ECON60241 Student ID: 7691068

Task: Explain and evaluate the use of index numbers to measure changes in the ‘cost of
living’.

Introduction

As expected, in a modern economy, consumers can purchase millions of distinct goods and
services. The issue goes further than just final goods, since on the business-to-business part of
the economy, firms employ even more goods in order to produce what consumers are able to
purchase in retail stores. As a result, one can confidently assert that there are millions of
active transactions happening each day. It is not surprising therefore that economists attempt
to summarize this bewildering amount of information (regarding prices and quantities of
traded commodities) into a more compact set of numbers. The purpose for such summarized
information is rather self-intuitive: everything that is bought has a price and since prices vary
over time; price index numbers are designed to measure such changes over time.

From an economic perspective, cost of living indexes are measured in terms of utility – “the
minimum change in expenditure required to keep a consumer at the same utility level (or
indifference surface) in two different situations” (Stapleford, 2009). Other sources state that
the the definition of a cost-of-living index is the answer to the following question “What is
the minimum cost, at this month’s prices, of achieving the level of utility actually attained in
the base period?” (Office for National Statistics, 2007).

In order to analyze the use of index numbers, this paper is structured in several parts. First of
all, a historical overview explaining the theoretical concepts behind index numbers - the
transition from cardinal to ordinal utility in consumer theory and the purpose of index
numbers - will be detailed. The second part of this paper deals with methods of computing
index numbers: the Paasche and Laspeyres indexes will be derived from the Slutsky methods
of decomposition. Thirdly, an analysis of current-day cost of living indexes will be
conducted: the CPI and potential biases that can enlarge the gap between the true cost of
living index and the computed one.

Historical Overview

Even though most contemporary economists agree nowadays to the above mentioned
definition, its evolution has seen many milestones across time. Initially, economists adopted
the idea that satisfaction could be measured objectively across individuals (Stapleford, 2009).
However, the idea was soon abandoned, since as early as 1902, economists belonging to the
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Austrian School have brought arguments against the notion of cardinal utility; furthermore
Hicks and Allen have developed even more the notion that utility should be measured in
ordinal terms (High & Block, 1989).

With the adoption of this ordinal revision, economists could argue fairly easily that bundles
of goods on the same indifference curves would yield the same amount of satisfaction
(welfare). However, comparing two different moments in time was something that was more
complicated since in order to be able to compare the two moments, the assumption of
constant tastes would have to hold. However, since individuals clearly change their
preferences this would mean that the whole map of indifference curves would be altered. As a
result, the concept of keeping an individual on the same indifference curve did not make
much sense, especially because 2 moments in time would almost surely imply 2 different
indifference curve maps (Stapleford, 2009).

As such the assumption of ordinal utility was not enough to settle the issue of price indexes.
Therefore, it was necessary to redefine the purpose of the cost-of-living index. Up until this
point, economists would agree that “a true cost of living would show the minimum change in
expenditure needed to maintain an individual at the same level of economic welfare in two
different time periods” (Stapleford, 2009). Given the constraints on comparing two moments
in time, the new objective became the calculation of the “minimum change in expenditure
needed to make a given individual (fixed in time and space) indifferent between two systems
of prices” (Stapleford, 2009). Thus, in 1968, a new definition made clearer what index
numbers were supposed to do “Given an indifference map, we compare two hypothetical
situations, A and B. We ask how much income the consumer in B would require to make him
just indifferent between facing B’s prices and facing A’s prices with a stated income” (Fisher
& Shell, 1968). Thus, one can state, that at this point, there were no more paramount
operational problems that could prevent the efficiency and accuracy of index price numbers.

Calculation of index numbers

Apart from resolving some of the theoretical conundrums of price index theory, it made sense
for price indexes to be employed in real life measurements in changes in the cost of living.

