Efficiency and Productivity Measurement:

Index Numbers

D.S. Prasada Rao

School of Economics
The University of Queensland, Australia

1
 Index number methods
• Index numbers are used in measuring changes in a set of
related variables:
– consumer prices;
– stock market prices;
– quantities produced; etc.
• Index numbers can also be used in comparing levels of a
set of related variables across space or firms:
– Agricultural output in two different countries;
– Input indexes across two farms or firms;
– Price levels in different countries; etc.
• In general we compute
– Price Index Numbers
– Quantity Index Numbers
– Decompose Value ratios into Price and Quantity index numbers
2
 Outline
• A simple TFP index example
• Price index numbers
• Quantity index numbers
• Tornqvist TFP index
• A small empirical example
• Properties of index numbers
• Additional issues
– Indirect index numbers
– Chaining index numbers
– Transitive index numbers
3
 TFP growth
• Productivity growth means getting more
output from a particular level of inputs
• When we have just one input and output the
TFP change between period 1 and 2 is:
q2 q1 q2 x2
TFP12  
x2 x1 q1 x1

• When we have more inputs and outputs we

must aggregate using index numbers
• A basic property of any TFP index is that
when q2=aq1 and x2=bx1, then TFP12=a/b 4
 Index number formulae
• When we have more than one input or output
we need to find an aggregation method
• Four most popular index number formulae
are:
– Laspeyres
– Paasche
– Fisher
– Tornqvist
• We will look at price indices first - they are
more familiar

5
 Price Index Numbers
• Measure changes (or levels) in prices of a set of
commodities.
• Let pmj and qmj represent prices and quantiies (m-th
commodity; m = 1,2,...,M and j-th period or firm j =
s, t).
• The index number poblem is to decompose value
change into price and quantity change components.

Vt
p q it it
 i
 Pst  Qst  Price Index  Quantity Index
Vs
p
i
is qis

6
 Laspeyres price index numbers
N
 pit qis N
pit N
PstL  i 1
N

pis
 is , where is  pis qis  pis qis
 pis qis i 1 i 1

i 1
• Price change index for N goods from period s to
period t
• pit = price of i-th good in t-th period, qit =
quantity
• Uses base-period (period s) quantity weights
• Share-weighted sum of individual price indices
• Often used in CPI calculations 7
 Paasche price index numbers
N
 pit qit 1
i 1
PstP  N

pis
 pis qit  pit
 it
i 1 i

• Uses current-period (period t) quantity

weights
• Share-weighted harmonic mean of
individual price indices
• Paasche  Laspeyres - when people respond
to relative price changes by adjusting mix of
goods purchased (in periods of inflation) 8
 Fisher price index numbers
F
Pst  Pst  Pst
L P

• Fisher index is the geometric mean of the

Laspeyres and Paasche index numbers
• Paasche  Fisher  Laspeyres - when
consumers respond to relative price changes
by adjusting mix of goods purchased (in
periods of inflation)
• Paasche and Fisher more data intensive and
costly because we need to obtain
expenditure weights in each period
9
 Tornqvist price index numbers
is it
N
 pit  N
 is  it 
 ln pit  ln pis 
2
Pst    
T
, ln PstT  
i 1  pis  i 1  2 

• Share-weighted geometric mean of

individual price indices
• Uses average of value share from period t
and period s
• Log form is commonly used in calculations -
has an approximate percentage change
interpretation 10
 Quantity Index Numbers
There are three approaches to the compilation
of quantity index numbers.
1. Simply use the same formulae as in the case
of price index numbers – simply interchange
prices and quantities.
2. Use the index number identity:
 

Vst 
 pit qit 
 p q it it / Pst
Qst   i
 / Pst  i
Pst  
  pis qis 
 p is qis
 i  i
11
 Quantity Index Numbers

value in period t (at cons tan t prices, in period s )

 Qst 
value in period s (at prices in period s)

3. Compute quantity index directly

• Malmquist approach
• Using distance functions defined before
• Economic theoretic approach

Comments
• All the three approaches have some common elements
• Fisher index can be derived using all the three approaches
• Tornqvist index can be derived using the first and the last
approaches
•Fisher index is known as the “ideal” index.
12
 Four quantity index numbers
To obtain the corresponding quantity index
numbers we interchange prices and quantities:
N N
 pis qit  pit qit
i 1 i 1
Laspeyres = QstL  N
, Paasche = QstP  N
 pis qis  pit qis
i 1 i 1

Fisher = QstF  QstL  QstP

is it
N
 qit  2 N
 is  it 
Tornqvist = QstT    , ln QstT     ln qit  ln qis 
i 1  qis  i 1  2 

