INDEX NUMBER

➢ Prove that Fisher’s ideal index number lies between Laspeyre’s and
Paasche’s index numbers.
Solution: Let us consider two real numbers a>0, b>0.
Let, 𝑎 < 𝑏
 𝑎2 < 𝑎𝑏(∵ 𝑎 > 0)
 𝑎 < √𝑎𝑏 (∵ 𝑎 > 0) − − − − − − − − − − − −(𝑖)
Also, 𝑎 < 𝑏
 𝑎𝑏 < 𝑏 2 (∵ 𝑏 > 0)
 √𝑎𝑏 < 𝑏(∵ 𝑏 > 0) − − − − − − − − − − − −(𝑖𝑖)
From equation (i) and (ii) we get, 𝑎 < √𝑎𝑏 < 𝑏
Thus, the geometric mean of two real positive numbers lies between
them. The desired result now immediately follows since Fisher’s ideal
index number is the geometric mean between Laspeyre’s and Paasche’s
index numbers.
𝐿𝑎 𝑃𝑎
∴ 𝑃01 < 𝑃01
𝐿𝑎 𝑃𝑎 𝐹
=> 𝑃01 < 𝑃01 < 𝑃01
𝑃𝑎 𝐿𝑎
𝑇ℎ𝑒𝑛, 𝑃01 < 𝑃01
𝑃𝑎 𝐹 𝐿𝑎
=> 𝑃01 < 𝑃01 < 𝑃01
In particular, if 𝑃01
𝐿𝑎 𝑃𝑎
< 𝑃01 then Laspeyre’s, Paasche’s and Fisher’s
indices are all equal.
 Tests for Perfection
Several formulae have been suggested for constructing index numbers and the
problem is that of selecting the most appropriate one in a given situation. The
following tests are suggested for choosing an appropriate index.
1. Time Reversal Test
2. Factor Reversal Test
3. Circular Test
4. Unit Test

Time Reversal Test

Time reversal test is a test to determine whether a given method will work both
ways in time, forward and backward. In other words, when the data for any two
years are treated by the same method, but with the bases reversed, the two
index numbers secured should be reciprocals of each other so that their
product is unity. Symbolically, the following relation should be satisfied:
𝑷𝟎𝟏 × 𝑷𝟏𝟎 = 𝟏

Where 𝑃01 is the index for time “1” on time “0” as base and 𝑃10 is the index for
time “0” on time “1” as base.

If the product is not unity, there is said to be a time bias in the method.

The test is not satisfied by Laspeyres method, and the Paasche method as
can be seen below:
When Laspeyres method is used:

and the test is not satisfied.

When Paasche method is used

and the test is not satisfied.

Let us now see how Fisher’s Ideal formula satisfies the test:
Proof:

Changing time, i.e., 0 to 1 and 1 to 0.

Since 𝑷𝟎𝟏 × 𝑷𝟏𝟎 = 𝟏, the Fisher’s ideal index satisfies the test.
Factor Reversal Test

Another test suggested by Fisher is known as factor reversal test. It holds that
the product of a price index and the quantity index should be equal to the
corresponding value index. In other words, if p1 and p0 represent price and q1
and q0 the quantities in the current year and the base year, respectively, and if
P01 represents the change in price in the current year and Q01 the change in
quantity in the current year, then factor reversal test:

= V01
The factor reversal test is satisfied only by the Fisher’s Ideal Index.
Proof:

Change p to q and q to p

So, the factor reversal test is satisfied by the Fisher’s Ideal index.
Circular Test
Another test of the adequacy of index number formula is what is known as
‘circular test’. If in the use of index numbers interest attaches not merely to a
comparison of two years, but to the measurement of price changes over a
period of years, it is frequently desirable to shift the base. Clearly, the
desirability of this property is that it enables us to adjust the index values from
period to period without referring each time to the original base. A test of this
shift ability of base is called to the circular test. This test is just an extension of
the time reversal test. The test requires that if an index is constructed for the
year a on base year b, and for the year b on base year c, we ought to get the
same result as if we calculated direct an index for a on base year c without going
through b as an intermediary.

Symbolically, if there are three years a, b and c the Circular test will be
𝑷𝒃 𝑷𝒄 𝑷𝒂
satisfied if: × × =𝟏
𝑷𝒂 𝑷𝒃 𝑷𝒄

The Laspeyres index does not satisfy the test as can be seen from the
following:
If the three years are 0, 1, 2, the index by Laspeyres method will be

The product of all these is not equal to 1. Hence the test is not satisfied.
Similarly, it can be shown that the Paasche’s index and Fisher’s index do not
satisfy the test. However, the simple aggregative method and the fixed weight
aggregative method satisfy the test as can be seen from the following:
When the test is applied to the simple aggregative method, we will get:

Similarly, when applied to fix weight aggregative method, we will get:

Unit Test
The unit test requires that the formula constructing an index should be
independent of the units in which, or for which, prices and quantities are
quoted.
➢ Show with the help of the following data that the Time and Factor
Reversal Tests are satisfied by Fisher’s Ideal Formula for index
number construction.

Commodity Base Year Base Year Current Year Current Year

Price Quantity Price Quantity
A 6 50 10 56
B 2 100 2 120
C 4 60 6 61
D 8.5 30 12 24
E 8 40 16 22