CHAPTER TEN

INDEX NUMBERS

SPECIIFIC OBJECTIVES
At the end of this topic the trainee should be able to:
➢ Define index numbers;
➢ Differentiate between the types of index numbers
➢ Explain the uses of index numbers
➢ List the limitations of index numbers.

INTRODUCTION
An index number is a device which shows by its variation the changes in a
magnitude which is not capable of accurate measurement in itself or of
direct valuation in practice. An index number may be described as a
specialized average designed to measure the level of a phenomenon with
respect to time geographic location or other characteristics such as income.
Uses of index numbers
• They help in framing suitable policies
• They reveal trends and tendencies
• Index numbers are very useful in deflating
Classification of index numbers.
Index numbers may be classified in terms of what they measure. In
economics and business the classification is;
• Price
• Quantity
• Value
• Special purpose
Problems in the constructing of index numbers
Before constructing index numbers a careful thought must be given to the
following problems.
i) The purpose of the index; as the very outset the purpose of
constructing the must be very clearly decided.
ii) Availability and comparability of data; it is needles to say that it
is impossible to make appropriate comparison unless the
necessary statistical data can be obtained
iii) Selection of base period; whenever index number are constructs,
a reference is made to some base period ,safe period should be
normal , it should not be too distant.
iv) Selection of number of items; every item cannot be included
while constructing an index number and hence one has to select a
sample.
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 v) Price quotation; after the commodities have been selected the
next problem is to obtain price quotation for these commodities
pricing vary from place to place and even from shop to shop.
vi) Choice of an average; since index numbers are specific average a
decision has to be made as to which particular average (i.e.
arithmetic mean, median , mode , geometric mean)
vii) Selection of appropriate weight; the problem of selecting suitable
weights are quite important and at the same time quite difficult
to decide.
viii) Selection of appropriate formula; a large number of formula have
been devised for often constructing the index numbers. The
problem very often is that in selecting the most appropriate
formula.

An index number is an attempt to summarize a whole mass of data into one

figure. The single figure shows how one year differs from another year. It is
a statistical devise used to measure the change in the level of prices, wages
output and other variables at given times, relative to their level at an
earlier time which is taken as the base for comparison purposes
 Pn
A simple price index = × 100 (an unweighted price index)
 Po

 Qn
A simple quantity index = × 100 (an unweighted quantity index)
 Qo

Where pn is the price of a commodity in the current year (the year for
which the price index to be calculated)

Where po is the price of the same commodity in the base year (the year for
comparison purposes)

Similarly Qn and Qo are defined in the same way

Methods of constructing index numbers

a) unweighed indices
b) weighed indices

In the unweighted indices weight are not expressively assigned whereas in

the weighed indices weights are assigned to the various items. Each of
these types may further be divided under two heads.
i) simple aggregate
ii) simple average of price relations

Unweighted index numbers

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 i) simple aggregate method
This is the simplest method of constructing index numbers. When this
method is used to construct a price index number, the total of current year
prices for the various commodities is divided by total of base year and
quotient is multiplied by 100.
P01 = ∑p1 x 100
∑p0
Where ∑p1 = total current price for various commodities
∑p0 = total of base year price for various commodities
Limitation of the method
• The units in which prices of commodities are given affect the
price index.
• No consideration is given to the relative importance of the
commodities.
ii) simple average of relative method
When this method is used to construct a price index, price relative are
obtained for the various items include intercontinental he index and then
an average of these relative
P01 = ∑p1 x 100 /N
∑p0
Where N= refers to the number of items
Merits
• Extreme items do not influence the index
• The index is not influenced by the units in which prices are quoted.
Limitations
• Difficulty is faced with regard to the selection of an appropriate
average.
• The relatives are assumed to have equal importance.
Weighed index numbers
Weighed index numbers are of two types
i) weighed aggregate index numbers
ii) weighed average of relative index numbers

Weighed aggregate method

An index is called a weighed aggregate index when it is constructed fro an
aggregate of items (price) that have been weighed.
Some important formulae of construction a weighed aggregate index are
i) Laspeyres Method
ii) Paasche Method
iii) Fishers Ideal Method
iv) Marshall – Edgeworth

Laspeyres method
In this method the base year’s quantities are taken as weights. The formula
for constructing index is
P01 = ∑ p1q0 x 100
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 ∑ p0q0

Paasche method
In this method the current year quantities are taken as the formula for
constructing index is
P01 = ∑ p1q1 x 100
∑ p0q1

Fischer’s ideal method

Prof Fischer has given a number of formulas for constructing index numbers

P01 = √ ∑ p1q0 x ∑ p1q1 x 100

∑ p0q0 ∑ p0q1 or

po1 = √ (L*P)

