expenditures to maintain a constant level of satisfaction. It is not clear what to make of COLIs in such an environment, though one line of approach is through consideration of the literature on habit formation, according to which the cost of living increases in response to previously increased consumption because of the “needs” induced by the earlier consumption, so that the unconditional cost of living will drift upward relative to the conditional cost of living. Once again, a conditional COLI seems to be the appropriate concept for measuring the price level.

Using Indexes for Compensation

Since a COLI is calculated by measuring compensation, it is the natural index to use for compensation and indexation purposes, though one might want different COLIs for different people and circumstances. But a COGI could be adjusted to make it more like a COLI, for example, by making an allowance for substitution bias. Similarly, one could adjust a COLI to make it more like a price index by narrowing the domain (conditioning). However, there are practical and conceptual issues that arise in cost-of-living adjustments when people are sellers as well as consumers of goods, as well as when people have incomes other than those which the index is intended to compensate.

In an industrialized economy, and putting aside the supply of labor which is outside the domain of our index, the most important group of consumers who supply goods are homeowners, who sell housing services to themselves. The issue can perhaps be most clearly seen if one considers the example of a farmer who grows beans for market and uses the proceeds to buy as much as he can afford of a fixed bundle of goods. Sales of beans are his only source of income, and he saves nothing. Suppose that all prices increase by 10 percent. The farmer needs no compensation: the cost of his bundle of goods has gone up by 10 percent, but so has his income. At the conceptual level, a COLI can once again be made to give the right answer but only if one separates the COLI from its basis as compensation. This can be done by adopting the (perhaps strained) device of separating the farmer into his production and consumption selves, so that the latter can be said to have suffered a 10 percent increase in prices. The farmer as producer gets the profits and is better off, while the farmer as consumer pays more for his consumption and is worse off. The “integrated” farmer is both 10 percent better off and 10 percent worse off; he has had no net change in real income. The compensation required by the farmer for the price increase is zero, though he would receive money from a social security or other benefits system that was indexed to a price index of goods. Such a system would therefore fail to hold the farmer at the same level of living as before the prices rose.

Exactly the same issue arise for homeowners, though because they sell only to themselves they cannot be made better off by an increase in the cost of housing. Yet an increase in the price index driven by an increase in rental costs has no

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