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Give the meaning of cost of living index number and state the points to be considered for its construction.

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Meaning of cost of living index number: The number showing the percentage of relative changes in the cost of living of the people of a certain section of the society in the current year as composed to the base year is called the cost of living index number.

The following points should be taken into account while constructing the cost of living index number:

1. Purpose of construction: While constructing the cost of living index number, first of all its purpose should be defined. It should be made clear about the class of people for whom this index number is to be constructed. The decision regarding selection of commodities, their numbers, their quantities, etc. can be taken after knowing the requirements of different classes of people. This means that it is absolutely necessary to clarify the purpose for which the cost of living index number is to be constructed.

2. Family budget inquiry: For family budget inquiry, a random sample for specified class of people is selected for whom the cost of living Index number is to be constructed.

3. Classification of commodities: Generally, the list of commodities obtained by family budget inquiry can be classified into five heads :

  1. Food items,
  2. Clothing,
  3. House rent,
  4. Fuel and Light,
  5. Miscellaneous expenditure

4. Availability of prices of items : The retail prices of items of consumption by families are collected from the government recognised or approved shops located in the area where the families of that class of people reside. Sometimes the simple average of retail prices obtained from different shops at different times are taken into consideration. To obtain retail prices of commodities unit of quantity is taken as base unit.
For example, price is obtained as ₹ 10 per kg and not as ₹ 1 per 100 gm. This type of retail prices are obtained according to the requirements of index numbers as weekly, fortnightly, monthly or yearly basis.

5. Selection of base year: The year with normal events should be selected as the base year and price relatives of all the selected items are obtained as follows:
Price relative (I) \(= \cfrac{Retail\, price\, of\, the\, current \,year}  {Retail\, price\, of\, the\, base\, year}  × 100\)

6. Selection of average : For obtaining common price relative from different price relatives of different commodities, appropriate average should be used. Theoretically, the Geometric mean is an ideal average for construction of Index number, but it’s computation is difficult. Hence, weighted average is used in the practice.

7. Selection of weighted method: In the context of total expenditure, importance (weight) of each group and each item is determined and by the following two methods cost of living index number is constructed :

  1. Total expenditure method and
  2. Family budget method.

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