8/11/2022

Chapter 7
Index Numbers

Objectives
• Finishing this chapter, you should be able to:

Understand what are index numbers and

their applications

Calculate price indexes

Calculate quantity indexes

1
 8/11/2022

Outline
• What are index numbers and their applications
• Price indexes
• Simple price index
• Weighted price index
• Deflating a Series by Price Indexes
• Quantity indexes
• Simple quantity index
• Weighted quantity index

What are index numbers?

• Index numbers are time series that focus on the relative change in a count
or measurement over time.
• Index numbers express the count or measurement as a percentage of the
comparable count or measurement in a base period.
• An index number is a statistical value that measures the change in a
variable with respect to time
• Two variables often considered in this analysis are price and quantity

2
 8/11/2022

Base period
• A base period is a given starting point in time, chosen depending on economic
factors:
• it should be a ‘normal’ period with respect to the relevant index
• it is arbitrary but should be a convenient point of reference
• it should not be chosen too far in the past
• it may be a single period or an average of multiple adjacent periods
• The base period for most indexes is adjusted periodically to a more recent period
of time.
→The value of an index number corresponding to the base period is always 100.

Applications of Index Numbers in

Business and Economics
 Used to compare:
• Prices or Quantities
 Can be utilised as:
• some measure of the change in things such as ‘the cost of goods and
services’

3
 8/11/2022

Price indexes
• A price index shows the change in the price of a commodity or group of
commodities over time.

• Simple Price Index

• Aggregate Price Indexes

Simple Price Index

• Simple price indexes (or price relatives) are helpful in understanding and
interpreting changing economic and business conditions over time.
• A simple price index shows how the current price per unit for a given item
compares to a base period price per unit for the same item.
• A simple price index expresses the unit price in each period as a
percentage of the unit price in the base period.

4
 8/11/2022

Simple Price Index

• Simple price index in period t, denoted by 𝑖
𝒑𝒕
𝒊𝒑𝒕 𝟏𝟎𝟎
𝒑𝟎
Where: 𝑝 is the price per unit for a given item in period t
𝑝 is the price per unit for a given item in base period

Simple Price Index

• The simple price index finds the percentage change in the price of an item
from one period to another.
• If the simple price index is more than 100, subtract 100 from the simple
price index. The result is the percentage increase in price from the
base period to the current period.
• If the simple price index is less than 100 subtract the simple price index
from 100. The result is the percentage by which the item cost less in
the base period than it does in the current period.

10

5
 8/11/2022

Simple Price Index

• E.g. The prices Best paid for newspaper and television ads in 2009 and
2019 are shown below. Using 2009 as the base year, compute a 2019
simple price index for newspaper and television ad prices.

2009 2019
Newspaper $14,794 $29,412
Television $11,469 $23,904

11

Simple Price Index

Newspaper Television

, ,
𝑖 (100) = 199 𝑖 (100) = 208
, ,

Television advertising cost increased at a greater rate.

12

6
 8/11/2022

Aggregate Price Indexes

• An aggregate price index is developed for the specific purpose of
measuring the combined change of a group of items.
• Includes:
• unweighted aggregate price index
• weighted aggregate price index

13

Unweighted aggregate price index

• An unweighted aggregate price index in period t, denoted by It, is given
by
∑𝑃
𝐼 100
∑𝑃
where
Pit = unit price for item i in period t
Pi0 = unit price for item i in the base period

14

7
 8/11/2022

Weighted Aggregate Price Index

• With a weighted aggregate index, each item in the group is weighted
according to its importance, which typically is the quantity of usage.
• Letting Qi is quantity for item i, the weighted aggregate price index in
period t is given by
∑𝑃 𝑄
𝐼 100
∑𝑃 𝑄
where the sums are over all items in the group

15

Weighted aggregate Price Indexes

• E.g. Dina Evers is pleased with her lovely lawn, but she is concern about the
increasing cost of maintaining it. The cost includes mowing, fertilizing, watering,
and more.
• Dina wants an index that measures the change in the overall cost of her lawn
care. Price and quantity data for her annual lawn expenses are listed as follow.
Unit Price ($)
Item Quantity (Units)
2010 2019
Mowing 32 57.00 79.00
Leaf Removal 3 56.00 71.00
Watering (1000s gal.) 40 1.83 2.78
Fertilizing 2 56.00 67.00
Sprinkler Repair 1 109.00 128.00

16

8
 8/11/2022

Weighted aggregate Price Indexes

• Unweighted Aggregate Price Index
79.00 71.00 2.78 67.00 128.00
𝐼 100 124
57.00 56.00 1.83 56.00 109.00
Annual lawn care expenses increased 24% from 2010 to 2019.
• Weighted Aggregate Price Index (Fixed Quantity)
. . . . .
𝐼 100 136
. . . . .