In 1823 Joseph Lowe, an English economist, described a method of measuring price changes
between 2 periods of time by specification of an approximate representative commodity

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basket that was to be updated once every five years (Diewert, 2008). Diewert explains that a
basic Lowe index would be:

Two special cases of Lowe indexes are the Paasche and Laspeyres indexes. These indexes
have appeared on numerous occasions in index number theory. When the employed
quantities are those of the price reference period, one obtains the Laspeyres index and when
the quantities are those of the other period, the Paasche index is obtained (International Labor
Organization, 2004).

A. Laspeyers Index

The Laspeyres weighted index is related to the Slutsky method of decomposition in its
compensating variation form (Peach, 2010). This index computes the amount by which the
income of the consumer must change relative to base period expenditure to allow the
individual to consume the original bundle of goods at the new prices.

The graphical representation of the Slutsky method of decomposition in its compensating

variation form is shown in the diagram below.

Assuming a model of 2 perfectly divisible, homogenous goods and a consumer with well-
behaved preferences one can explain the Slutsky compensating variation method of
decomposition.

As can be seen the individual

initially consumes bundle
(X1,Y1). Assuming that the
price of good Y rises, then the
budget line pivots downwards.
As such, this change in real
income is now explained by the
new budget line. In order to
obtain a bundle yielding the
same satisfaction at the new set
of prices, one must draw a
parallel to the new budget line.
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One can say the cost of living has risen by the amount we can increase the income of the
individual in order for him/her to consume the original bundle (X1, Y1) at new prices namely
[P1X1+P2Y1]-[P1X1-P1Y1]. The Laspeyres is related to the SCV and it is given by the
following formula:

L= (P2X1+P2Y1)/ (P1X1+P1Y1)

As such the change in income must equal:

ΔM= (E*L)-E

where M stands for income and E stands for base period expenditure.

The Laspeyres index uses base-year quantities as weights for prices in 2 different time
periods, not taking into consideration the fact that consumers have the possibility to substitute
goods. Therefore, a consumer whose money income rises as much as the Laspeyres index in a
given year and thus is able to buy the original bundle at the new prices cannot be worse off
and is more likely to be more satisfied in the year in question. Thus, an individual can also be
better off if their change in income is not as much as the increase in the Laspeyres index and
one can unambiguously argue that when the ratio of income in the given year to the income
in the base period exceeds the Laspeyres index, the individual will be better off in the given
year.

B. Paasche Index

The Paasche – current period- weighted index is related to the Slutsky method of
decomposition in its equivalent variation form. It computes the amount by which income
must change relative to current period expenditure to enable consumption of the new bundle
of goods at old prices (Peach, 2010). Using the same two-good, one consumer model
explained earlier, one can derive the Paasche index.

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Thus, assuming that the price of good y increases, resulting in the budget line pivoting
downwards, one can state that the rise in the cost of living is equal to the amount it would be
required to reduce income in order to allow the consumption of the second bundle (X2, Y2)
at initial prices:

[P1X2+P2Y2]- [P1X2+P1Y2]

The Paasche index is given by the following formula:

P= (P2X2+P2Y2)/ (P1X2+P1Y2)

As such the change in income must be equal to

ΔM=E-E/P

where M represents income and E represents the current period expenditure on bundle (X2,
Y2).

If the Laspeyres index tended to overestimate increases in cost of living changes, the Paasche
index tends to underestimate the real cost of living. Since this index number assumes that if
the consumer would have had in the base period a level of income equal to the sum of the
base-year prices weighted by the current year quantities, he or she would have purchased the

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given year quantities. However, the individual would have probably purchased items that
tended to become relatively more expensive. As a consequence, a consumer whose level of
income rises as much as the Paasche index, and thus would have been able to buy the same
bundle of goods in the base year as he/she does in the given year, is likely to be worse off in
the current time period. As such, an individual can be worse off when his income rises as
much as the Paasche index.

