Several formulae have been suggested for

constructing index numbers and the problem is
that of selecting the most appropriate one in a
given situation. Below the tests are suggested for
choosing an appropriate index.
a) Time reversal test, b) Factor reversal test & c)
circular test.
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 other
words, if the time subscripts of a price or quantity
index number formula be interchanged, the resulting
price or quantity formula should be reciprocal of
the original formula, so that their product is unity.
If the product is not unity there should be a time
bias in the method. Symbolically, the following
relation should be satisfied, P01X P10=1. Thus if
from 2005 to 2006 the price of butter increased
from 360taka to 480 taka per kg, the price in 2006
should be 133.33% of the price 2005 and the price
in 2005 should be 75% of the price in 2006. One
figure is the reciprocal of the other, the product
(1.33X0.75) is unity.
 Let us now take Laspeyre’s, Paache’s and Fisher’s
formula for index numbers and see whether they
satisfy the time reversal test:
Laspeyre’s formula- P01= ∑p1 q0
∑p0 q0 ; Interchanging the
timesubscripts we get, P10= ∑p0 q1
∑p1 q1 ; multiply the
two index number ∑p1q0 ∑p0 q1 ≠ 1
∑p0 q0 ∑p1 q1
This test is not met the Laspeyre’s method.
Fisher’s formula P01=√(∑p1q0 ∑p0 q0 )X(∑p1q1 ∑p0 q1 )
Interchanging the timesubscripts we get,
P10=√(∑p0q1 ∑p1 q1 )X(∑p0q0 ∑p1 q0 ); product of two
index number
√(∑p1q0 ∑p0 q0 )X(∑p1q1 ∑p0 q1 ) X√(∑p0q1 ∑p1 q1 )X(∑p0q0 ∑p1 q0 )
=1.
Thus time reversal test is satisfied by Fisher’s
formula.
 Factor reversal test

This test holds that the product of price index and the
quantity index should be equal to the
corresponding value index. In other words, the test
is that, the change in price multiplied by the change
in quantity should be equal to the total change in
value. Symbolically, P01XQ01= ∑p1 q1 ∑p0q0=V
Let us now take Laspeyre’s, and Fisher’s formula for
index numbers and see whether they satisfy the
time reversal test:
Laspeyre’s formula- P01= ∑p1 q0
∑p0 q0
Transforming into quantity index number,Q 01= ∑q1 p0
∑q0 p0
Multiply both we get ∑p1 q0 ∑q1 p0 ≠ ∑p1 q1
∑p0 q0 ∑q0 p0 ∑p0 q0
Fisher’s formula P01=√(∑p1q0 ∑p0 q0 )X(∑p1q1 ∑p0 q1 )
Quantity index Q01=√(∑q1p0 ∑q0 p0 )X(∑q1p1 ∑q0 p1 )
Multiply both index
√(∑p1q0 ∑p0 q0 )X(∑p1q1 ∑p0 q1 ) X√(∑q1p0 ∑q0 p0 )X(∑q1p1 ∑q0 p1 )
= √(∑p1q0 ∑p0 q0 )X(∑p1q1 ∑p0 q1 ) X(∑q1p0 ∑q0 p0 )X(∑q1p1 ∑q0 p1 )
= √( ∑p1q1) 2 (∑p0 q0 )2 =
∑p1q1 ∑p0 q0 =V
Fisher’s method satisfy the factor reversal test.
 Cost of living index number