Annual lawn care expenses increased 36% from 2010 to 2019.

17

Weighted Aggregate Price Index

• Special case of the fixed quantity index, when the fixed quantity weights are
determined from the base-year usage, the index is called a Laspeyres index.
∑𝑃 𝑄
𝐼 100
∑𝑃 𝑄

• When the weights are based on period t usage, the index is a Paasche index.
∑𝑃 𝑄
𝐼 100
∑𝑃 𝑄

18

9
 8/11/2022

Weighted aggregate Price Indexes

• E.g. Data on energy consumption and expenditures by sector for the city of
Rockdale are given on the table. Construct an aggregate price index for
energy expenditures in 2019 using 2003 as the base year.

Quantity (BTU) Unit Price ($/BTU)

Sector
2003 2019 2003 2019
Residential 9,473 8,804 2.12 10.92
Commercial 5,416 6,015 1.97 11.32
Industrial 21,287 17,832 0.79 5.13
Transportation 15,293 20,262 2.32 6.16

19

Weighted aggregate Price Indexes

• Weighted Aggregate Price Index (Laspeyres Method)
10.92 9,473 ⋯ 6.16 15,293
𝐼 100 443
2.12 9,473 ⋯ 2.32 15,293
• Weighted Aggregate Price Index (Paasche Method)
10.92 8,804 ⋯ 6.16 20,262
𝐼 100 415
2.12 8,804 ⋯ 2.32 20,262
→The Paasche value being less than the Laspeyres indicates usage has
increased faster in the lower-priced sectors.

20

10
 8/11/2022

Laspeyres versus Paasche Index

When is Laspeyres most appropriate and when is Paasche the better choice?
• Laspeyres
• Advantages: Requires quantity data from only the base period. This allows a more
meaningful comparison over time. The changes in the index can be attributed to
changes in the price.
• Disadvantages: Does not reflect changes in buying patterns over time. Also, it may
overweight goods whose prices increase.
• Paasche
• Advantages: Because it uses quantities from the current period, it reflects current
buying habits.
• Disadvantages: It requires quantity data for the current year. Because different
quantities are used each year, it is impossible to attribute changes in the index to
changes in price alone. It tends to overweight the goods whose prices have declined.
It requires the prices to be recomputed each year.

21

Weighted Aggregate Price Index

• The weighted aggregate price index in period t:
𝑃
∑𝑃 𝑄 ∑ .𝑃 𝑄 ∑𝑖 .𝑤
𝑃
𝐼 100
∑𝑃 𝑄 ∑𝑃 𝑄 ∑𝑤

where: 𝑤 𝑃 𝑄 is the weight applied to the price relative for item i.

22

11
 8/11/2022

Weighted aggregate Price Indexes

• E.g. Dina Evers

Unit Price ($) Simple price

Item
2010 2019 index (ip)
Mowing 57.00 79.00 138.6
Leaf Removal 56.00 71.00 126.8
Watering (1000s gal.) 1.83 2.78 151.9
Fertilizing 56.00 67.00 119.6
Sprinkler Repair 109.00 128.00 117.4

The 10-year increases in unit price ranged from a low of 17.4% for
sprinkler repair to a high of 51.9% for water.

23

Weighted aggregate Price Indexes

Simple Base Weighted
Quantity Weight Price
Item price price ($) Relative
(Qi) (wi=Pi0Qi)
index (ipi) (Pi0) (ipiwi)
Mowing 138.6 57.00 32 1824.0 252806.4
Leaf Removal 126.8 56.00 3 168.0 21302.4
Watering (1000s gal.) 151.9 1.83 40 73.2 11119.08
Fertilizing 119.6 56.00 2 112.0 13395.2
Sprinkler Repair 117.4 109.00 1 109.0 12796.6
Sum 2286.2 311419.7

∑ ∑ This value is the same as the one 
, .
𝐼 ∑ ∑
=  136 identified by the weighted aggregate 
, .
index computation.

24

12
 8/11/2022

Some Important Price Indexes

• Consumer Price Index (CPI): A weighted aggregate price index used to reflect
the overall change in the cost of goods and services purchased by a typical
consumer.
• Weighted aggregate price index with fixed weights derived from a usage survey.
• Published monthly by the General Statistics Office of Vietnam
• Applications:
• Indicator of rate of inflation
• Used to adjust wages to compensate for lost purchasing power due to
inflation
• Used to convert a price or wage to a real price or real wage to show the
equivalent amount in a base period after adjusting for inflation.

