WHY CPI SHOULD NOT BE COST OF LIVING INDEX

In this article I assert that, CPI  must not be used as Cost of Living Index.The article focuses on two main issues: need for CPI , Cost of Living Index(COLI)and interplay of CPI and COLI i.e. why CPI must not be used as COLI.

What economists have taken COLI to be when they  advocate for measuring the Cost of Living Index is they want to track the cost of achieving certain level of utility.Now the cost of achieving a certain level of utility depends upon a) :Price Changes-How expensive is it to attain the  same level of utility that they had earlier.b)change of quality of goods. For example:Mobile Phones. Their quality and price go up simultaneously. In that case it might not be as expensive to gain the same level of utility as both price and utility gained have gone up.c)Further, the introduction of new goods that raise our quality of life also influences the utility level and we must take account of that.d)Lastly,changes in environment also influence the utility level.If a place becomes less polluted the we may need less resources to maintain the same utility level.Even if prices go up the COLI  may not increase as it is offset by decrease in the pollution level.So, all these issues will matter if we think of measuring COLI as cost of obtaining certain level of utility. Further, scholars like Schultze and Mackie have focused on some important uses of CPI which include use as: general macroeconomic indicator,indexing tax brackets ,bonds and transfer payments compensation including social security benefits.

Now, COLI is cost of obtaining certain level of utility. In thiscontext, using CPI as an ideal notion to measure COLI, involves various issues like Substitution bias, inability to capture quality changes with time. These have been specifically mentioned in the Boskin Commission report of 1996 which pointed that CPI creating agency, BLS should embrace COLI as its objective. The most important issue is that this CPI index which has been condemned by  the commission is nothing but modified Laspeyres index which is based on comparing cost of fixed basket of goods in base and current period.

They pointed that there is an overestimation of true cost of living by 1.1 percentage points per year owing to substitution and quality change issues. Let us take these issues one by one:

1. Suppose British Pen and French pen are two products which cost the same and customer has slight preference for the French pen. The base line quantity will reflect that. Now, if the French pen gets thrice as costly then CPI will reflect 200 percent inflation.Infact what customer does is that as the french pen gets thrice expensive , he shifts  towards British pen as it is as good. If the price of the British pen remains fixed then there is almost no inflation.This is called the substitution bias as the price of previous consumption basket go up,the customer chooses a relatively cheaper option.So, maintaining the same utility level is not as expensive as CPI would reflect. Similarly , there can be cases where we can underestimate the inflation. This phenomenon has been mentioned in the Boskin Commission report and based on the example discussed above we can see that the CPI fails to incorporate the substitutions that allow customers to take on the price change impact .This has big implications on many government policies specially  transfer payment related to social security. The practical connotation of substitution bias in case of social security payment issues involves the logic that the recipients are over paid as they can achieve the same level of utility cheaply. So, this indicates that the social welfare and security issues must be oriented in such a way that the governments pay the  beneficiaries enough to sustain the life standards which provides the desired level of utility(cost of living) rather than consumption of fixed basket of goods as per Laspeyres index.

A real COLI should be measured by an index such that the information about both current and base period quantities can be gathered.In this context, the Boskin Commission recommended the Tornquist index which is obtained by weighing the rate of growth of individual price by their share in budget,averaged over base and current periods. Now BLS uses this index and it correctly tracks the COLI of single utility maximize where utility function is right functional form or constant over time. This also fits the assumptions of general equilibrium theory.

b) Next, important issue is how we should think about quality change with time if we go for COLI. We must look at how changes in quality link to the utility of people. The main concern is whether the linking procedure used at present does this correctly.

If we consider CPI as COLI framework, this linking presupposes that the difference in prices reflect difference in quality.If two machines A(old version) and B (modern version) are operating in Y1 (last year) and Y2 (present year) respectively and the cost of B is 50 percent less than the quality of B is also assumed to be fifty percent less. This assumption linking price change and the quality offered is not appropriate. In this context, we must take into account the Boskin Commission report which presents quality bias as an important reason for overestimation by BLS.They stated that all types of goods have become much better in quality and the CPI was not reflecting that. Actually inflation should not have been so high once we take into account the better quality of goods that we get now.

Next, there are also issues of theory and value ladenness when we try to use CPI as COLI.It is well known that utility is concept in Expected Utility Theory. If we take CPI as COLI then the validity of our measurement procedure of CPI is linked to the validity of standard macroeconomic theory.Why is it so? Normally, Economists argue that we can only assign utility function to economic agents only if they are infact Expected Utility Maximizers. So, if individuals are operationalist or constructivist about utility they will think that utility is just a way of having convenient form ofpresentation of preference of consistent choosers.So, the economic logic of utility itself might not standif individuals are not expected utility maximizers. So, if weare no Expected utility maximizersthen this may be a problem for our Consumerprice index based measurement procedure.

Another worry is regarding value ladenness of the measurement procedure linking CPI to COLI. If we link CPI to COLI, there are two important value judgments being made:

1)The purpose of CPI is to measure cost of fixed standard of life rather than cost of having enough which will be possible alternative.

2)Utility as economists understand is the correct measureof standard of life or welfare.When we say COLI based on basic needs we need to satisfy and people need tobe productive members of society point to more objective understanding of what welfare is.It is good for people to have shelter or food whether they like it or not.

The major concern is that theory and value judgments seem to conflict with initial idea what measurement is? Measurement should be objective and theory free way of capturing an aspect of real world. Too much theory should not be going in CPI based COLImeasurement procedure.In this context, measuring theory and value laden concepts like CPI as COLI needs much proper characterization. Scholars like Cartwright and Runhardt have specifically focused on the point that in case of inflation measurements, different characterizations have different consequences for different group of people. So, theoryand value ladenness may further propel this issue of multiplicity of measurementsand various conceptions it can take. So, the appropriateness of CPI to measure COLI amidst various conceptions and consequences is heavily dependent on the appropriateness of use of CPI as COLI.We must also understand that the value ladenness seems to undermine the objectivity of measure.

The ideal that measurement has to betheory free is not possible as we always have some theory about how measurement work. Similarly we cannot make measurement of COLI based on CPI value free as thepurpose of measurement is important.In this context, Expected Utility theory is very importantcomponent of general equilibirium theory.Here we want to use CPI based inflation measure as part of way of testing general equilibirium theoryor its implementation . In the process of studyingCPI based COLIin depth, we mustrealize that Expected utility going in General Equilibirium theory undermines our ability to test the theory afterwards. We cannot do away with theory but base our study of COLI on theory independent of what we are trying to test or find. Further, we cannot do away with values but try and reduce it.Therefore, rather than importing conceptions of welfare while using inflation measurement as COLI, we must focus on values consistent with society as stated by scholars like Reiss.

So, mainly due to issues like substitution bias, quality change bias , theory and value ladennessCPI based COLI should not be promoted globally.

The author is candidate at Philosophy department of The London School of Economics.