There are three major issues which may be faced in the construction of index numbers. They are:
1) Collection of Data; 2) Selection of Base Year and 3) Selection of Appropriate Index.
Let us discuss them in detail:
1) Collection of Data: Data collection through a sample method is one of the issues in the construction of index numbers. The data has to be as reliable, adequate, accurate, comparable, and representative, as possible. Here a large number of questions need to be answered. The answers ultimately depend on the purpose and individual judgement. For example, one needs to decide the following:
i) Identification of Commodities to be Included: How many and which category of commodities to include? A large number of items may be present. It is not possible to include all of them, only those items deserve to be included in the construction of an index number as would make it more representative. For example, if we are required to construct indices for shares on the Bombay Stock Exchange, there are several shares listed and traded, it is not possible to include all of them. Therefore, it has to be decided which sample number of shares (may be 30 or 40) should represent the general movement of share prices of the Bombay Stock Exchange. Therefore, it is worthwhile to note that the selection of items must be deliberate and in keeping with the relevance and significance of each individual item to the purpose for which the index is constructed.
ii) Sources of Data: From where to collect data? It is an important and difficult issue. The source depends on the information requirement. For example, one may need to collect prices and quantities consumed related to certain commodities for a consumer price index. However, there may be a large number of retailers and wholesalers, selling the commodities, and quoting different prices. To get the details, only a few representative shops (which represent the typical purchasing points of the people under question) need to be selected. Thus, based on a representative sample survey, sources should be from where accurate, adequate, and timely data can be available.
iii) Timings of Data Collection: It is also equally important to collect the data at an appropriate time. Referring to the example of consumer price index, prices are likely to vary on different days of the month. For certain commodities prices may vary at different times of the same day. Take an example, vegetable prices are usually high in the morning when fresh vegetables arrive and are low in the late evening when sellers are closing for the day and wish to clear the perishable stock. For each commodity, individual judgment needs to be exercised to represent reality and to serve the purpose for which an index is to be used.
2) Selection of Base Year: A base period is the reference period for comparing and analysing the changes in prices or quantities in a given period. For many index number series, value of a particular time period, usually a year, is taken as reference period against which all subsequent index numbers in the series are calculated and compared. In some other cases, especially when cost of living needs to be compared across the cities, the value of cost of living prevailing in a selected city is taken as a base against which cost of living in other cities is compared.
In yet other cases, we may be required to compare one index number series against another series. In such a context, a ‘base’ common to all series is more appropriate. In the light of the above considerations, therefore, the period/year selected as base period/year must be a ‘normal’ period. Normal period is a period with price or quantity figures neither too low, nor too high. It should not have been affected by abnormal occurrences, such as floods, (if interested in agricultural production), wars, sudden recession etc. What is normal should also be decided keeping in view the purpose of constructing an index number, and the specific situation.
3) Selection of an Appropriate Index: Different methods of indices give different results, when applied to the same data. Utmost care must be taken in selection of a formula which is the most suitable for the purpose. Whether to use an unweighted or weighted index is a difficult question to answer. It depends on the purpose for which the index number is required to be used. For example, if we are interested in an index for the purpose of negotiating wages or compensating for price rise, only a weighted index would be worthwhile to use. Which weights to be used? Whether base year quantities or current year quantities or some other weights are to be used is an important question to answer. Weights which realistically reflect the relative importance of items included in the construction of an index is perhaps the only answer. The purpose for which an index is needed will of course remain a vital factor to reckon with.
