An index number is a statistical derives to measure changes in the value of money. It is a number which represents the average price of a group of commodities at a particular time in relation to the average price of the same group of commodities at another time.
An index number expresses the average of all such diverse items in different units. Second, an index number measures the net increase or decrease of the average prices for the group under study. For instance, if the consumer price index has increased from 150 in 1982 as compared to 100 in 1980, it shows a net increase of 50 per cent in the prices of commodities included in the index. Third, an index number measures the extent of changes in the value of money (or price level) over a period of time, given a base period. If the base period is the year 1970, we can measure change in the average price level for the preceding and succeeding years.
Methods of Construction of Index Number:
In constructing an index number, the following steps should be noted:
1. Purpose of the Index Number:
Before constructing an index number, it should be decided the purpose for which it is needed. An index number constructed for one category or purpose cannot be used for others. A cost of living index of working classes cannot be used for farmers because the items entering into their consumption will be different.
2. Selection of Commodities:
Commodities to be selected depend upon the purpose or objective of the index number to be constructed. But the number of commodities should neither be too large nor too small.
Moreover, commodities to be selected must be broadly representative of the group of commodities. They should also be comparable in the sense that standard or graded items should be taken.
3. Selection of Prices:
The next step is to select the prices of these commodities. For this purpose, care should be taken to select prices from representative persons, places or journals or other sources. But they must be reliable. Prices may be quoted in money terms i.e. Rs. 100 per quintal or in quantity terms, i.e. 2 kg. per rupee. Care should be taken not to mix these prices. Then the problem is to select wholesale or retail prices. This depends on the type of index number. For a consumer price index, wholesale prices are required, while for a cost of living index, retail prices are needed. But different prices should not be mixed up.
4. Selection of an Average:
Since index numbers are averages, the problem is how to select an appropriate average. The two important averages are the arithmetic mean and geometric mean. The arithmetic mean is the simpler of the two. But geometric mean is more accurate. However, the average prices should be reduced to price relatives (percentages) either on the basis of the fixed base method or the chain base method.
5. Selection of Weights:
While constructing an index number due weightage or importance should be given to the various commodities. Commodities which are more important in the consumption of consumers should be given higher weightage than other commodities. The weights are determined with reference to the relative amounts of income spent on commodities by consumers. Weights may be given in terms of value or quantity.
6. Selection of the Base Period:
The selection of the base period is the most important step in the construction of an index number. It is a period against which comparisons are made. The base period should be normal and free from any unusual events such as war, famine, earthquake, drought, boom, etc. It should not be either very recent or remote.
7. Selection of Formula:
A number of formulas have been devised to construct an index number. But the selection of an appropriate formula depends upon the availability of data and purpose of the index number. No single formula may be used for all types of index numbers.