Question

Explain the steps involved in the construction of index numbers.

Define Index number and explain the various steps involved in the construction of index numbers

Answer 1

Index numbers are one of the most used statistical tools in economics. An index number is a device to measure changes in an economic variable (or group of variables) over a period of time.

The following steps are involved in the construction of index numbers:

1. Purpose of index number: The purpose for constructing the index number, its scope as well as which variable is intended to be measured should be clearly decided to achieve fruitful results.
2. Selection of the base year: The base year is also called the reference year. It is the year against which comparisons are made. The base year should be normal i.e. it should be free from natural calamities. It should not be too distant from the past.
3. Selection of items: It is necessary to select a sample of the number of items to be included in the construction of a particular index number. For example, in the construction of price index numbers, it is impossible to include each and every commodity. The commodities to be selected should represent the tastes, habits, and customs of the people. Besides this, only standardized or graded items should be included to give better results.
4. Selection of price quotations: Prices of the selected commodities may vary from place to place and shop to shop in the same market. Therefore, it is desirable that price quotations should be obtained from an unbiased price reporting agency. To achieve accuracy, a proper selection of representative places and persons is required.
5. Choice of a suitable average: The construction of index numbers requires the choice of a suitable average. Generally, the Arithmetic mean is used in the construction of index numbers because it is simple to compute compared to other averages.
6. Assigning proper weights: Weight refers to the relative importance of the different items in the construction of an index number. Weights are of two types i.e. quantity weights (q) and value weights (p × q). Since all items are not of equal importance, by assigning specific weights, better results can be achieved.
7. Selection of an appropriate formula: Various formulae are devised for the construction of index numbers. The choice of a suitable formula depends upon the purpose of the index number and the availability of data.