Issues in the Construction of an Index Number
While constructing an index number we should keep the following things in mind:
Clarity of Purpose
The purpose of calculation of the index needs to be clear. For example, the Wholesale price Index of four wheelers will be of no use to a farmer producing sugarcane. He will be more interested in the Agricultural Production Index of his crop.
Choice of commodities
The number and types of commodities to be included in the construction of an index number depend on the particular problem at hand, economy and ease of calculations.
The commodities included in the calculation of the index should be relevant to the purpose. All items are not equally important for different groups of consumers. For example, the rise in price of silk may not directly impact the living condition of the poor manual labourers. Hence the items to be incorporated in any index have to be selected carefully to be as representative as possible.
Selection of Base Period
- The base date must be "normal" in the sense that the data chosen should not be from any abnormal situations such as natural calamities, war,etc.
- It should not be too back-dated as the patterns of trade, imports or consumer preferences may vary considerably if the time-span is too long.
- For indices dealing with economic data, the base period should have some economic significance.
Choice of a Suitable Average
An index number is basically the result of averaging a series of data. There are, however, several methods of averaging namely arithmetic mean, mode, median, geometric mean and harmonic mean.
The choice of the formula also depends on the nature of question to be studied. The only difference between the Laspeyres' index and Paasche's index is the weights used in these formulae.
Collection of Data
The reliability of the index depends upon the unbiasedness of the data collected. Data of poor reliability will give misleading results. Therefore, utmost care should be taken in the collection of data.
Index numbers in economics
The commonly used index numbers like Wholesale price index number (WPI), consumer price index number (CPI) and industrial production index (IIP) play a big role in policy making and budgeting.
- Consumer index number (CPI) or cost of living index numbers are instrumental in negotiation of wages , formulation of income policy, price policy, rent control, taxation and general economic policy formulation.
- The wholesale price index (WPI) is used to remove the effect of changes in prices on aggregates such as national income, capital formation etc.
- The WPI is extensively used to measure the rate of inflation. Inflation is an increase in the price of a basket of goods and services that is representative of the economy as a whole.
The weekly inflation rate is given by
- CPI is used to calculate the buying power of money and real wages.
- IPI gives us an idea about the change in production in the industrial sector.
- API provides us a benchmark for the performance of agricultural sector.
- Sensex is a useful guide for investors in the stock market for an appropriate time and strategy for investment. If the sensex is rising, investors are optimistic of the performance of the economy.
Where can we get these index numbers?
Some of the widely used index numbers namely WPI, CPI, Index Number of Yield of Principal Crops, Index of Industrial Production, Index of Foreign Trade are routinely published in the Economic Survey, an annual publication of the Government of India.