Marshall Edge Worth Method

In this method also the current year as well as base year and quantities are
considered
P01= ∑ (q0 + q1) p1 x 100
∑ (q0 + q1) p0

INDEX NUMBERS APPLICATION

The index of industrial production

It is a quantity index compiled by the government. It measures changes in
the volume of production in major industries. The index is a good indication
of the state of national economy.
It covers the following major industries in the UK
i. Mining and quarrying
ii. Manufacturing such as food, drinks and tobacco, chemicals, metal
manufacture, engineering e.t.c
iii. Textile

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 iv. Construction
v. Gas electricity, water e.t.c
It excludes agriculture, fishing, trade, transport, finance and other such
industries.
Each industries order is given a weighting. The weighting is based on
average monthly production in each industry in a fixed base year. It gives
each item its relative importance amongst all other items and thus gives a
better estimate of the index for comparison purposes.

The Geometric Index (Industrial Share index)

This index is an index of 30 selected top industrial companies. It is
calculated by taking an unweighted geometric mean of the price relatives
of the selected shares.

Example
The share prices of ordinary shares of four companies on 1 st January 1990
and 1st January 1991 were as follows.

Share Price on Price on

1.1.1990 1.1.1991
Company A Shs 10 Shs 12
Company B Shs 12 Shs 15
Company C Shs 20 Shs 25
Company D Shs 5 Shs 6

Using an unweighted geometric index, calculate the index of share prices at

1.1.1991 if 1.1.1990 is the base date, index 100

Solution
1 1
 12 15 25 6  4  27000  4
 = ( 2.25 )
1

     =
4

 10 12 20 5   12000 
= 1.225
Percentage increase = 22.5% index = 122.5

Inflation
The inflation rate for a given period can be calculated using the following
formula;
Current retail price index
Inflation = × 100
Retail price index in the base year

Marshal Hedge Worth Index

Marshal Hedge worth index =

p (p
n o + qn )
× 100
 p (q
o o + qn )

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Tests for an Ideal Index Number

1. Factor Reversal Test

This test indicates that when the price index is multiplied with a quantity
index i.e. factors are reversed), it should result in the value index.

2. The time reversal test

If we reverse the time subscripts of a price or quantity index, the result
should be reciprocal of the original index.

PRACTICE QUESTION

QUESTION FIVE
Prodco PLC manufactures an item of domestic equipment which requires a
number of components which have varied as various modifications of the
model have been used. The following table shows the number of
components required together with the price over the last three years of
production.

COMPONENT 1981 1982 1983

Prices Quantity Prices Quantity Prices Quantity
A 3.63 3 4.00 2 4.49 2
B 2.11 4 3.10 5 3.26 6
C 10.03 1 10.36 1 12.05 1
D 4.01 7 5.23 6 5.21 5

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Required:
a) Establish the base weighted price indices for 1982 and 1983 based on
1981 for the item of equipment. (8 marks)
b) Establish the current weighted price indices for 1982 and 1983 based on
1981 for the item of equipment. (8 marks)
c) Using the results of (a) and (b) as illustrations, compare and contrast
Laspeyre’s and Paasche price index numbers.(4 marks)
(Total: 20 marks)

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 QUESTION SIX
a) A company manufacturing a product known as 257 uses five components
in its assembly.

The quantities and prices of the components used to produce a unit of

K257 in 1982, 1983 and 1984 are tabulated as follows:

COMPONENT 1982 1983 1984

Quantity Prices Quantity Prices Quantity Prices
A 10 3.12 12 3.17 14 3.20
B 6 11.49 7 11.58 5 11.67
C 5 1.40 8 1.35 9 1.31
D 9 2.15 9 2.14 10 2.63
E 50 0.32 53 0.32 57 0.32

Required:
i) Calculate Laspyere’s type price index number for the cost of one unit of
K257 for 1983 and 1984 based on 1982. (6 marks)

ii) Calculate Paasche type price index numbers for the cost of one unit of
K257 for 1983 and 1984 based on 1982. (6 marks)

iii) Compare and contrast the Laspeyre and Paasche price-index numbers
you have obtained in (i) and (ii) (3 marks)

A number of employers manufacturing plastic components used in plumbing

have formed themselves into an association for the purpose of negotiating
with the trade union for this industrial sector.

The negotiations cover pay and contributions in this sector.

Required:
Explain the usefulness of an index of Industrial Production and an index of
retail prices to both sides in a series of pay negotiations.
(5 marks)
(Total: 20marks)

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