A. Bridging the issues between the Laspeyres and Paasche indexes

Even if both indexes can be proven to be plausible, using these two formulae will typically
yield different results. Thus, because one underestimates the rise in cost of living whereas the
other overestimates it, it was necessary for economists to come up with another index that
would be closer to the true cost of living index. Over the years, several formulae were used:
arithmetic averages (Bowley, 1919), (Sidgwick, 1883), geometric averages (Fisher I. , 1922).
The economic literature in the field of index numbers has also approached the idea of
efficiency of index numbers via multiple tests that can be performed. Recently it was proven
that the Fisher ideal index (Diewert, 1997) and the Walsh index (Diewert, 2002) are among
the most efficient ones in pinpointing the true cost of living index.

The CPI as a practical application of index numbers

The purpose of the Consumer Price Index is to measure the cost of purchasing a “fixed
market basket of goods and services” (Advisory Commission To Study the Consumer Price
Index, 1996). The same source explains that “based on surveys of households from some base
period, the index sets weight for different goods and services. The weights reflect average or
representative shares for the groups surveyed”. These weights are usually fixed in time and
the CPI attempts to measure monthly changes in the price of the average basket of goods and
services. The importance of this particular index number is paramount since it can be
employed for the purpose of adjusting for the effects of inflation. In this manner,
governments can adjust the value of wages, pensions or use the CPI for price-regulation
purposes.

The CPI is computed for groups of individuals and not for each consumer using their own
consumption levels as weights. In the process of computing such indices, the weights used
are total or average consumption bundles for particular groups (the inhabitants of a certain
region, pensioners, working individuals etc). The measure of CPI can make a group as a
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whole appear better-off after a certain price change, but this does not mean that a particular
individual is not in fact worse off (Gravelle & Rees, 2004)

Furthermore, any CPI index assumes that consumer tastes have not changed, since it assumes
that a consumer derives the same welfare of the average basket. However, consumer tastes
and preferences change each year, if not more often. As such, the CPI needs to adapt its
components fairly often in order to be representative for the population. Therefore, the longer
the period of time the basket remains unchanged, the more likely it is that the index does not
measure accurately changes in the cost of living.

On a more practical note, in the US, the BLS (Bureau of Labor Statistics) collects price
information on 71,000 goods and services at approximately 22,000 retail outlets either once
or twice every month (Gordon, 2000). Collecting this vast amount of information can be
tantalising for governmental agencies and several biases can intervene in the process.

Government agencies may fail to respond to changes in consumer behaviour in response to

relative prices. If average baskets are not updated regularly, a substitution bias may appear –
because changes in relative prices or marketing schemes as discount coupons, buyers’ clubs
etc. may change consumer behaviour. As a result, it may be likely that the weights for the
base period basket are no longer reflective of what consumer purchase in the current period
(Advisory Commission To Study the Consumer Price Index, 1996). The Boskin Commission
estimated that in 1996, the CPI was higher with 0.4 percentage points than reality due to the
substitution effect (Gordon, 2000).

Another possible source of bias is the outlet substitution bias. In an economy where
supermarkets, discount stores etc. are ubiquitous trends in where purchases are made may
also be changing. Such changes may be too fast-paced for agencies to be able to respond and
paid prices may differ compared to those that are actually recorded. Such bias was estimated
at a level of 0.1 in the US in 1996 (Gordon, 2000).

Inadequate quality adjustment can also cause problems in the estimation of the CPI. Dating
back to 1961 it was indicated that “if a poll were taken of professional economists and
statisticians, in all probability they would designate (and by a wide majority) the failure of the
price indices to take full account of quality changes as the most important defect of these
indices” (Stigler Commmittee, 1961). It is true that products suffer dramatic improvements
each year and it is important to separate a price increase caused by quality change rather than
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actual inflation, a task that is not particularly simple. When it comes to new products, it is
very possible that the numerous yearly product launches may be ignored by agencies and the
products may not be included in the representative basket fast enough (leading to a new-
product bias) (Advisory Commission To Study the Consumer Price Index, 1996). It is
estimated that the largest bias in the estimation of CPI in 1996 came from new product or
quality change bias (almost 0.6 out of a total of 1.1 points of bias) (Gordon, 2000).