13
Which index is best for use in TFP studies?

• Two methods are used to assess the suitability of

index number formulae:
– economic theory or functional approach
• Exact and superlative index numbers
– axiomatic or test approach
• Index numbers that satisfy a number of desirable
properties
• Both approaches suggest that the Fisher and
Tornqvist are best (Diewert)
• We outline these arguments later in this session
14
 Tornqvist TFP index
The Tornqvist has been the most popular TFP
index
Output Indexst
ln TFP Indexst  ln
Input Indexst

 ln Output Indexst  ln Input Indexst

1M 1 K
 
   ris  rit  ln qit  ln qis    s js  s jt ln x jt  ln x js
2 i 1 2 j 1

This approach is also know as the Hicks-Moorsteen Approach –
defines productivity index simply as the ratio of output and input
index numbers. 15
 Example
• Recall our example in session 2
• Two firms producing t-shirts using labour
and capital (machines)
• Let us now assume that they face different
input prices

firm labour capital cost output

x1 w1 x2 w2 q
A 2 80 2 100 360 200
B 4 90 1 120 480 200
16
• In this example we compare productivity
across 2 firms (instead of 2 periods)
• First we calculate the input cost shares
• Labour share for firm A
= (280)/(280+2100) = 0.44
• Labour share for firm B
= (490)/(490+1120) = 0.75
• Thus the capital shares are (1-0.44)=0.56
and (1-0.75)=0.25, respectively
17
Ln Output index = ln(200)-ln(200)
= 0.0

Ln Input index = [0.5(0.44+0.75)(ln(2)-ln(4))

+0.5(0.56+0.25)(ln(2)-ln(1))]
= -0.13

ln TFP Index = 0.0-(-0.13)

= 0.13

TFP Index = exp(0.13)=1.139

ie. firm A is 14% more productive than firm B

18
 Properties of index numbers
• Used to evaluate index numbers
– Economic theory
– Axioms
• Both suggest Tornqvist and Fisher best for
TFP calculations

19
 Economic theory arguments
• Laspeyres and Paasche imply simplistic
linear production structures
• Fisher is exact for quadratic - Tornqvist is
exact for translog - both are 2nd-order
flexible forms - thus “superlative” indices
• If we assume technical efficiency, allocative
efficiency and CRS, then Tornqvist and
Fisher indices can be interpreted as
production function shift (technical change)
• Read more in text…
20
 The Test or Axiomatic Approach

• Basically we postulate a number of

desirable properties of index numbers
in the form of axioms and tests and
see which index number satisfy these
properties
• Fisher (1922) provided a list of these
tests.

21
• Positivity: The index (price or quantity)
should be everywhere positive.
• Continuity: The index is a continuous
function of the prices and quantities.
• Proportionality: If all prices (quantities)
increase by the same proportion then Pst
(Qst) should increase by that proportion.
• Units invariance: The price (quantity)
index must be independent of the units of
measurement of quantities (prices).
22
• Time-reversal test: For two periods s and
t: Ist=1/Its.
• Mean-value test: The price (or quantity)
index must lie between the respective
minimum and maximum changes at the
commodity level.
• Factor-reversal test: A formula is said to
satisfy this test if the same formula is
used for direct price and quantity indices
and the product of the resulting indices is
equal to the value ratio (PQ=V). 23
• Factor Test: The product of the price and
quantity index numbers should be equal to the
value index.
• Circularity test (transitivity): For any three
periods, s, t and r, this test requires that:
Ist=IsrIrt. That is, a direct comparison between
s and t yields the same index as an indirect
comparison through r (we provide an example
later).

24
 How many tests are satisfied?

• Diewert (1992) looks at 22 tests for TFP

indices - Tornqvist fails factor reversal
and transitivity - Fisher fails transitivity.
• Factor reversal is not greatly important -
transitivity is important when making
spatial comparisons - Tornqvist and
Fisher indices often produce identical
numbers (to 2 or 3 significant digits).
25
 Chaining indices
• Example: 4 time periods
• Calculate indices between adjacent years
(I12, I23, I34)=(1.03, 1.04, 0.98)
• Then form the chained index:
C1=1.00
C2=C1×I12=1.00×1.03=1.03
C3=C2×I23=1.03×1.05=1.08
C4=C3×I34=1.08×0.98=1.06
• Advantage is that weights change regularly
26
 Transitivity
• Example: 3 firms
• Calculate all direct comparisons:
(I12, I23, I13)=(1.10, 1.10, 1.15)
• These are not consistent (ie. transitive)
because 1.10×1.10=1.211.15
• The EKS method is used to convert non-
transitive indices into transitive indices:
1

 
N
  Isr  I rt
N
transitive
I st
r 1 27
• EKS is minimum sum of squares deviation
from original index number series
• Original indices:
(I12, I23, I13)=(1.10, 1.10, 1.15)
• Transitive indices:
TI12=(I11×I12)1/3×(I12×I22)1/3×(I13×I32)1/3=1.0815
TI23=(I21×I13)1/3×(I22×I23)1/3×(I23×I33)1/3 =1.0815
TI13=(I11×I13)1/3×(I12×I23)1/3×(I13×I33)1/3 =1.1697
• Note that TI12×TI23 = 1.0815×1.0851
= 1.1697 = TI13
28
 Transitive Tornqvist TFP index

