Uses and Limitations of Index Numbers
Uses and limitations of Index Numbers
Uses of Index numbers
Index numbers can be used for a number of purposes:
(i) Index numbers are used not merely to measure changes in the price level or changes in the value of money. They can be used to measure any quantitative change. Thus, we can prepare an index number of wages, imports, exports, industrial production, unemployment, profit, area under cultivation, enrolment in a college, etc.
(ii) Such quantitative changes as are measured by index numbers can indicate social and economic trends and help in framing policies with respect to them. For instance, an index number of cost of living can guide us in the adjustment of wages to changing prices.
(iii) We can also compare, with the help of index numbers, economic conditions of a class of people at two different periods.
(iv) Index numbers can be used as basis for, and equitable discharge of, contracts relating to borrowing and lending. We know when prices rise, creditors lose. It may perhaps be considered more just to ensure that the creditor gets back the same purchasing power. Hence, when prices rise, the debtor may be asked to pay a correspondingly higher sum to discharge a debt.
Limitations of Index numbers
However, the index numbers are not a faultless guide. They suffer from a number of limitations, some of which are given below:
1. They are approximations: They cannot be taken as infallible guides. Their data are open to question and they lead to different interpretations.
2. International comparisons are difficult, if not impossible, on account of the different bases, different sets of commodities or difference in their quality or quantity.
3. Comparison between different times are is not easy. Over long periods, some popular commodities are replaced by others. Entirely new commodities come to figure in consumption or a commodity may be vastly different from what it used to be. Think of a modern railway engine and one of the early times. Ford car 1984 is a different commodity from the 1975 Ford.
4. Index numbers measure only changes in the sectional price levels. An index number that helps us to study the economic conditions of mill hands or railway coolies will be useless for a study of the conditions of college lecturers. An entirely different set of commodities will have to be selected. Different people use different things and hold different assets. Therefore, different classes of people are affected differently by a given change in the price level. Hence, the same index number cannot throw light on the effects of price changes on all sections of society.
As you can see, using index numbers can help you decide between which products to buy. In addition, the use of index numbers can be very useful when comparing all types of data, like home prices, population and wage increases or decreases.
One of the main limitations of using index numbers is that, the comparisons must be apples to apples. Comparing apples to oranges never works and can be used to skew the comparison. For example, comparing an average to the mean is not a useful comparison index and can be used to confuse or skew the index comparison numbers. Always remember to keep this in mind.
You may also be interested in: