The following steps are considered for the construction of price index numbers.
The first and most important step in the construction of index numbers is to decide the object for making the index numbers of prices. The prices may be retail or whole-sale. The index numbers of retail prices are called the consumer price index (CPI) numbers, and if whole-sale prices are taken into consideration the index numbers are called the whole-sale price index numbers.
The index numbers of prices may be calculated for a certain locality or for a certain class of people like textile workers or office clerks, etc. The index numbers may be required for geographical regions like districts or provinces, etc. First of all we decide the purpose of making the index numbers. Once the purpose is decided, then we decide about the scope and the area or the people who are to be considered.
Selection of Commodities
A list of important commodities is prepared. Commodities which are commonly consumed are taken into account. There is no hard and fast rule about the number of commodities; however commodities are considered only if a reasonable amount is spent. As unpopular commodities are omitted, only those which are representative of the tastes and customs of the people are considered.
Dr. Irving Fisher has said that 20 commodities is a small number and 50 commodities is a reasonable number. For the construction of wholesale price index numbers, about 80 commodities are taken and for retail-price index numbers about 300 commodities are considered. Sometimes only the index numbers of very important commodities like wheat, rice, oil, ghee, etc. are calculated. These index numbers are based on about one dozen commodities and are called sensitive price index numbers.
Collection of Price Data
The most important and difficult step is the collection of prices. The prices are to be taken from the field. For retail price index numbers, retail prices are needed. The prices change from place to place and from time to time, so in actual practice there are many difficulties with collecting this data. Usually some representative shops that are popular with consumers are selected and the prices are taken from those shops. The prices are taken on a daily basis and then the weekly and monthly averages are calculated. Finally quarterly or yearly averages are calculated.
Some commodities are sold in different varieties. Rice, sugar, mangoes, etc., have different variables which are sold for different prices. This problem is solved by assigning due weights to different varieties and then the weighted average price is calculated. Sometimes different varieties are treated as different commodities.
For whole-sale prices, the prices are taken from whole-sale markets, discount warehouses and whole-sale agencies. Whole-sale prices are usually stable; therefore these prices are not taken on a daily basis. The price reporting is done on a weekly or monthly basis depending upon the nature of the commodity. The prices of some commodities are controlled by the government. These prices are reported whenever a change takes place.
Selection of Base Period
The prices of the commodities in the current period will be compared with the prices of a period in the past. This period in the past is called the base period or the reference period. The base period is a decided statistical division of the government. This period should not be in the remote past, and it should be economically stable and free of disturbances and strikes.