An index number is a statistical measure used to show the relative change in a variable or a group of related variables over time, place, or other characteristics. In economics, it helps compare data from different periods by converting complex and large sets of information into a single figure, making trends and changes easier to understand. Since absolute values may be affected by factors such as inflation, changes in currency value, or population growth, index numbers provide a more meaningful basis for comparison. They serve as important economic indicators, enabling economists, policymakers, and researchers to measure changes in prices, wages, production, and the cost of living. For example, if the Consumer Price Index (CPI) increases by 5%, it indicates that the average prices of consumer goods and services have risen by 5% compared to the base period.
Hence, index numbers act as economic barometers, just like a thermometer measures temperature — they measure the level of economic activity, price movements, and production changes within an economy.
Formally:
If the index value for a certain year is greater than 100, it indicates a rise compared to the base year.
If it is less than 100, it indicates a fall.
For example, suppose the price index of food items is 120 (base year = 100).
This means that food prices have increased by 20% compared to the base year.
If the index is 90, it implies a 10% fall in prices.
In essence:
- Base Year = The reference point (usually taken as 100).
- Current Year = The year whose value is being compared.
- Index Value = Indicates the percentage change in relation to the base year.
Thus, index numbers transform complex numerical data into simple percentage values that are easy to interpret and compare.
Illustration
An illustration can help explain the concept of index numbers. Take a look at how prices are expected to rise in 2019. In this situation, there are three basic questions.
- First, in comparison to which year did prices rise in 2019?
- Second, how to respond when certain products' prices increase more rapidly than others?
- Third, is there any standard unit or not in which the prices of different goods and services can be expressed? The price of milk can be expressed in terms of a rupee per litter, of cloth in terms of a rupee per meter, and sweets in terms of a rupee per kilogram.
All questions can be answered by studying index numbers.
- First, the rise in the prices in 2019 can be studied using the previous year, like 2015 or 2010 as the reference/base.
- Second, the index number suggests considering an average change. For example, if the price of potato rise from ₹100 to ₹200 and the price of onions rise from ₹100 to ₹300, then the average price is considered ₹250; i.e.,
\frac{200+300}{2}=\frac{500}{2} - Third, the index number suggests considering only the percentage change. Thus, the unit of commodity losses its relevance.
Characteristics of Index Numbers
The various features of Index Numbers are as follows:
Specialized Averages: To compare two or more series, averages like mean, median and mode can be used. But averages can not be used for comparison when series are composed of different types of items, or if two or more series are expressed in different units. Index numbers enable comparing changes in series.
Expressed in Percentages: The magnitude of a group's changes is expressed in terms of percentages, which are independent of the measurement units. It helps in figuring out how two or more index numbers compare in various circumstances. Although, the % sign is never used.
Assesses the impact of changes with respect to time or location: To compare changes over time, between places, and within categories, index numbers can be used. For example, the cost of living in two locations may differ at the same time, or the cost of living in one city can be compared over two time periods.
Measures the change that can not be measured directly: Its purpose is to examine changes in the effect of such factors that cannot be observed directly. For example, the cost of living can not be measured directly. We can only study relative changes by examining variations in some related external factors.
Steps in the Construction of an Index Number
Constructing an index number involves several systematic steps:
Step 1: Define the Purpose of the Index: The first step is to clearly define the objective for which the index number is to be constructed.
It could be to measure price changes, production levels, or cost of living. The purpose helps decide what type of data and method are to be used.
Step 2: Select a Base Year: A base year serves as the point of reference against which comparisons are made. It should be a normal year, free from abnormal events such as wars, natural disasters, or major economic fluctuations. The base year is generally assigned an index value of 100.
Step 3: Select Representative Items: It is not possible to include every item in an index, so representative items are chosen that reflect the general trend of the group.
For example, in a consumer price index, commonly used goods like food, clothing, and housing are selected.