Index number related to cost of living is termed as

cost of living index number. Prices of the basic
items (food, cloth, fuel housing etc.) change with
the change of time. As commodity price usually
increases, cost of living also increase to maintain
the similar standard of living. Cost of level-index is
the index of relative change in the expenditure on
different commodities in order to maintain the
same living standard. Cost of living index number
also known as consumer price index number.
 Construction of cost of living index number
Aggregate expenditure method:- In this method, cost
of living index is computed in the weighted
aggregate method. Here base year quantity is used
as the weight. The formula is similar to that of
Laspeyre.
Cost of living= Current year total expenditure 100
Base year total expenditure
= ∑p1 q0 100
∑p0 q0
This method is popular method for constructing consumer
price index number.
 Family budget method
In this method also base year quantities are used as weights.
This method is the same as the weighted average of price
relatives method. It may be mentioned that aggregate
expenditure method and family budget method are
practically same.
Family budget method= ∑PV ; P=(p1/p0) X100
∑V V= Value index
= p0 q 0
= ∑(p1/p0 X100) p0 q0 = ∑p1 q0 X 100
∑p0 q0 ∑p0 q0
 Problems in construction of index number
The methods of construction of index numbers warrant a
careful study of following problems:
1. The purpose of index number: An index number which
is properly designed for a purpose can be most powerful
and useful tool otherwise it can be equally misleading
and dangerous. Thus the first and foremost problem is to
determine the purpose of index number without which it
is not possible to follow the steps in its construction.
2. Selection of commodity: Having defined the purpose of
index numbers, select only those commodities which are
relevant to the index. For example, if the purpose of an
index is to measure
the cost of living of low income group(poor families)
we should select only those commodities or items
which are consumed or utilized by persons
belonging to this group and due care should be
taken not to include the goods or services which
are ordinarily consumed by middle-income or
high-income groups. For such an index, selection
commodities like cosmetics and other luxury goods cars,
refrigerators, computer etc. will be absolutely useless.
3. Data of index numbers: The data usually the prices
and quantities consumed of the selected
commodities for different periods, places etc.
constitute the raw material for the construction of
index number. The data should be collected from reliable
sources such as standard trade journals, official
publications, periodicals, exporters etc. or through field
agencies. The principles of data collection such as
accuracy, comparability, sample representatives and
adequacy should be borne in mind.
4.Selection of base period: The base period is the period
with which comparisons of relative changes are made.
It may be a year, month or a day. The index number of
base period is always taken as 100. Selection of base
period should be normal period. It should be free from
all abnormalities like wars, earthquakes, famines,
boom, depressions,
labour strikes etc. Base period should not take that is
too distance in the past.
5. Choice of average: A decision has to be made as to
which particular average such as AM, GM, median
should be used for construction of index number. In
practice, GM is not used as often as AM. However
in the interest of greater accuracy and precision
GM should be recommended.
6. Selection of appropriate weights: Generally
various items of commodities such wheat, rice,
kerosene, clothing etc. included in the index are not
equal importance; proper weights should be
attached to them to take into account their relative
7. Selection of appropriate formula: A large number
of formulae have been derived for constructing the
index. The problem very often is that of selecting
the most appropriate formula. The choice of the
formula depend in the purpose of the index but
also on the data available.
 Problems

1. From the following data construct an index for

1997 taking 1996 as base.

Commodity & Price in 1996 (Tk.) Price in 1997 (Tk.)

unit
Butter(kg.) 20.00 21.00
Cheese(kg.) 15.00 14.00
Milk(lt.) 3.00 3.00
Bread(1) 2.80 2.80
Eggs(Doz.) 6.00 8.00
Ghee(1 tin) 250.00 260.00
Solution: Construction of price index
Commodity & unit Price in 1996 Price in 1997 P=(p1/p0)x100 logP
(Tk.)p0 (Tk.)p1
Butter(kg.) 20.00 21.00 105.00 2.0212
Cheese(kg.) 15.00 14.00 93.33 1.9700
Milk(lt.) 3.00 3.00 100.00 2.0000
Bread(1) 2.80 2.80 100.00 2.0000
Eggs(Doz.) 6.00 8.00 133.33 2.1249
Ghee(1 tin) 250.00 260.00 104.00 2.0170
∑p0=296.80 ∑p1 =308.80 ∑(p1/p0)x100= ∑logP=12.1331
635.66
P01= ∑p1 /∑p0 = 308.80/296.80 = 104.04
This means that as compared to 1996, in 1997 there
is a net increase in price of commodities included
in the index to extent of 4.04%.
Price index based on simple average of price relatives
P01= ∑(p1/p0)x100 = 635.66 =105.94 (For AM)
N 6
P01= Antilog[∑logP/N] = Antilog[12.1331/6]
=Antilog 2.0222 = 105.20 [For GM]
2. Construct index numbers of price from the
following data by applying: i) Laspeyre’s ii)
Paache’s iii) Dorbish and Bowlay’s iv) Fisher’s v)
Marshall-Edgeworth methods.
Commodity 2005 2006
Price Quantity Price Quantity
A 2 8 4 6
B 5 10 6 5
C 4 14 5 10
D 2 19 2 13
Solution: Calculation of various indices-
Commodity 2005 2006 p1q0 p0q0 p1q1 p0q1
Price p0 Qty q0 Price p1 Qty q1
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
∑p1q0 ∑p0q0 ∑p1q1 ∑p1q0
=200 =160 =130 =103

i) Laspeyre method: P01= (∑p1q0 ∑p0q0)X100

= (200/160)X100=125
ii) Paache's method: P01= (∑p1q1 ∑p0q1)X100
= (130/103)X100= 126.21
3. Bowlay’s method:P01=(∑p1q0 ∑p0q0)+(∑p1q1 ∑p0q1)x100
2
={(200/160)+(130/103)}x100 = 125.61
2
4. Fisher’s method: P01=√(∑p1q0 ∑p0q0)x(∑p1q1 ∑p0q1) x100
=√(200/160)x(130/103)x100 = 125.6
5. Marshal-Edgeworth method: P01=∑(q0+q1) p1 x100
∑(q0+q1) p0
= (∑p1q0+ ∑p1q1)x100 =(200+130)x100=125.48
(∑p0q0+ ∑p0q1) (160+103)
3. From the following data compute price index by
applying weighted average of price relatives using
arithmetic mean & geometric mean.
Commodity p0(Tk.) q0 p1 (Tk.)
Sugar 3.0 20kg. 4.0
Flour 1.5 40kg. 1.6
Milk 1.0 10lt. 1.5

