Index Numbers in Economics

Index Numbers In Economics

Index numbers in economics are statistical numbers often described in percentages to measure changes over time. It is also used to compare a given situation to a defined initial point known as the standard or the base value. It makes statistical analysis quick and easy. Index numbers in statistics make it possible to determine growth or observe decline at one glance.

For example, if the price of onion per kilogram from the years 2014 to 2021 has increased by an index number of 150, it implies that there has been a 50% inflation in the price of onion per kilogram. Here, 2014 is the base year of comparison, and the value assigned to it is 100. All base values are assigned an index number of 100. Similarly, if the index number for price change were to be 85, it would mean that the price has decreased by 15%. 

Another way of expressing index numbers is ratio because it is always said in comparison to the base value. For example, if the use of a commodity in 2018 has decreased by half since 2000, the index number relative to 2000 would be 50. 

It is common in economics, statistics, and mathematics to use index numbers to analyze average change over time and arrive at meaningful conclusions between two situations.

Types of Index Numbers

1. Consumer price index or cost of living index numbers:

For any national economy, it is important to monitor the change in the cost of living price index or the consumer price index. This index number considers the mean change in retail prices of amenities consumed by a reference consumer category such as the common man. Hence, based on the cost of a living index number, employees’ salaries or wages are adjusted to meet the changing prices of necessary commodities in the market. 

2. Wholesale price index

The wholesale price index is constructed using the wholesale prices of raw materials or semi-finished products usually sold in wholesale markets. It accounts for the change in the general price level over some time. The weight or importance of each commodity varies depending on its demand. The wholesale price index measures the worth of money in the market. As this index does not consider the selling price of the product paid by an ordinary man and only accounts for the wholesale price, it is not a correct way to evaluate the value of money.

3. Index of industrial production

The industrial index has been constructed to measure the changes in production at the industrial level. Production data from multiple industries are added. The base year for calculation changes quickly to consider the wide variety of products that start to and seize to manufacture every year. It tries to account for quantity relatives. The Laspeyres formula is used to calculate the industrial index as the qubase year quantities are taken for calculation on the index number. 

4. Human Development Index

The Human Development Index (HDI) measures key aspects of human development to assess the result of a country. It moves beyond economic growth. “The Human Development Index (HDI) is a summary measure of average achievement in key dimensions of human development: a long and healthy life, being knowledgeable and having a decent standard of living.” (Human Development Index (HDI) | Human Development Reports, 2020)

How to Calculate Index Numbers in Economics?

There are two ways to construct index numbers in statistics: The aggregative and Averaging relatives methods.

1. Aggregative method of calculating index numbers

The aggregative method is commonly used to calculate the price index. In this method, the index number (P) = the sum of all the values of all the commodities in the current year (P1) divided by the sum of all the values of the same commodities in the base year (P0) and multiplied by 100. 

The formula for Simple Aggregative price index: 

P01=Σp1/ Σp0x100

Where P01= Current price Index number

 Σp1 = the total of commodity prices in the current year 

Σp0 = the total of the same commodity prices in the base year. 

However, there is a limitation to using the aggregative method to calculate the index numbers in economics. Across a time frame, the quantities of purchased goods change. Hence, if a particular commodity A is bought more than commodity B, the overall change in the index number is affected by this difference in the “weights” of goods. The simple aggregative price index calculates only the “unweighted” index number wherein all commodities are assumed equal weight or importance. 

The formula to calculate the weighted aggregative price index or Laspeyre’s price index considers the relative importance of all commodities in terms of the quantity (q0) of that product from the base year. The resultant index number answers how much the price has changed from the base year to the selected year if the same quantities were bought as before.

Alternatively, Paasche’s price index is calculated by exchanging q0 with quantities bought in the selected year (q1) to see how much price has changed with current quantity consumption since the base year.

1. Averaging relatives method of calculating index numbers

In cases when the number(n) of commodities is high, averaging relatives method is used to calculate index numbers in economics.

Another kind of price relative index is a weighted relative index wherein weights are the percentage of expenditure done on a given commodity during the base period or current period, using the different formulae. 

Conclusion

Index numbers in economics are usually expressed in percentages that assess change in a group of variables between two given situations: base value and current chosen values. There are four main index numbers in economics – consumer price index or cost of living index, industrial index, wholesale price index, and human development index. There are two key ways to construct an index number: the aggregating method and the averaging method. Index numbers make concluding changes in the economy straightforward.