Selection of base year
To construct price index number one of the past year is to be taken as base year but the base year should be normal year. The year without natural calamities, civic war, external war etc is called normal year. The base year should not be of long time ago then the current year. The goods and services consumed in base year and current year should be same too.
Selection of commodities
After selection of base year the commodities should be selected. The commodities consumed by all or majority of people regularly spending more fraction of their income are selected to construct price index number. The commodities that reflect the living standard of people must not be forgotten however the commodities taken into consideration must be consumed in both years.
Collection of prices
After selection of commodities prices of those commodities must be collected,. But each commodity has different prices like producer’s price, distributor’s price, wholesaler’s price, retailer’s price etc. each type of price differs from place to place too. Moreover, there is seasonal variation and organizational variation. Price index is constructed to measure the living standard of people so it is better to take wholesaler’s price into consideration because retail price can be highly different.
Calculation of average price or price level
The average price is calculated using two different methods. To calculate average price the commodities may be given equal or more and less weights. The price index is constructed giving equal weights to all commodities is called simple price index. The price index constructed by giving different weights to different commodities is called weighted price index. Weights are given on the basis of regularity in consumption and the amount spent and the number of consumers.
simple average price = sum of price / number of commodities
weighted average price = sum of weighted price / sum of weights
Construction of price index
After the calculation of average prices or price level of base year and current year we convert them into indices. The average price of base year is indexed as 10.