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At What Price?: Conceptualizing and Measuring Cost-of-Living and Price Indexes
The Domain of the Index: Conditional and Unconditional Cost-of-Living Indexes
Any price index, whether derived from a COGI or COLI approach, needs a list of goods that are covered and a list of goods that are not. In its discussions the panel came to call this the domain issue. There is general agreement, within the panel if not universally, that the domain should follow current practice, including market goods and excluding nonmarket goods (e.g., public goods, the environment, crime, life expectancy). In addition, only current goods and services should be covered, not leisure, nor goods and services in past or future periods, even though consumers currently get part of their well-being from consuming time, as well as from the contemplation of past and future purchases. These conclusions are consistent with either a basket or cost-of-living approach to index number construction, though the arguments are different. As we shall see, the definition of a cost-of-living index needs to be modified to become a conditional cost-of-living index (for more technical discussions, see Caves et al., 1982; Pollak, 1989; Diewert 2000a). This modification is somewhat controversial, and it has important implications for the application of the cost-of-living framework in other contexts.
For a COGI, the domain can be anything that is thought to be suitable. For example, one can select what people think ought to be in a price index, recognizing that they will certainly need some guidance on how to handle such matters as interest rates or durable goods. Such a procedure would almost certainly lead to the inclusion of the prices of market goods and services. People recognize that it is a good thing when life expectancy goes up, when crime goes down, or when a new product (cell phones or Viagra) makes life more enjoyable, but they seldom think that such improvements reduce the level of prices.
The COLI approach can get to the same place but requires more steps, some of which would be resisted by those who take a comprehensive approach to cost-of-living indexes. A good place to start is with the example of a local government raising sales taxes to build a bridge. Some local taxpayers would prefer to keep their money while others would prefer the bridge, so that the tax to fund the bridge will make some people better off and some worse off. Suppose that, on average and taking into account the taxes, people are about as well off after completion of the bridge as they were before. What has happened to the cost of living? According to the comprehensive approach, nothing. Although prices of goods are higher, the bridge brings benefits which, by assumption, exactly offset the increased cost of goods. So consumers need no compensation, and the cost of living has not changed. By contrast, the COGI approach says that prices have gone up, which means that the CPI has gone up. It is not that the bridge is irrelevant to people’s welfare or is not worth anything, but simply that the existence of the bridge seems irrelevant to the measurement of the price level. This seems like an excellent example of a case in which the price index and the cost of