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At What Price?: Conceptualizing and Measuring Cost-of-Living and Price Indexes
defined in terms of the basket approach, the BLS kept the cost-of-living concept in mind when making decisions about index methodology. Similarly, and as we show in this chapter, there are strong arguments for replacing a pure cost-of-living index by what is known as a “conditional” cost-of-living index which, in some respects, brings the COLI concept closer to a basket price index. In consequence of this two-way traffic, sharp differences in operating practices are uncommon. Most practical indexes or procedures for computing the CPI can be justified in terms of both approaches, though the arguments will often differ.
Still, the distinctions are important. Indexes derived from the cost-of-living approach allow for the fact that, when relative prices change, consumers tend to substitute toward the relatively cheaper items. Basket price indexes simply measure the cost of a fixed bundle of goods and are not designed with substitution in mind, notwithstanding the fact that a suitable choice of basket sometimes allows them to be interpreted as cost-of-living index numbers. The language is also important, at least in the eyes of policy makers and the public, even if those who make the index know that the formulas are the same. How the CPI is labeled affects the way that people think about it and may influence the credibility of the measure in the view of those who are affected by it. A useful analogy is perhaps the social security system, whose legitimacy in the eyes of many is enhanced by the perception that it is a fund, “the social security trust fund,” out of which they draw during retirement the contributions and interest on savings they made when working. Note too that the words “price index” and “cost of living” do not have the same connotation in common speech. The coincidence of the two ideas is relatively recent even among economists. The relationship between the “cost of things” and the “cost of living” needs to be thought about seriously. The argument that, under some circumstances, they are the same thing needs to be carefully argued and clearly laid out. The possibility that under other circumstances they are not the same thing also needs to be kept in mind.
A clear conception of what one is trying to measure also serves as a touch-stone to help resolve the many practical issues of price index construction that come up as an economy changes. Theory is the authority to which index designers appeal when it is hard to choose among alternative practical procedures or deal with new developments. Theory can be thought of as a constitution whose wise (if occasionally rather general or even delphic) principles can be applied to settle questions and disputes. A recent practical example is the adoption by the BLS of a new “geometric means” procedure for combining prices at the most detailed level of commodity disaggregation. It seems unlikely that this change would have been adopted without the shift of conceptual basis toward a COLI that followed the Boskin et al. (1996) commission report. An even more important and more difficult issue, which pervades the present report, is how to allow for quality change in the CPI. Here again, the cost-of-living framework has promise for helping design good practical procedures.