ECONOMICS-VI

ASSIGNMENT
ON

LASPEYER’S, PAASCHE’S AND

FISHER’S INDEX NUMBERS,
LIMITATION OF INDEX NUMBERS

SUBMITTED TO:
Mr. Hari Chand Thakur
SUBMITTED BY:
Kush Goel
ROLL NO. - 18
B.A. LL.B (HONS.)

6TH SEMESTER
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INTRODUCTION:
An index number is a statistical device for comparing the general level of
magnitude of a group of related variables in two or more situation. If we want to
compare the price level of 2000 with what it was in 1990, we shall have to
consider a group of variables such as price of wheat, rice, vegetables, cloth, house
rent etc., if the changes are in the same ratio and the same direction; we face no
difficulty to find out the general price level. But practically, if we think changes in
different variables are different and that too, upward or downward, then the price
is quoted in different units i.e milk for litre, rice or wheat for kilogram, rent for
square feet, etc
We want one figure to indicate the changes of different commodities as a whole.
This is called an Index number. Index Number is a number which indicate the
changes in magnitudes. M. Spiegel says, “An index number is a statistical measure
designed to show changes in variable or a group of related variables with respect
to time, geographic location or other characteristic”. In general, index numbers are
used to measure changes over time in magnitude which are not capable of direct
measurement.

WEIGHTED AGGREGATE INDEX NUMBERS:

In order to attribute appropriate importance to each of the items used in an

aggregate index number some reasonable weights must be used. There are
various methods of assigning weights and consequently a large number of
formulae for constructing index numbers have been devised of which some of
the most important ones are:

1. Laspeyre’s method
2. Paasche’s method
3. Fisher’s ideal method

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LASPEYRE’S METHOD:

This method proposed by German economist Étienne Laspeyres (1834–1913) for

measuring current prices or quantities in relation to those of a selected base period.
A Laspeyres’ price index is computed by taking the ratio of the total cost of
purchasing a specified group of commodities at current prices to the cost of that
same group at base-period prices and multiplying by 100. The distinctive feature
of the Laspeyres index is that it uses a group of commodities purchased in the base
period as the basis for comparison. In other words, in computing the index, a
commodity’s relative price (the ratio of the current price to the base- period price)
is weighted by the commodity’s relative importance to all purchases during the
base period.

The Laspeyres price index is a weighted aggregate price index, where the
weights are determined by quantities in the based period and is given by

Where,
P0 = Price for the
base year P1 =
Price for the
current year
q0 = Quantity for the base year

PAASCHE’S MEHOD:
This method was developed by German economist Hermann Paasche for
measuring current price or quantity levels relative to those of a selected base
period. It differs from the Laspeyres index in that it uses current-period
weighting. The index is a ratio that compares the total purchase cost of a
specified bundle of current-period commodities (commodities valued at current

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prices) with the value of those same commodities at base-period prices; this ratio
is multiplied by 100. The Paasche price index tends to understate price increases,
since it already reflects some of the changes in consumption patterns that occur
when consumers respond to price increases-i.e. increased consumption of goods
will indicate reduced relative prices.
The Paasche’s price index is a weighted aggregate price index in which the weight
is determined by the quantities in the current year. The formulae for constructing
the index is

Where
P0 = Price for the
base year P1 =
Price for the
current year

q0 = Quantity for the

base year q1 =
Quantity for the
current year

In general this formula answers the question: “What would be the Value of the
given period list of goods when valued at base-period prices?"

The difficulty in computing the Paasche index in practice is that revised weights
or quantities must be computed each year or each period adding to the data
collection expense in the preparation of the index. For this reason the Paasche
index is not used frequently in practice where the number (if commodities are
large).

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Laspeyres index measures change in a “fixed market basket” of goods and
services. The same quantities are used in each period. The Paasche index
continually updates the quantities to the levels of current consumption. These two
approaches tend to produce opposite extremes in index values computed from the
same data. From a practical point of view, Laspeyres index is often preferred to
Paasche’s for the simple reason that in Laspeyres index weights (q0) are the base
year quantities and do not change from one period to the next. On the other hand,
the use of Paasche index requires the continuous use of new quantity weights for
each period considered and in most cases these weights are difficult and expensive
to obtain. In most countries index numbers are constructed by using Laspeyres
formula. An interesting property of Laspeyres and Paasche indices is that the
former is generally expected to overestimate or to leave an upward bias whereas
the latter tends to underestimate i.e. shows a downward bias.

When the prices increase there is usually a reduction in the consumption of those
items for which the increase has been the most pronounced and hence, by using
base year quantities we will be giving too much weight to the prices that have
increased the most and the numerator of the Laspeyres index will be too large.
When the prices go down, consumers often shift their preference to those items
which have declined the most and, hence by using base period weights in the
numerator of the Laspeyres index we shall not be giving sufficient weight to the
prices that have gone down the most and the numerator will again be too large.
Similarly because people tend to spend less on goods when their prices are rising
the use of the Paasche or current weighing produces an index which tends to
underestimate the rise in prices, i.e., it has a downward bias. But the above
arguments do not imply that Laspeyres index must necessarily be larger than
Paasche’s.

FISHER’S IDEAL METHOD:

The Fisher Price Index, also called the Fisher’s Ideal Price Index, is a consumer
price index (CPI) used to measure the price level of goods and services over a
given period. The Fisher Price Index is a geometric average of the Laspeyres Price
Index and the Paasche Price Index. It is deemed the “ideal” price index as it

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corrects the positive price bias in the Laspeyres Price Index and the negative price
bias in the Paasche Price Index.
Fisher’s Price index number is the geometric mean of the Laspeyres and Paasche
indices symbolically
Fisher’s ideal index number

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Where
P0 = Price for the
base year P1 =
Price for the
current year

q0 = Quantity for the

base year q1 =
Quantity for the
current year

It is known as ideal index number because

(a) It is based on the geometric mean
(b) It is based on the current year as well as the base year
(c) It conform certain tests of consistency
(d) It is free from bias.

CALCULATE PRICE INDEX:

2007 2008

Com P0 q0 P1 q1 P1q0 P0q0 P1q1 P0q1

moditi es

A 20 8 40 6 320 160 240 120

B 50 10 60 5 600 500 300 150
C 40 15 50 10 750 600 500 400
D 20 20 20 15 400 400 300 300

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Com P0 q0 P1 q1 P1q0 P0q0 P1q1 P0q1
moditi es

2070 1660 1340 1070

According to LASPEYRE’S METHOD

= (2070/1660)*100
= 124.69

According to PAASCHE’S METHOD

= (1340/ 1070) * 100

= 125.23

According to FISHER’S IDEAL METHOD

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=

= 1.249 * 100
= 124.9

LIMITATIONS OF INDEX NUMBERS:

No doubt index numbers are considered to be economic barometers. yet it
has certain limitations.

1. Limited Use-
Index numbers are constructed with a specific objective. If these are used
for any other purpose, they will lead to wrong conclusions.

2. Not a true indicator-

Index numbers are averages. They show approximate changes in prices and not the
real variations.

3. Non-comparable-
International and inter regional comparison of index numbers is not possible.
Therefore, they are of little use for comparing inter-regional communities.

4. Possibility of manipulations-
There is no scientific method of allotting weights to different items. It becomes
easier for investigator to manipulate the results.

5. Excessively based on samples-

Index numbers are heavily based on different types of sample like family budget
enquiry, price quotations etc. It samples are not true representative. the results
may be misleading.

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5. Use of different methods-
Index numbers can be constructed by using different methods. Their results will
also show variation and pose the problem of comparison.

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