Solution: Weighted average of price relatives:

Commodity p0(Tk.) q0 p1(Tk) V=p0q0 P=(p1/p0)x100 PV Log p V. logp
Sugar 3.0 20kg 4.0 60 133.33 8000 2.1249 127.494
Flour 1.5 40kg 1.6 60 106.7 6400 2.0282 121.692
Milk 1.0 10lt 1.5 10 150.0 1500 2.1761 21.761
∑V=130 ∑PV=15900 ∑VlogP=270.95
a) For arithmetic mean, P01= ∑PV/ ∑V =15900/130=122.31
This means that there has been a 22.31% increase in
price over the base level.
b) For geometric mean, P01=Antilog[∑VlogP/∑V]
= Antilog[270.95/130]=Antilog 2.08=121.3
4. Compute by suitable method the index number of
quantity from the data given below:
1995 1996
Commodity
Price Value Price Value
A 8 80 10 110
B 10 90 12 108
C 16 256 20 340
Solution: Since we are given the value and the price
we can obtain quantity figure by dividing the value
by price for each commodity. We can apply
Fisher’s method for finding quantity index.
1995 1996
q0p0 q1p1 q0p1
Commodity p0 q0 p1 q1 q1p0

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
∑q1p0=450 ∑q0p0=426 ∑q1p1=558 ∑q0p1=528

Quantity index, Q01=√(∑q1p0 ∑q0p0)x(∑q1p1 ∑q0p1) x100

=√(450/426)X(558/528)X100 = √1.116 X 100=105.6
5. Show from the data below that the time & factor
reversal tests are satisfied by Fisher’s ideal formula
for constructing index number.
Base year price Base year Current year Current year
Commodity (Tk.) quantity(kg.) price (Tk.) quantity (kg.)

A 6 50 10 56
B 2 100 2 120
C 4 60 6 60
D 10 30 12 24
E 8 40 12 36

Solution: We prepare a table for computations of time

reversal test and factor reversal test.
 Table
Commodity p0 q0 p1 q1 p1q0 p0q0 p1q1 p0q1
A 6 50 10 56 500 300 560 336
B 2 100 2 120 200 200 240 240
C 4 60 6 60 360 240 360 240
D 10 30 12 24 360 300 288 240
E 8 40 12 36 480 320 432 288
∑p1q0=1900 ∑p0q0=1360 ∑p1q1=1880 ∑p0q1=1344

Time reversal test is satisfied when- P01XP10=1

P01=√(∑p1q0 ∑p0q0)x(∑p1q1 ∑p0q1) and
P10=√(∑p0q1 ∑p1q1)x(∑p0q0 ∑p1q0)
Now substituting the values, P01XP10=
√(1900/1360)x(1880/1344)x(1344/1880)x(1360/1900)
=√1=1.
Hence time reversal test is satisfied
Factor reversal test is satisfied when-
P01XQ01= (∑p1q1)/(∑p0q0)
P01=√(∑p1q0 ∑p0q0)x(∑p1q1 ∑p0q1) and
Q01=√(∑q1p0 ∑q0p0)x(∑q1p1 ∑q0p1)
Hence P01XQ01 =
√(1900/1360)x(1880/1344)x(1344/1360)x(1880/1900)
=1880/1360= (∑p1q1)/(∑p0q0)
Hence Fisher’s ideal index satisfies factor reversal
test.
6. Construct cost of living index number from the
following data.
Items Quantity(in 1985) Price(in 1985) Price(in1986)
Rice 5md. 400 500
Wheat 2md. 200 300
Pulse 30kg. 20 28
Oil 30lt. 25 35
Fuel 50md. 60 90
Clothes 80m. 20 30
Others 10md. 200 300
Solution: We prepare a table for construct a cost of
living index number below.
 Table
Items Qty Price Price P=(p1/p0)x100 V=p0q0 p1q0 PV
(1985)q0 (1985)p0 (1986)p1
Rice 5md. 400 500 125 2000 2500 250000
Wheat 2md. 200 300 150 400 600 60000
Pulse 30kg. 20 28 140 600 840 84000
Oil 30lt. 25 35 140 750 1050 105000
Fuel 50md. 60 90 150 3000 4500 450000
Clothes 80m. 20 30 150 1600 2400 240000
Others 10md. 200 300 150 2000 3000 300000
∑V= ∑p1q0= ∑PV=
10350 14890 1489000

Cost of living index number: Aggregate expenditure method

= (∑p1q0 ∑p0q0)x100=(14890/10350)x100=143.86
Family budget method= ∑PV/ ∑V= 1489000/10350=143.86