“standard of living.” This is done by using the economic theory of consumer behavior. Consumers always think that more goods are better (or at least no worse) than less, and they can rank different bundles of goods consistently. Consumers’ choices are governed by preferences but constrained by the market prices of goods, as well as by the amount of money they have to spend. Subject to these constraints, each consumer chooses the best (most preferred) basket among all the baskets that are affordable. The standard of living is then a measure of the extent to which preferences are satisfied. Given a set of prices that remain constant over a number of periods, the standard of living can be measured by the amount of money spent or, essentially, by real income. More technically, one can measure living standards by the size of the budget at a reference set of prices. This concept of the standard of living is a narrow one, defined entirely in terms of consumption of goods and services. It makes no claim to capture broader aspects of well-being, such as health or happiness, even though consumer choice is often described, for largely historical reasons, as “maximizing utility” or “maximizing consumer satisfaction.”
Consider an individual who is behaving according to the theory. In the reference period, there is a set of (reference) prices, and the individual has a certain amount of money to spend. This, together with the prices of goods, sets her standard of living. Next, consider a new, comparison, situation, when the prices are different. How can we think about a cost-of-living index based on holding constant not the original bundle but the standard of living? Since the standard of living is not observed, one may appear to be facing a difficult, if not impossible, task. But there is one straightforward way to make at least a first approximation, which is to calculate the new cost of the reference period basket of goods. This is, of course, the Laspeyres procedure discussed above. The key insight is that, provided nothing else (such as the quality of goods) has changed, the new cost of the original basket is always sufficient to ensure that the individual can reach the original standard of living. If the consumer buys the same bundle, her standard of living is the same. But because relative prices have changed, there may be other bundles that are just as good for the consumer, that also maintain the original standard of living. At the new prices, some of these bundles may cost less than the original bundle. If so, it will be possible to maintain the original standard of living for an amount of money less than the new cost of the original basket. Since it is always possible to reach the original standard of living by buying the original basket, the Laspeyres price index sets an upper bound on the increase in the cost-of-living index based on the original (or base) standard of living.
The difference between changes in the cost of the base period basket and changes in the cost of the base period level of living plays an important part in cost-of-living index theory, as well as in this report. The size of this difference depends on the extent to which the consumer is able to rearrange her purchases to take advantage of the fact that some goods have become relatively cheaper and others relatively more expensive. This rearrangement of purchases is referred to