Index Numbers

Chapter 15

McGraw-Hill/Irwin

The McGraw-Hill Companies, Inc. 2008

GOALS

Describe the term index.

Understand the difference between a weighted and
an unweighted index.
Construct and interpret a Laspeyres price index.
Construct and interpret a Paasche price index.
Construct and interpret a value index.
Explain how the Consumer Price Index is
constructed and interpreted.

Index Numbers
An index number measures the
relative change in price, quantity,
value, or some other item of
interest from one time period to
another.
A simple index number measures
the relative change in just one
variable.

Index Number Example 1

According to the Bureau of Labor Statistics, in January
1995 the average hourly earnings of production
workers was $11.47. In June 2005 it was $16.07.
What is the index of hourly earnings of production
workers for June 2005 based on January 1995?

Index Number Example 2

An index can also compare one item with another.
Example: The population of the Canadian province of
British Columbia in 2004 was 4,196,400 and for
Ontario it was 12,392,700. What is the population
index of British Columbia compared to Ontario?

Index Number Example 3

The following Excel output
shows the number of
passengers (in millions)
for the five largest
airports in the United
States in 2004.
What is the index for
Atlanta, Chicago, Los
Angeles, and Dallas/Ft.
Worth compared to
Denver?

Index Number Example 3 (cont.)

Why Convert Data to Indexes?

An index is a convenient way to express a change in a diverse

group of items.

Converting data to indexes also makes it easier to assess the

trend in a series composed of exceptionally large numbers.

The Consumer Price Index (CPI), for example, encompasses

about 400 itemsincluding golf balls, lawn mowers, hamburgers,
funeral services, and dentists fees. Prices are expressed in dollars
per pound, box, yard, and many other different units. Only by
converting the prices of these many diverse goods and services to
one index number can the federal government and others
concerned with inflation keep informed of the overall movement of
consumer prices.

For example, total U.S. retail sales for the month of July 2005 were
$357,013,000. For July 2004, the total retail sales were
$323,604,000. This increase of $33,409,000 appears significant.
Yet if the July 2005 retail sales are expressed as an index based
on July 2004 retail sales the increase is 10.3 percent.

Indexes

In many situations we wish to combine several items

and develop an index to compare the cost of this
aggregation of items in two different time periods.

For example, we might be interested in an index for items that

relate to the expense of operating and maintaining an automobile.
The items in the index might include tires, oil changes, and
gasoline prices.
Or we might be interested in a college student index. This index
might include the cost of books, tuition, housing, meals, and
entertainment.

There are several ways we can combine the items to

determine the index.

Indexes

Unweighted Indexes

Weighted Indexes

Lespeyres Price Index

Paasche Price Index

Fishers Price Index

Value Index
Special Purpose Index

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Simple Average of the Price Indexes

Simple Aggregate Index

Consumer Price Index

Producer Price Index
S&P Index

Unweighted Indexes

11

Laspeyres versus Paasche Index

When is Laspeyres most appropriate and when is Paasche the
better choice?
Laspeyres

Paasche

12

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.
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.

Simple Average - Example

13

Simple Aggregate Index Example

14

Weighted Indexes

15

Lespeyres Index - Example

16

Lespeyres Index - Example

p0

q0

p0q
0

17

pt

q0

ptq0

Paasche Index - Example

18

Paasche Index - Example

p0

19

qt

p0qt

pt

qt

ptqt

Fishers Ideal Index

20

Laspeyres index tends to overweight goods whose

prices have increased. Paasches index, on the other
hand, tends to overweight goods whose prices have
gone down.
Fishers ideal index was developed in an attempt
to offset these shortcomings.
It is the geometric mean of the Laspeyres and
Paasche indexes.

Fishers Ideal Index - Example

Determine Fishers ideal index for the data in Table 153.

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Value Index

22

A value index measures changes in both the price

and quantities involved.
A value index, such as the index of department store
sales, needs the original base-year prices, the
original base-year quantities, the present-year
prices, and the present year quantities for its
construction.
Its formula is:

Value Index - Example

The prices and quantities sold at the Waleska Clothing Emporium
for various items of apparel for May 2000 and May 2005 are:

What is the index of value for May 2005 using May 2000 as the base period?
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Value Index - Example

24

Consumer Price Index

The U.S. Bureau of Labor Statistics reports this index monthly. It
describes the changes in prices from one period to another for a
market basket of goods and services.

25

Producers Price Index

26

Formerly called the Wholesale Price Index, it dates back to 1890 and is
also published by the U.S. Bureau of Labor Statistics.
It reflects the prices of over 3,400 commodities. Price data are collected
from the sellers of the commodities, and it usually refers to the first largevolume transaction for each commodity. It is a Laspeyres-type index.

Dow Jones Industrial Average (DJIA)

27

DJIA is an index of stock prices, but

perhaps it would be better to say it is
an indicator rather than an index.
It is supposed to be the mean price of
30 specific industrial stocks.
However, summing the 30 stock prices
and dividing by 30 does not calculate
its value. This is because of stock
splits, mergers, and stocks being
added or dropped.
When changes occur, adjustments are
made in the denominator used with the
average.

28

CPI Uses

29

It allows consumers to determine the effect of

price increases on their purchasing power.
It is a yardstick for revising wages, pensions,
alimony payments, etc.
It is an economic indicator of the rate of
inflation in the United States.
It computes real income: real income =
money income/CPI X (100)

CPI Uses - Formulas

30

End of Chapter 15

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