Difficulties or Problems in the Construction of Index Numbers

 

Difficulties or Problems in the Construction of Index Numbers

 (1) Purpose of Index Number: There are various types of index number constructed with different objectives. Before constructing an index number, one must define the objective. The construction of index number is significantly influenced by the objective or purpose of the study. Thus, for example, if the objective is to study the impact of change in the value of money on the consumers one should construct consumers' price index number. If we are to study the impact of change in the purchasing power of money on the producers, we shall construct index number on the basis of wholesale prices. Haberler has rightly pointed out that, "Different index numbers are constructed to fulfil different objective and before setting to construct a particular index number, one must clearly define one's object of study because, it is on the objective of the study, that the nature and format of the index number depends."

 

(2) Selection of Base Year: Selection of Base Year is another problem in the construction of index number. Base year is the reference year. It is the year with which prices of the current year are compared. As far as possible, Base Year should be a normal year. That is, it should be the one without much ups and downs. Otherwise, the index values would fail to capture the real change in the variable. The year 2004-05 is treated as base year in India, at present.

(3) Selection of Goods and Services: Having defined the objective, the problem is of the selection of goods or services to be included in the index number. To construct the Consumers' Price Index, for example, all commodities are not included. It is neither possible nor desirable to include all the goods and services produced in the country. We have to choose those goods and services which represent most of others in the market. In other words, commodities selected should be such as are widely consumed, for example, rice, milk, ghee, cloth, etc. Larger the number of goods and services more representative is the index number.

 

 (4) Selection of the Prices of the Goods and Services: Having selected the goods and services, the problem arises of prices to be selected. Broadly, in the construction of Price Index, the problem is whether to adopt retail prices or wholesale prices, controlled or open market prices. The choice would depend upon the objective or purpose of the study.

 

 (5) To Find Out the Average Prices: In the construction of index number, base year value is assumed to be 100 and other values of different years are related to 100. Thus, if cloth price is Rs 5 per metre in the base year and is found to be Rs 10 per metre in the current year, the index of prices of cloth would be 10/5*100 = 200 for the current year. Likewise, price relatives for other commodities are worked out and average for these price relatives is determined and compared with the base year value of 100. It may be noted here that average of base year remains 100, but the average of the year under investigation may be more or less than 100. In case the average of the year under investigation is more than the average of the base year, it means that general price level has gone up. If it is less than the base year, it means that general price level has gone down. Generally, base year is indicated as '0' and current year as '1'. Price index is written as P01, and it is read as price index of year 1 in relation year 0.

 

(6) Selection of Method of Weighting: In working out the average price, every care should be taken of the relative significance of different commodities. While constructing index number, weights are accorded to different commodities according to their relative significance. There are several methods of according weight, e.g., Fisher's method, Paasche's method, Laspeyre's method. While constructing weighted index number, one must justify his choice of weighting technique in accordance with the nature and objective of his study.

 

(7) Problem of Finding Average: In finding out average values, different kinds of average may be used, geometric average, arithmetic average, etc. The choice of average significantly influences the results. Different kinds of averages may give different index number of a given change in price.

 

 (8) Selection of Formula: Index numbers can be constructed with the help of many formulae, such as, Laspeyre's method, Paasche's method Dorbish and Bowley's method, Fisher's method. One has to decide about the method to be used while constructing the index number

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Difficulties or Problems in the Construction of Index Numbers | Index Numbers | 11th Commerce | by @statomics11comm

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