The number showing the percentage relative changes in the cost of living of the people of a certain section of the society in the current year as compared to the base year is called the cost of living index number.
1. Points for the Construction of Cost of Living Index Number:
- Family budget inquiry,
- Price quotations of the commodities,
- Selection of the base year,
- Selection of the average and
- Selection of the weight.
The number showing the importance assigned to different items selected for the construction of an index number according to their importance is called weight.
Types of Weight:
- Implicit Weight: This is an indirect method of assigning weights. It is implied in the selection of items. It cannot be expressed in number.
- Explicit Weight: This is a direct method of assigning weights. Such weights are determined according to importance of the items. It can be expressed in numbers.
There are two popular methods of assigning explicit weights:
- Aggregate expenditure method and
- Family budget method.
2. Uses of Cost of Living Index Number:
- It represents the economic condition of the class of people for whom it is constructed.
- It is useful to find the real purchasing power of money for the concerned class of people.
- It is useful to fix the standards of living for different classes of people.
- It also gives some idea about what special amenities should be provided to different classes of people.
- It facilitates government in devising policies in matters of taxation and price control.
3. Limitation of Cost of Living Index Number:
- It represents the average changes of the entire class but it cannot be used, for a particular person of that class.
- It is based on the Impractical assumption that levels of consumption of quantities of different items of the base year are also maintained in the current year.
- Problem arises in assigning weights to different items as the consumptions made by the people of same class are in different proportion.
- The cost of living index number obtained for a particular class of people in a region cannot be used for the same class of people in some other region.
- It represents the average percentage change in the cost of living of the people of any class of the society. So the individual expenditure for the cost of living cannot be measured.
- For different class of people of the society and for different region separate index numbers are to be constructed.