1

TM 107
BUSINESS MATHEMATICS
CHAPTER 1-2:
Index Numbers
2
Objectives
To understand the concept of an index
number
To scale number series for comparative
purposes
To construct a Laspeyre Index
To construct a Paasche Index
To understand the Retail Prices Index
(RPI)
3
Topics
The Interpretation of an index number
The construction of index numbers
The weighting of index numbers
The Retail Prices Index
4
The Construction of Index Numbers
Index numbers best known for measuring the
change of prices over time
The Simple Price Index
The Simple Aggregate Price Index
The Average Price Relative Index
The Laspeyre Index
The Paasche Index
Other Indices
5
The Construction of Index Numbers
The Simple Price Index
Given by;
P
n
X 100
P
0

Where; P
n
= new price
P
0
= Base year price
(P
n
/P
0
) = Price Relative


6
The Construction of Index Numbers
Example
Given are the prices and consumption of tea,
coffee and chocolate drinks by a representative
individual in typical week.
Drinks Year 0 Year 1 Year 2
P Q P Q P Q
Tea 32 15 48 12 64 10
Coffee 60 3 68 3 72 4
Chocolate 88 1 92 3 96 5
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The Construction of Index Numbers
Example
Find the Simple Price Index for Tea with year 0 as the
base year.
Year Price P
n
/ P
0
Simple Price
Index
0 32 (32 / 32) = 1 100
1 48 (48 / 32) = 1.5 150
2 64 (64 / 32) = 2 200
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The Construction of Index Numbers
EXERCISE
Using the data given in slide 6,
i) Find a Simple Price Index for Coffee and
Chocolate with Year 0 as the base year.
ii) Find a Simple Price Index for Coffee and
Chocolate with Year 1 as the base year.

9
The Construction of Index Numbers
The Simple Aggregate Price Index
Include all items in basket of goods
Sum the prices year by year to construct
index.
Given by:
P
n
X 100
P
0

10
The Construction of Index Numbers
The Simple Aggregate Price Index
Example
Referring to the given table, construct Simple Aggregate
Price Index, using Year 0 as a base year.
Drinks P
0
P
1
P
2

Tea 12 20 36
Coffee 34 45 63
Chocolate 23 32 54
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The Construction of Index Numbers
Solution
Year P P
n

P
0

Simple
Aggregate
Price Index
0 69 (69 / 69) = 1 100
1 97 (97 / 69) = 1.41 141
2 153 (153 / 69) = 2.22 222
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The Construction of Index Numbers
EXERCISE
Using data from slide 6, construct the
Simple Aggregate Price Index, using:
i) Year 0 as the base year.
ii) Year 1 as the base year.
iii) Year 2 as the base year.
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The Construction of Index Numbers
The Average Price Relatives Index
To overcome units problem
Considering only the Price Ratio.
Assuming quantity is fixed all the time.
Given by
(1/k)(P
n
/P
0
) X 100
Where k = numbers of goods
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The Construction of Index Numbers
The Average Price Relatives Index
Example
Referring to the given table, construct Average Price
Relatives Index, using Year 0 as a base year.

Drinks P
0
P
1
P
2

Tea 12 20 36
Coffee 34 45 63
Chocolate 23 32 54
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The Construction of Index Numbers
Solution
Drinks P
0
P
1
P
2
P
1
/ P
0
P
2
/ P
0

Tea 12 20 36 1.67 3.00
Coffee 34 45 63 1.32 1.85
Chocolate 23 32 54 1.39 2.35
(P
n
/ P
0
) 4.38 7.20
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The Construction of Index Numbers
Solution

Year (1/k) (P
n
/ P
0
) Average Price
Relatives
Index
0 1.00 100
1 (1/3)(4.38)=1.46 146
2 (1/3)(7.20)=2.4 240
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The Construction of Index Numbers
EXERCISE
Using data from slide 6, construct the
Average Price Relatives Index.
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The Construction of Index Numbers
The Laspeyre Index
Uses of the quantities bought in the base year
to define typical basket.
Assuming that the quantities purchased will
remain the same and no substitution is
allowed.
Tends to overstate inflation.
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The Construction of Index Numbers
The Laspeyre Index
Given by
P
n
Q
0
X 100

P
0
Q
0
* P
0
Q
0
= cost of the base year basket of
goods in the base year
* P
n
Q
0
= cost of the base year basket of goods
in any year

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The Construction of Index Numbers
The Laspeyre Index
Example
Referring to the data from slide 6, Construct a
Lespeyre Index using Year 0 as the base
year.
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The Construction of Index Numbers
The Laspeyre Index
Solution
Drinks P
0
Q
0
P
1
P
2

Tea 32 15 48 64
Coffee 60 3 68 72
Chocolate 88 1 92 96
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The Construction of Index Numbers
The Laspeyre Index
Solution (Cont..)
Drinks P
0
Q
0
P
1
Q
0
P
2
Q
0

Tea 480 720 960
Coffee 180 204 216
Chocolate 88 92 96
PQ 748 1016 1272
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The Construction of Index Numbers
The Laspeyre Index
Solution (Cont..)
Year P
n
Q
0
/ P
0
Q
0
Laspeyre Index
0 1.00 100
1 1.36 136
3 1.70 170
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The Construction of Index Numbers
The Laspeyre Index
EXERCISE
Referring to the data from slide 6, Construct
a Lespeyre Index using Year 0 as the base
year, for;
A) Coffee and Chocolate.
B) Tea and Chocolate.

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The Construction of Index Numbers
The Paasche Index
Uses quantities bought in the current year for
typical basket.
Tends to understate Inflation
Difficult to compare between years
Current quantities is difficult or expensive to
obtain
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The Construction of Index Numbers
The Paasche Index
Given by
P
n
Q
n
X 100

P
0
Q
n
* P
0
Q
n
= cost of the year n basket of goods in
the base year price
* P
n
Q
n
= cost of the basket of goods in n year
and at n year price

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The Construction of Index Numbers
The Paasche Index
Example
Construct Paasche Index from the given data.
Drinks P
0
P
1
Q
1
P
2
Q
2

Tea 32 48 7 64 4
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The Construction of Index Numbers
Solution
Drinks P
0
Q
1
P
1
Q
1
P
0
Q
2
P
2
Q
2

Tea 224 336 128 256
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The Construction of Index Numbers
Solution
Year P
n
Q
n
/ P
0

Qn
Paasche Index
0 1.00 100
1 1.5 150
2 2.0 200
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The Construction of Index Numbers
The Paasche Index
EXERCISE
Referring to the data from slide 6, Construct
a Paasche Index, for;
A) Coffee and Chocolate.
B) Tea and Chocolate.
C) All the items in the Basket of Goods

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The Construction of Index Numbers
Other Indices
Laspeyre Quantity Index

100 X P
0
Q
n
P
0
Q
0

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The Construction of Index Numbers
Other Indices
Paasche Quantity Index

100 X P
n
Q
n
P
n
Q
0

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The Construction of Index Numbers
Other Indices
Value Index

100 X P
n
Q
n
P
0
Q
0