7.2 I FUNDAMENTALS OF BUSINESS MATHEMATICS AND STATISTICSIndex Numbers
(4) Index numbers help to measures the Purchasing Power of money - Once the price index is computed,
then the earnings of a group of people or class is adjusted with a price index that provides an overall
view of the purchasing power for the group.
(5) Consumer price indices are used for deflating - The price index number is useful in deflating the national
income to remove the effect of inflation over a long term, so that we may understand whether there
is any change in the real income to the people or not.7.2 PROBLEMS INVOLVED IN CONSTRUCTION OF INDEX NUMBERS
There are several problems that a statistician encounter in process of construction of Index Numbers. These
are as follows—
(1) A clear definition of the purpose for which the index is constructed should be made. Before collection
of data for construction of index numbers, it is of utmost importance to know what is the purpose for
construction of index numbers. For example if we wish to measure trend in price changes with a view
point of finding the consumption pattern of a household; in such a case we should take retail prices
and not wholesale prices of items into consideration.
(2) Selection of number of items. Those items which are relevant for a partiality type of changes are to be
selected, for example in computing the cost of living index Number of a middle class family gold will
not be a relevant item, where as family clothing should be included.
(3) Base period - Base period is a reference period whose level of prices (in case of Price Index) represents
the base from which changes in prices are measured. For example when we compare the prices of
wheat in the year 2008 with that of 2000, the year 2000 is the base year.
The choice of base period is very critical in construction of Index Numbers and it is based on the
following two considerations- (a) base year should be a normal period i.e. period with relative stability
and should not be affected by extraordinary events like war, famine etc. (b) It should not be in too
distant past.
The choice is also to be made about the kind of base to be used i.e. whether fixed base should be
used or chain base should be used.
(4) Selection of weights - Weights imply the relative importance of the different variables. It is very essential
to adopt a suitable method of weighting to avoid arbitrary & haphazard weights. For instance, in
computing cost of living index, wheat or rice should be given more importance as compared to
sugar or salt.
(5) Adoption of suitable formula for construction of index number- As there are number of formulas to
calculate index number; most appropriate & proper one should be used & selected depending upon
the circumstances.
7.3 METHOD OF CONSTRUCTION OF INDEX NUMBERS
Index numbers may be constructed by any of the following methods—
(1) Unweighted Index :
(a) Simple Aggregative Index
(b) Simple Average of Relatives
(2) Weighted Indices:
(a) Weighted Aggregative. Index
(b) Weighted Average of Relatives