Under this method, the price Index for a given year is calculated as the simple average of the price relatives of the different items included in the index numbers. The simple average used, here, may be of any type viz. arithmetic mean, geometric mean, harmonic mean, median or mode, but arithmetic mean is usually preferred to, for its simplicity in calculation and geometric mean for its ability of measuring the relative changes which is the inherent feature of an index number.
As such, the price index, under this method, is computed by the formula
P01 = ∑1/N (When Mean is used)
Or = AL ∑log.1/N (When G.M. is used)
where, P01 = Price index of the current year w.r.t. the base year
I = Price relative of the respective items
i.e. (P0 / P1) X 100
P1 = Price of the current year
P0 = Price of the base year
and N = Total number of items.
The merits and demerits of this method can be enumerated under:
- It is simple to understand.
- It is not affected by the magnitude of the prices of the various items.
- It satisfies the unit test in the sense that it is not affected by the units of price quotations.
- It can be computed using any average.
- It gives equal weights to all the items.
- It creates problems in the selection of an appropriate average.
- It is difficult to calculate particularly when geometric mean is used.
- It assumes that all the relatives are of equal importance which is highly objectionable from economic point of view.