Step 4: Collect and Organize Data: Accurate and comparable data for both the base year and the current year must be collected from reliable sources such as government records, trade journals, or surveys. Data should be in the same units and quality to ensure fair comparison.
Step 5: Choose an Appropriate Formula: Depending on the purpose and nature of data, a suitable mathematical formula is selected to compute the index. Common methods include the Simple Aggregate Method, Weighted Aggregate Method, and Average of Relatives Method.
Step 6: Assign Weights (if necessary): When the items vary in importance, weights are assigned to each item. Weights reflect how significant each item is in the overall group — for example, food items get higher weight in a cost-of-living index than luxury goods.
Step 7: Compute the Index Number: Finally, substitute the collected data and weights into the chosen formula to calculate the index value for the current period. The result indicates the percentage change from the base year (which is taken as 100).
Uses of Index Numbers
Practically, in all areas of economic activity, changes are measured using index numbers. It helps in recording changes in output, income, employment, business activities, productivity, etc.
Measurement and Comparison of Changes in the Price Level: It is not possible to measure changes in the price level of two variables in absolute terms; therefore, index numbers provide a relative measure to the changes in the magnitude of a group of variables. It can be used to know the influence of changes in the value of money on different sections of society. It is possible to solve the problem of inflation or deflation in the system.
Helps in Policy Formulation: An index number is an important tool for government or non-government organizations in the following ways:
In policy formulation, there is a need for a base or trend. With the index numbers, the trends of different phenomena can be studied.
It can also be utilized in the formulation and planning of government and business policies.
Acts as an Economic Barometer: A barometer is an instrument that is used to measure atmospheric pressure. It indicates fluctuations in the general conditions of a country and measures the pulse of the economy.
Helps in Studying Trade: Index numbers are useful in studying the trend of a series over a period of time. It helps in forecasting future trends which is crucial for any business or production activity's future operations. Besides, it also aids in determining patterns in exports, imports, prices, and several other occurrences. For example, If someone is planning on opening up a new business, then by studying the trend of price, wages, income, etc., in different industries will help the businessman in planning the future course of action for the business.
Measure Purchasing Power: Money's worth is determined by purchasing power, and purchasing power is determined by commodity prices. Index numbers help find the intrinsic value of money as contrasted with its nominal value. It helps in establishing the nation's wage policy. Besides, a change in the price of the commodity adversely affects the value of money. When the price level of a commodity rises, the purchasing power or value of money falls.
Helps in Deflating Various Values: With price index numbers, it becomes easy to adjust the monetary figures of the different periods for changes in the price. For example, a country's national income is calculated on the basis of the prices of the year mentioned in the question. However, the real change in the production level of goods and services cannot be revealed through the national income computed at the current year's price. To know the real change, first, we have to adjust the figures for the price changes in different years. Making adjustments is possible only by using price index numbers. Besides, in case of rise in prices, the process of adjustment is known as deflating.
Limitations of Index numbers
- Provides Relative Changes only: Index Numbers estimate relative changes only and cannot speak the truth as they are only approximate indicators. Besides, they represent the generalized truth based on the overall average of the items. Therefore, it does not apply to specific units.
- Lack of Perfect Accuracy: Index numbers do not consider every item and are based on the sample items. Thus, in case of an inadequate sample or a sample selected through a faulty process, there will be inaccurate results.
- Ignores Qualitative Changes: Index numbers do not pay any attention to the qualitative changes in the product while constructing the price or production. An increase in the price possibly results from the improvement in the quality of the product. But it is neglected in the index numbers.
- Possibility of Manipulations: Index numbers can be created in a way that allows for manipulation. This manipulation can be made in a selection of a particular base year, a particular group of commodities, a specific set of prices, etc.
- Difference between purpose and method of Construction: When the index numbers are created for a specific purpose using a specific methodology, they are not suitable for all situations and uses. If they are employed for other reasons, they are bound to produce incorrect conclusions.