Index Numbers- meaning, uses & problems

1. What are Index Numbers ? Explain uses of Index No.s and discuss various problems faced in the construction of Index No.s. 

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What are Index Numbers ? Explain various problems faced in the construction of Index No.s .  

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Explain the uses of Index Numbers. What are the difficulties in the construction of Index Numbers ?

Ans. MEANING OF INDEX NO.s: Index Numbers is a statistical technique which helps us to measure (which measure) the relative changes in general price level. These are a specialized type of averages designed to measure the change in a group of related variables over a period of time. These are economic barometer of (economic activities of) the country because if one wants to have an idea as to what is happening in an economy, he should check the important indicators like the index number of industrial production, index number of business activity etc.

USES/UTILITY OF INDEX NO.S:  The main uses of Index No.s are the followings:

i) To Simplify Complexities: An index number makes possible the measurement of such complex changes whose direct measurement is not possible. In other words, index numbers are used to measure the changes in some quantity which we cannot observe directly.

ii) Helpful in the Fixation of salary and Dearness Allowances: By index numbers, government and other employees can properly make wage and salary fixation. They determine the instalment of dearness allowance for employees on the basis of index numbers only.

iii) Helpful in Prediction: Index Numbers give the knowledge as to what changes have occured in the past. On the basis of these changes alone, predictions about the future are made. Thus, index numbers are economic barometers.

iv) Helpful in Comparison: Index Numbers make possible the comparative study of phenomena (fact or event that can be observed). By index numbers, the relative changes occurring in the variables are determined. This simplifies the comparison of data on the basis of time and space.

v) To measure purchasing power of money: By index numbers, the changes taking place in purchasing power of money can also measured.

vi) Useful in Business: Index Numbers measures the changes taking place in the business world and prove very useful in making a comparative study of those changes e.g. sales, change in output and value etc. Thus, index numbers, for a businessman, function like a barometer.

PROBLEMS FACED IN THE CONSTRUCTION OF INDEX NO.S: The number of problems come up while constructing the index numbers. Some of them are as follows:

i) Purpose of Index Number: Index numbers are of many types as they are constructed for different purposes. A single index can not fulfil all the purposes. It is very essential to fix the purpose of index number, because selection of commodities, their prices, fixation of their weights etc., depend on the very purpose of index numbers. There can be many purposes of an index number- measurement of changes in retail prices or measurement of changes in wholesale prices etc.

ii) Selection of Items: Another important problem in the construction of index numbers is the selection of items. The following things should be considered while making a selection of items. (i) Only those items should be selected which represent the taste, habit, custom and needs of the related group of people, (ii) the selected items should be standardized and of classified feature, (iii) their quality too must be considered, (iv) the number of items should be enough and they should be of current quality, and (v) the selected items must be classified into groups and sub-groups.

iii) Selection of Prices: After making the Selection of items, the next arises the problem of selection of prices. Prices can be of both types– retail and wholesale. Whether wholesale or retail prices are to be used, the decision depends upon the purpose of index number.

iv) Selection of Base year: Another important problem in the construction of index numbers is related to the selection of base year. A base year has to be selected for making an index number. The year for which changes are to be determined, is known as base year. Index number of base year is always taken as 100. In selecting a base year, the following things are to be kept in mind.
a) Base year should be normal year and no unusual event like Earthquake, Flood, War etc. should have taken place in that year.
b) Base year should not be very far in past.
c) So far as possible, base year should be close to the current year.
d) Base year should not be too old or too distant.

v) Selection of Weights: The term weight refers to the relative importance of different items in the construction of index numbers. Another important problem in making of index numbers is to assign weights to different commodities or items. In fact, all commodities included in the construction of Index numbers do not have equal importance. Therefore, to have accurate results, commodities are assigned weights according to their importance. There are two ways of assigning weights: (i) Quantity, (ii) Value. Weights decided in the construction of index numbers should be logical, accurate and rational.

vi) Selection of an Average: Averages can be of several types. Theoretically, any average can be used but in practice, arithmetic mean and geometric mean are used. Geometric mean is considered to be best for the construction of index numbers as this is the most suitable for measuring relative changes but due to the difficulties of computation, in place of geometric mean, arithmetic mean is often used in the construction of index numbers.

vii) Selection of an Appropriate Formula: Various formulae can be used in the construction of index numbers but it is very essential to select the most suitable out of them. This selection depends upon the purpose of index number and availability of data. Fisher's formula, which is called as Fisher's Ideal Index, is considered to be the best.