The following points highlight the five major limitations of price index.
Limitation # 1. Problems of Structure:
An initial problem is the choice of items to be included and the weights attached to them. In the case of an index of retail prices, the question is essentially one of deciding the range of households to which the index should apply.
Clearly, the patterns of consumer spending largely depend on income so that different commodities and weights should be used for households on different income levels. Thus, an index based on the expenditure of an average family is not a suitable guide to the cost of living of pensioners. For instance, they are less likely to be affected by changes in the index due to transport costs or hotel/restaurant charges.
Even if the products themselves do not alter, changing tastes or fashions require periodic revision of the weights. Above all, in an expanding economy, a rising standard of living is certain to be accompanied by changes in the pattern of spending. Thus, in the index of retail prices, an increasing proportion of the total weights has had to be allocated to luxury forms of spending while the food category as a whole has been proportionately reduced.
Limitation # 2. Problems of Price Measurement:
Obvious difficulties arise in recording price changes over such a vast range of items. There are likely to be local variations in the prices of some goods and services. However, this difficulty is met to some extent by calculating an average of prices taken from different parts of the country.
More difficult to overcome is the fact that price changes may be concealed by changes in the character of the products themselves. Thus, small reductions in the weight, size, or quality of products amount to effective increases in prices which may go unnoticed.
Limitation # 3. Problems of Change:
In a rapidly changing economy, the structure of any index is liable to become seriously out of date unless there is frequent revision of items and weights. New products coming on to the market may have to be added to the list of items or substituted for other items no longer in demand. Television sets, for example, were not a candidate for inclusion in a retail price index in India before 1972.
Limitation # 4. Choice of Weights:
Fourthly, it is necessary to decide how much significance, or relative weight, should be given to the items selected. Since consumers’ incomes and tastes differ, the pattern of expenditure will differ from one locality to another, from one period to another.
In practice, the compiler of the index number makes an arbitrary decision by selecting for a particular year (the base year) what is considered to be the pattern of expenditure (known as a ‘basket’) in a sample of consumers. A relative weight is allocated to each item according to its share of total expenditure. The pattern selected is used to apply weights to the various commodities in succeeding years for which the index number is calculated.
Clearly, the index will be limited in its significance. There will be many consumers who will weigh their expenditure differently by buying different basket of goods.
Further drawback is that the chosen basket is really only applicable to the base year. Over a period of time, the whole pattern of expenditure changes as incomes alter as the national income changes in size, and, in the manner of its distribution of national income, as qualities alter, and as new commodities and services come into existence and use.
Limitation # 5. Choice of Base Year:
The fifth major problem concerns the choice of a base year. Movements in prices will appear to be more or less significant, according to the base year chosen for the prices of items selected. It is important, therefore, to select a base year when prices were relatively stable and so years during periods either of severe inflation or deflation should be avoided.