Index Numbers
1. Introduction
In today’s dynamic economy, prices, production levels, and economic indicators are
constantly changing. To measure and compare these changes over time, economists
and businesses use a statistical tool called the index number. Index numbers help track
changes in the value of a variable (or group of variables) relative to a base period.
They are widely used in economics, finance, business, and public policy for
understanding trends and making informed decisions.
2. Definition
An index number is a statistical measure that expresses the relative change in the
value of a variable or group of variables over time, from a base period. It is usually
expressed as a percentage, with the base period index value set to 100.
> Example: If the price index for 2025 is 125 and the base year is 2020, it means that
prices have increased by 25% from 2020 to 2025.
3. Characteristics of Index Numbers
(i) Relative Measure: Index numbers show percentage changes compared to a base
value.
(ii) Time-Specific: They compare data over different time periods.
(iii) Dimensionless: Index numbers are pure numbers without units.
(iv) Base Year: A specific year is chosen as the reference (usually assigned an index
value of 100).
(v) Composite or Simple: They can measure changes in a single item or a group of
items.
(vi) Purpose-Oriented: Designed to reflect price, quantity, or value changes in a
specific context.
4. Uses of Index Numbers
(i) Measuring Inflation or Deflation: Consumer Price Index (CPI) and Wholesale
Price Index (WPI) measure the change in the cost of living.
(ii) Economic Analysis: Index numbers are used to study business cycles and national
economic performance.
(iii) Policy Formulation: Governments rely on index numbers for setting minimum
wages, interest rates, and subsidies.
(iv) Business Decisions: Companies use them to forecast trends, set prices, and make
investment decisions.
(v) Adjusting Financial Values: Indexing salaries, pensions, or contracts based on
inflation.
5. Problems in the Construction of Index Numbers
(i) Choice of Base Year: An unsuitable base year may distort comparisons.
(ii) Selection of Items: It’s difficult to select a representative basket of goods or
services.
(iii) Changes in Quality: Products evolve, and changes in quality are hard to measure
statistically.
(iv) Substitution Effect: Consumers may change their consumption patterns, but index
numbers often assume fixed items.
(v) Weighting Issues: Assigning accurate importance (weight) to each item can be
challenging.
(vi) Data Collection Problems: Reliable and timely data may not always be available.
6. Classification of Index Numbers
(i) Price Index Numbers: Measure changes in the price level (e.g., CPI, WPI).
(ii) Quantity Index Numbers: Measure changes in quantity or volume (e.g.,
agricultural or industrial output).
(iii) Value Index Numbers: Measure changes in the total value (price × quantity).
(iv) Special Purpose Index Numbers: Designed for specific uses (e.g., cost of living
index, stock market index).
7. Methods of Constructing Index Numbers
There are two main methods:
A. Unweighted Index Numbers
(i) Simple Aggregative Method:
Index = (∑P1/∑P0)×100
Where P1 = current year prices, P0 = base year prices.
(ii) Simple Average of Price Relatives:
Index = (∑(P1/P0)×100)/n
B. Weighted Index Numbers
(i) Laspeyres Method (uses base year quantity weights):
Index = (∑P1Q0/∑P0Q0)×100
(ii) Paasche’s Method (uses current year quantity weights):
Index = (∑P1Q1/∑P0Q1)×100
(iii) Fisher’s Ideal Index:
Index = √(Laspeyres Index×Paasche Index)
Considered the most accurate because it uses both base and current year weights.
8. Weighted Index Numbers
Weighted index numbers assign importance (weights) to each item based on its
significance in the overall dataset.
Why Weights Are Important: Not all items are equally important. For example, in a
consumer price index, food items may carry more weight than luxury goods.
Types of Weights:
a. Quantity Weights: Used in price indices (e.g., Laspeyres, Paasche).
b. Value Weights: Used when both price and quantity are relevant.
c. Subjective Weights: Based on expert judgment or user preference.
Example:
If rice accounts for 30% of a consumer’s budget and soap accounts for 5%, the price
of rice should influence the index much more than soap.
Conclusion
Index numbers are a powerful statistical tool for measuring relative changes in
variables such as prices, quantities, or values. While they have limitations in accuracy
due to changing preferences, quality variations, and data availability, their usefulness
in economic analysis, policy-making, and business decisions is undeniable.
Understanding index numbers is essential for anyone studying economics, finance, or
business management.
