Quantitative Techniques in Business Unit 7

Unit 7 Index Numbers

Structure:
7.1 Introduction
Objectives
7.2 Meaning of index number
7.3 Types of index number
7.4 Uses of Index Numbers
7.5 Methods of constructing Index Numbers
7.6 Test For Adequacy of Index Number Formulae
7.7 Consumer Price Index Number
Uses of Consumer Price Index Numbers
7.8 Assumptions of cost of living index number
7.9 Methods of constructing Consumer Price Index
7.10 Limitations of Index Numbers
7.11 Summary
7.12 Glossary
7.13 Terminal Questions
7.14 Answers

7.1 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 the 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 all these commodities may be
increasing while of others may be stagnant or falling. Similarly the prices of
some commodities increase and others decrease like 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 of change occur over a period of time. We may
want to know how much the price of petrol/diesel has increased, or how

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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 educations
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 gives 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 numbers, its use, importance, methodology, and application.
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

7.2 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 phenomenon with respect to time, geographical
locations or some other characteristic. It is an indicator which reflects the
relative changes in the level of certain phenomenon in any given period

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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 are 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 percentage: 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 also , 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

7.3 Types of Index Number

There are basically three principal types of indices, the price index, the
quantity index and the value index. 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

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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.
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 the increase or
decrease in the level of industrial production in a given period compared to
the base year.
The last one is the value index 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 effect of both quantity and price are required. However
this index number is unable to distinguish the effect of the price and quantity
separately.

7.4 Uses of Index Numbers

1. It acts as a barometer for measuring the value of money. Index numbers
helps 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 number helps 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.
2. It is useful in comparing changes in production and prices.
3. It is also used by the businesses in production planning, inventory level
and pricing of their goods & services.
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4. Consumer Price Index, a type of index umber guides the authorities and
the government for the fixation and revision of wages.
5. 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.
6. 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.

7.5 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 importances are given to all the
commodities taken for computing index number.

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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 P 1

Step 2. Add the base year prices for same commodities of Find P 0

Step 3. Divide the total of current year prices by the total of base year prices
and multiply the quotient by 100 that is

P01 
 P 100
1

P 0

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

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We have taken the base year as 2005 and current year as 2011.
Substituting the values in the formula we get

P01 
 P 100
1

P 0

Therefore P01 = 530 X 100

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 importances is given to all commodities this
aggregate method of calculation did not get much acceptance.

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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

Pr ice of item in current year

Pr ice Re lative for current year   100
Pr ice of item in base year

P1
P  100
P0

Relative is the ratio of a new price to the base year price.

Step 2. a. Calculation by the arithmetic mean
Calculate the arithmetic mean for the price relative obtained in step 1 and
denote it by P01

 P1 
   100 
P01   P0 
N
Step 2. b. Calculation by the geometric mean
Calculate the geometric mean for the price relative obtained in step 1 and
denote it by P01

 P1 
  log P  100 
P01  anti log  0 
N
We will solve a problem to understand it
Example 2: The Prices of wheat, rice & 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 relatives method by using
both arithmetic mean and geometric mean taking base year as 2005.

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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 Relative log R

P0 P1 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
P 0  2160 P 1  3305  R  451.63  log R  6.52
Simple average of relatives by using arithmetic mean

 P1 
   100 
P01   P0 
N
= 451.6
3
P01  150.54

Simple average of relatives by using geometric mean

 P1 
  log P  100 
P01  anti log  0 
N
= anti log6.52 / 3
= 149.05

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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 :

P01 
 PQ1 0
 100
Laspeyre‟s Price Index
P Q0 0

Where P1 =current year price; P0 = base year price; Q0  Base year

quantity
Similarly the Laspeyre‟s Quantity Index is given by the formula

Q01 
Q P 1 0
 100
Laspeyre‟s Quantity Index
Q P 0 0

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 prices
are known.

