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At What Price?: Conceptualizing and Measuring Cost-of-Living and Price Indexes
effect on their real incomes or their cost of living, and they need no compensation for it. Yet prices have risen, and a price index based on standard COGI or COLI procedures would recognize the fact. In such circumstances, though, compensation by such a COLI would not hold constant the level of living of homeowners whenever the rate of change of the price of housing is different from the rate of change of other prices. A COLI might still be useful as a price index in other contexts, and one might decide on other grounds not to treat homeowners differently from anyone else (or asset holders, for example), but the COLI would no longer be the correct cost-of-living index for homeowners.
Different problems arise when one seeks to compensate people for only part of their income. This issue arises most immediately for social security benefits. Many social security retirees have other income, in some cases substantially exceeding their social security benefits. When Congress legislated to protect these benefits, its intent was to protect the benefits themselves, not the total income of the recipients. It is not immediately obvious how to design a COLI for this purpose. In particular, one does not want an index that holds constant the standards of living of social security recipients supported by more than social security benefits. There are a number of possible approaches to this issue; perhaps the simplest is to define the COLI in terms of the costs of maintaining living standards for those who have no income other than social security benefits.
It seems quite unlikely that it would be worthwhile in practice to try to design price indexes that deal with homeowners separately from renters, or separately for social security recipients with or without other income. Nevertheless, this discussion highlights the fact that, even in the area for which it seems best suited—compensation—the cost-of-living index is not as obvious a choice as at first appears.
Stocks and Flows
Both basket and cost-of-living indexes are constructed from purchases and prices of goods. As we discussed above, the definition of goods cannot be taken for granted in a world of quality change. One property of a good, which can be thought of as an aspect of quality, is the length of time it lasts. For many goods, it is reasonable to use the convenient fiction that consumption happens at the moment of purchase. But for long-lived items like automobiles or houses, consumption is typically spread over several or many years. When computing a price index, it makes no sense to add together prices of durable and nondurable goods. Thus, one must use not the purchase price but the consumption price. For nondurable goods, they are the same thing, but for durable goods they differ. For durables, one needs an estimate of the cost of consuming the good for the same length of time for which one is looking at the consumption of nondurable goods. This concept is known as user cost. If the costs of buying and selling (the transactions costs) are ignored, it is calculated by finding out how much it would cost for someone to buy the good, use it for a year (or whatever is the specified