The measurement of bias has important implications. In 1996, the Boskin Commission was
reporting “if use of the CPI is expected to overstate the increase in the cost of living by one
percentage point per year over the next dozen years, the national debt would be about 1$
trillion greater in 2008 than if a corresponding correction were made in the indexing of
outlays and revenues” (Advisory Commission To Study the Consumer Price Index, 1996).
Furthermore, the elimination of upward bias can better the government budget situation
through reduced expenditure and increased tax revenues. It is estimated that in 1997 in the
US, the estimated overpayment of benefits was roughly $26 billion, with interest taken into
account, the total overpayments towards Old-Age, Survivor and Disability Insurance Trust
Funds reached $55 billion. An additional $519 billion dollars are estimated to be overpaid
until 2040 (Duggan & Gillingham, 1999). Another possible effect of a CPI bias (in any
direction) will also bias the growth rates of real output and productivity measures (Eldridge,
1999).

Conclusion

The history of index numbers has known a tumultous history and many changes in the basis
of index numbers have taken place both in the theoretical (from cardinal to ordinal utility
based consumer functions to other developments) and practical frames (a considerable
number of formulae have been used to calculate changes in the cost of living: Laspeyres,
Paasche, Fisher to the current CPI).

Adapted to real life purposes, index numbers have many purposes: from measuring inflation,
adjusting wages and pensions for the effects of inflation to price regulation. The CPI, one of
the most widely used measures is a reliable source for measuring cost of living changes, but it
is not without its problems: changing tastes, differences between individuals, bias in the
calculation can pose serious problems in the calculation of a true cost of living index.

Word Count (without references): 2721

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Word Count (with references): 3055

Works Cited

Advisory Commission To Study the Consumer Price Index. (1996). The Boskin Commission Report -
Toward a More Accurate MEasure of the Cost of Living.

Bowley, A. (1919). The measurements of changes in the cost of living. Journal of the Royal Statistical
Society .

Diewert, E. W. (2008). Index numbers. The New Palgrave Dictionary of Economics.

Diewert, W. (1997). Commentary on Mathew D. shapiro and David W. Wilcox: alternative strategies
for aggregating price in the CPI. Federal Reserve Bank of St. Louis .

Diewert, W. (2002). Harmonized index of consumer prices: their conceptual foundations. Swiss
Journal of Economics and Statistics .

Diewert, W. (2002). Harmonized indexes of consumer prices:their conceptual foundations. Swiss

Journal of Economics and Statistics .

Duggan, J. E., & Gillingham, R. (1999). The Effect of Errors in the CPI on Social Security Finances.
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Eldridge, L. P. (1999). How price indexes affect BLS productivity measures. Monthly Labor Review .

Fisher, F. M., & Shell, K. (1968). Taste and Quality Change in the Pure Theory of the True Cost-of-
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Fisher, I. (1922). The Making of Index Numbers.

Gordon, R. (2000). The Boskin Commission Report and its Aftermath. Nortwestern University and
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Gravelle, H., & Rees, R. (2004). Microeconomics, 3rd Edition. Prentice Hall, Pearson Education.

High, J., & Block, H. (1989). On the history of ordinal utility theory: 1900-1932. History of Political
Economy, Duke University Press .

International Labor Organization. (2004). Consumer Price Index Manual - Theory and Practice.

Office for National Statistics. (2007). Consumer Price Indices - Technical Manual, 2007 Edition.
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Peach, T. (2010). Intermediate Microeconomics Lectures. Manchester, United Kingdom: University

of Manchester.

Sidgwick, H. (1883). The Principles of Political Economy. London: Macmillan.

Stapleford, T. A. (2009). Aftershocks from a Revolution: Ordinal Utility and Cost-of-Living Indexes.
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Stigler Commmittee. (1961). Price Statistics Review Committee.

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