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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 have
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
 PQ
Paasche‟s Price Index P01   100
1 1

P Q
0 1

Where P1 = current year price; P0 = base year price; Q0  Base year

quantity
Q1  Current year quantity
Paasche‟s Quantity index number is given by the formula:

Paasche‟s Quantity Index P01 

 Q P  100
1 1

Q P 0 1

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

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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
 Lapeyres Pr ice Index  Paasche' s Pr ice Index 
P01     100
 2 

  P1Q0   P1Q1 
  
P Q  P Q 
 0 0  0 1 
P01   100
2
Where P1 =current year price; P0 = base year price; Q0  Base year
quantity
Q1  Current 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 :

  P1Q0    P1Q1 
P01      100
P Q  P Q 
 0 0   0 1 

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Where P1 = current year price; P0 = base year price; Q0  Base year

quantity
Q1  Current 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

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1990 2000
Commodities P0 Q0 P0 Q1 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

 PQ
Laspeyre‟s Price Index P01   100
1 0

P Q 0 0

= 3125/2240
= 139.51
 PQ
Paasche‟s Price Index P01   100
1 1

P Q 0 1

= 2675/1930
=138.60
Dorbish and Bowley‟s Price Index

 Lapeyres Pr ice Index  Paasche' s Pr ice Index 

P01   
 2 
  P1Q0    P1Q1 
  
P Q  P Q 
 0 0   0 1 
P01   100
2
= (139.51+138.60)/2
= 139.05
  P1Q0    P1Q1 
Fisher‟s Ideal Price Index = P01      100
P Q  P Q 
 0 0   0 1 

 3125   2675 
P01      100
 2240   1930 
P01  139.05

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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
Pr ice of item in current year
Pr ice Re lative for current year P   100
Pr ice 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   P Q 0 0

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

P01 
 PV
V
Where P is price relative and V is value weights
Case 2: By Geometric Mean
Step1: Find individual price relatives
Pr ice of item in current year
Pr ice Re lative for current year P   100
Pr ice 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   P Q 0 0

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Step 4 : Find the product of log P and V and get the sum as V log P
Step 5: Compute the price index by the following formula

P01  anti log

V log P
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  P0 Q0 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

P01 
 PV
V
Substituting in the formula we get
21700
P01 
154
=140.9

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(ii) By using geometric mean

We have the formula

P01  anti log

V log P
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:

V 
 PQ1 1
 100
P Q0 0

Self Assessment Questions

1. ______________ is statistical devices designed to express changes or
differences in a variable or a group of related variable.
2. The three types of index numbers are ___________
,______________and __________________.
3. The following is the formula of which method of Index Number?

P01  anti log

V log P
V
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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)

7.6 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.

P
Suppose if 01 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.

P01  Q01 
 PQ
1 1

P Q
0 0

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‟

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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

7.7 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.
7.7.1 Uses of Consumer Price Index Numbers
1. It is useful to measure the changes in 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.

7.8 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 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.

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5. Representative Goods: The commodities included in the cost of living

index number should represent the consumption of that class of people.

7.9 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

P01 
 PQ1 0
 100
P Q0 0

2. Family Budget Method: In this method the family budget of a large

number of people are 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 are 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

P01 
WI P1
 100 ; W  P 0 Q0
Where I 
W P0

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.

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Commo- Quantity Unit PRICES

dities consumed in
2007 ( P0 ) 2008 ( P1 )
2007( Q0 )
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 P0 Q0 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 Consumer price Index of is

P01 
 PQ 1 0
 100
P Q 0 0

16430
P01   100
15363
=106.94

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(ii) Family budget method

The formula using Family budget is

P01 
WI P1
 100 ; W  P 0 Q0
Where I 
W P0

P0 P1
P1
Commo- quantity I  100 W  P 0 Q0
dities 2007 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

P01 
WI
W
1642939
P01 
15363
= 106.941

Self Assessment Questions

10. The cost of living index number is based on the assumption that group
of consumer 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)

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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‟.

7.10 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 purpose.
4. Many formulae are used for the construction of index numbers. These
formulae give different values for the index.

7.11 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 number are 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 about the uses of index number and
methods of constructing index numbers. The two main types are the
unweighted index numbers and the weighted index numbers. Unweighted

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index number does not take the weights into consideration where as
weighted index number take 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 bias but the data collection
would be laborious.
In the third stage, we discussed about 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 .They are different methods
to calculate and each method give a different answer .

7.12 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 to 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.

7.13 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?

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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

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7.14 Answers
Answers to Self Assessment
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. It is an indicator which reflects the relative changes in current period with
respect to its value in base period .Refer Sec 7.2 & 7.3.
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 7.6.
3. 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 7.9.
4. 177.96
5. Arithmetic Mean 169.98
Geometric Mean 160.94
6. 106.59
7. 108.30

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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.

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