25

Some Important Price Indexes

• Producer Price Index (PPI): Measures the monthly changes in prices in
primary markets.
• Used as a leading indicator of the future trend of consumer prices and the
cost of living.
• Covers raw, manufactured, and processed goods at each level of
processing.
• PPI is a weighted average of price relatives using the Laspeyres method.
• Published monthly by the General Statistics Office of Vietnam

26

13
 8/11/2022

Some Important Price Indexes

• Vn-Index: designed to show price trends and movements on the
Hochiminh Stock Exchange.
• Vn-index is a weighted average of price relatives using the Paasche
method

27

Deflating a Series by Price Indexes

• In order to correctly interpret business activity over time when it is
expressed in currency unit amounts, we should adjust the data for the
price-increase effect.
• Removing the price-increase effect from a time series is called deflating
the series.

28

14
 8/11/2022

Deflating a Series by Price Indexes

• Deflating actual wages results in real wages or the purchasing power of wages.
100
𝑅𝑒𝑎𝑙 𝑤𝑎𝑔𝑒 𝑖𝑛 𝑝𝑒𝑟𝑖𝑜𝑑 𝑡 𝑊𝑎𝑔𝑒 𝑖𝑛 𝑝𝑒𝑟𝑖𝑜𝑑 𝑡
𝐶𝑃𝐼 𝑖𝑛 𝑝𝑒𝑟𝑖𝑜𝑑 𝑡

• Real wages are a better measure of purchasing power than actual wages.
Indeed, many union contracts call for wages to be adjusted in accordance with
changes in the cost of living.

29

Deflating a Series by Price Indexes

• E.g. McNeer Cleaners, with 46 branch locations, has had the total sales
revenues shown on the table for the last five years. Deflate the sales
revenue figures on the basis of 2011 constant dollars. Is the increase in
sales due entirely to the price-increase effect?

Year Total Sales ($1000) CPI

2015 8,446 218.1
2016 9,062 224.9
2017 9,830 229.6
2018 10,724 233.0
2019 11,690 236.7

30

15
 8/11/2022

Deflating a Series by Price Indexes

• Adjusting Revenue For the Price-Increase Effect
Year Total Sales CPI Deflated Annual
($1000) Sales Change (%)
($1000)
2015 8,446 218.1 3872.5
2016 9,062 224.9 4029.3 4.05
2017 9,830 229.6 4281.4 6.25
2018 10,724 233.0 4602.6 7.50
2019 11,690 236.7 4938.7 7.30

After adjusting, revenue is still increasing at an average rate of 6.3%

per year.
31

Price Indexes: Other Considerations

Selection of Items
• When the class of items is very large, a representative group (usually not a
random sample) must be used.
• The group of items in the aggregate index must be periodically reviewed and
revised if it is not representative of the class of items in mind.
Quality Changes
• A basic assumption of a price index is that prices over time are identified for the
same item.
• Is a product that has undergone a major quality change the same product it was?
• An increase in an item’s quality may or may not result in a price increase… and a
decrease in quality may or may not result in a price decrease.

32

16
 8/11/2022

Quantity indexes
• A quantity index shows the change in quantity of a commodity or group of
commodities used or purchased over time.
• Simple Quantity Index

• Aggregate Quantity Indexes

33

Simple Quantity Index

• A simple quantity index shows how the current quantity level for a single
item compares to a base period quantity level for the same item.

• Simple quantity index in period t, denoted by 𝑖

𝒒𝒕
𝒊𝒒𝒕 𝟏𝟎𝟎
𝒒𝟎
Where: 𝑞 is the quantity level for a given item in period t
𝑞 is the quantity level for a given item in base period

34

17
 8/11/2022

Aggregate Quantity Indexes

• An aggregate quantity index is developed for measuring the combined
change of quantity of a group of items.
• Includes:
• unweighted aggregate quantity index
• weighted aggregate quantity index

35

Unweighted aggregate quantity index

• Unweighted aggregate quantity index

∑𝑄
𝐼 100
∑𝑄

where: Qit = quantity for item i in period t

Qi0 = quantity for item i in the base period

36

18
 8/11/2022

Weighted aggregate quantity index

• Weight (Fixed Price)
∑𝑄 𝑃
𝐼 100
∑𝑄 𝑃
• Weighted (Base-Period Price) (Laspeyres method)
∑𝑄 𝑃
𝐼 100
∑𝑄 𝑃
• Weighted (Period t Price) (Paasche method)
∑𝑄 𝑃
𝐼 100
∑𝑄 𝑃

37

Quantity indexes
• E.g. Appliance Mart reports the 2010 and 2019 sales for three major
kitchen appliances as shown below. Compute quantity relatives and use
them to develop a weighted aggregate quantity index for 2019.

Kitchen Sales (Units) Sales Price

Appliance 2010 2019 (2010) ($)
Dishwasher 720 950 325
Range 540 610 450
Refrigerator 980 1110 710

Calculate quantity indexes.

38

19
 8/11/2022

Summary
• Introduced index numbers and their applications
• Described how to calculate price indexes in different cases
• Described how to calculate quantity indexes in different cases
• Discussed some important price indexes

39

20