The cost-of-living concept has been used to guide index construction by applying the economic theory of consumption to specific problems. The theory assumes that households act rationally to achieve the highest possible standard of living given their income and the prices they face. They, therefore, allocate their incomes so that, at the margin, goods for which they pay more make a larger contribution to their standard of living. As a result, information about the relative values to consumers of different goods can be inferred from their relative prices. However, since individuals have differing (marginal) evaluations of quality, the conceptual framework for deriving overall quality adjustments from observed differences in market prices raises some difficult issues that have not been fully worked through by the BLS or by academic researchers.
In applying the theory to specific cases, it is essential to examine how closely the underlying assumptions match, or depart from, the actual behavior of consumers and markets in the particular case at hand. To take an important example, the allocation of a consumer’s expenditures on medical care is to a major extent determined not by the buyer (the consumer) but by a physician, and those expenditures often come not directly out of the consumer’s income, but rather from private or public insurance payments.
What goods and service should be covered by the CPI—what should be its domain? In the traditional fixed-weight CPI, and in its counterparts in other countries, the domain is specified by the very definition of the index: it measures changes over time in the cost of purchasing a fixed market basket of goods and services. Its domain, therefore, is the universe of private goods and services. A relatively narrow range of essentially private goods that the government produces and sells in the marketplace, such as entrance fees to national parks or fares on a publicly owned transit system, are included. But no effort is made to estimate a “price” for truly public goods and services, such as national defense or the administration of justice. The adoption of a cost-of-living approach to index construction, however, raises a number of questions about what the index ought to cover beyond what is currently included in the CPI since, in addition to the purchase of private goods and services, a large number of economic, social, and environmental factors clearly have an effect on the standard of living and therefore on the cost of living. (For ease of exposition we use the term “outside conditions” when referring collectively to all of these factors.)
Our panel examined the issue of the appropriate scope or domain of a COLI from several perspectives. If we assume (perhaps unrealistically) that tools could be developed to measure the effects on the cost of living that arise from changes in outside conditions and government actions, we must then ask: Should one include the estimated effects of those conditions on a cost-of-living index that is used for the major purposes served now by the CPI? What role should the BLS