Recall that the binary TFP Index using

Tornqvist formula is given by:
Output Indexst
ln TFP Indexst  ln
Input Indexst

 ln Output Indexst  ln Input Indexst

1M 1 K
 
   ris  rit  ln qit  ln qis    s js  s jt ln x jt  ln x js
2 i 1 2 j 1

We note that this index is not transitive
29
 Transitive Tornqvist TFP Index
If we apply the EKS method and generate
transitive index numbers, we can show that

  
M
transitive
ln TFPst   12  rit  r i ln qit  ln qi
 i 1

  
M
 2  ris  r i ln qis  ln qi 
1

i 1 
 K
 
  12  s jt  s j ln x jt  ln x j 
 j 1

  
K
 12  s js  s j ln x js  ln x j 
j 1  30
 Transitive Tornqvist TFP Index

• This can be interpreted as an indirect

comparison through the sample mean
• The transitive Tornqvist can be calculated
directly using this formula
• The Fisher index has no equivalent
formula - one must calculate the Fisher
indices first and then apply EKS
• Need to recalculate all when one new
observation added
31
 Productivity comparisons using index
numbers
We note the following important properties:
1. Productivity measures can be computed using data
on just two firms (i.e., very limited data);
2. If the data refers to the same firm over two periods
and if the firm is technically and allocatively
efficient in both periods, then under the assumption
of constant returns to scale the productivity
measures provided correspond to theoretical
measures of productivity growth (Malmquist
productivity index – to be discussed next week).
3. Since the TFP index is based only on two
observations for s and t, the index is not transitive.
• If we have several firms, then we need to make the
measures transitive.
• Normally the EKS (Elteto-Koves-Szulc) method is used for
this purpose. 32
 Output Data for the Australian National Railways Example

Quantities Prices
Mainland Tasrail Passenger Mainland Tasrail Passenger
Freight (1,000 Freight (1,000 (1,000 Freight Freight ($/PTK)
NTKs) NTKs) PTKs) ($/NTK) ($/NTK)
5235000 383000 2924 0.02 0.07 10
5331000 420000 3057 0.03 0.07 12
5356000 375000 2992 0.03 0.08 14
4967000 381000 2395 0.03 0.08 18
5511000 401000 2355 0.03 0.08 20
5867000 403000 2188 0.03 0.08 22
6679000 402000 2486 0.03 0.09 23
6445000 429000 2381 0.03 0.09 23
7192000 455000 2439 0.03 0.09 23
7618000 459000 2397 0.03 0.08 26
7699000 413000 2316 0.03 0.11 32
7420000 369000 1664 0.03 0.12 47

33
 Quantities Prices
Labour Fuel (1,000 Other Inputs Labour Fuel ($/litre) Other Inputs
(persons) litres) ($1,000 )a ($/person) (index)
10481 77380 119113 13097 0.18 0.45
10071 80148 112939 14730 0.26 0.50
Other 9941 77105 108263 16692 0.28 0.56
inputs 9575
9252
72129
85868
110210
109292
18651
20166
0.37
0.37
0.62
0.66
8799 89706 97594 21307 0.39 0.70
8127 96312 93178 24990 0.41 0.75
7838 92519 80054 26412 0.42 0.81
7198 96435 77716 28572 0.43 0.87
6648 101327 74147 32617 0.39 0.94
6432 98874 80826 34565 0.43 1.00
5965 96016 73172 35646 0.46 1.04

Quantities Prices
Land, Building Plant and Rolling Land, Plant and Rolling
and Perway Equipment Stock Building and Equipment Stock
($1,000 )a ($1,000 )a ($1,000)a Perway (index)b (index)b
Capital (index)b
1858038 94057 332307 10 50 50
inputs 2101035 93927 308491 20 80 80
2059365 89764 285626 30 120 120
2118357 93271 269265 30 100 100
2117625 91837 275134 70 140 140
2095680 90120 261495 70 160 160
2069494 89617 251588 50 90 90
2034867 88773 239736 70 120 120
2017626 89653 235834 80 200 200
1998345 98762 252514 80 240 240
2011753 100495 251850 80 190 190
2018802 107654 242662 130 200 200
34
 Output, Input and TFP index numbers

Year Output Input TFP

79/80 1.0000 1.0000 1.0000
80/81 1.0343 0.9782 1.0573
81/82 1.0188 0.9515 1.0707
82/83 0.9304 0.9345 0.9956
83/84 1.0014 0.9316 1.0748
84/85 1.0311 0.8950 1.1521
85/86 1.1543 0.8596 1.3428
86/87 1.1268 0.8191 1.3756
87/88 1.2293 0.7885 1.5590
88/89 1.2766 0.7690 1.6600
89/90 1.2607 0.7684 1.6407
90/91 1.1283 0.7376 1.5296

• All the index numbers reported here are calculated using the
Tornqvist index number formula.
• All the indices here are reported for the base year 79/80.
•While there is a steady increase in output over the years, the
input index shows a secular decline resulting in TFP growth over 35
time.