Nevertheless, there is some disagreement, including among members of the panel, on how difficult it is to understand the COLI concept. Some argue that the basic idea of a cost-of-living index is straightforward and that the difficulties come with the detailed implementation. According to this view, there is no great difference between a COLI and a COGI, since the implementation of the latter also requires much that is complex and difficult to understand. Others challenge the comprehensibility of even the basic concepts underlying the COLI. The idea of holding constant the standard of living requires some notion of what is meant by a standard of living and whether this is “happiness,” “satisfaction,” “utility,” or something else. As we have shown, it is indeed something else, and explication of it takes a good deal of space. Finally, there is room for argument about the importance of public perception and understanding and how much weight it should be given in the construction of an index number for which there will inevitably be a great deal of technical detail.

Substitution Bias

The basket price index is just that, the cost of a basket of goods relative to the reference. The issue of substitution bias does not arise, at least if one is happy with the choice of basket. But if one has several reasonable choices of baskets and if they give different price indexes, one has to choose between them and recognize that at least part of the difference between the indexes, say the Paasche and Laspeyres, comes from consumers substituting in response to changes in relative prices. Once again, though, substitution is not the only reason—nor even necessarily the most important—for changes in the bundle; changes in tastes, in quality, and in the sociodemographic composition of the population also have their effects. If one chooses to maintain the distinction between the cost of living and the cost of things, with the former relevant for compensation and the latter for a price index, then recognizing the existence of substitution does not necessarily involve recognizing the existence of substitution bias. A fixed-basket index is biased as a measure of the cost of living but not necessarily as a measure of the price level itself.

From the COLI point of view, which does see the price level in terms of the cost of living, the Laspeyres index is at best an approximation that overstates the change in the price level between the reference and comparison periods. The degree of overstatement is the substitution bias, and it will tend to be larger when the difference in relative prices is large and when consumers’ ability and willingness to substitute one good for another are high. But it is not necessarily true, as is sometimes supposed, that the overstatement of the COLI by the Laspeyres becomes increasingly severe simply as the time between the base period and the (current) comparison period increases (see “Technical Note” at the end of this chapter). Indeed, there is some empirical evidence that, for recent U.S. history,

The National Academies | 500 Fifth St. N.W. | Washington, D.C. 20001
Copyright © National Academy of Sciences. All rights reserved.
Terms of Use and Privacy Statement