consumer price index
A consumer price index (CPI) is a measure of living costs based on changes in retail prices. Such indexes are generally based on a survey of a sample of the population in question to determine which goods and services compose the typical “market basket.” These goods and services are then priced periodically (typically, monthly and annually), and their prices are combined in proportion to the relative importance of the goods. This set of prices is compared with the initial set of prices (collected in the base year) to determine the percentage increase or decrease.
Consumer price indexes are widely used to measure changes in the cost of maintaining a given standard of living. Such indexes are available for more than 100 countries (as in the United Nations’ Monthly Bulletin of Statistics) and are usually prepared by the country’s ministry of labor or central statistical office. The indexes of the various countries differ widely in coverage and methods, but there are some general characteristics that can be described.
Attributes of a typical CPI
The population group covered almost always includes families of wage and salary earners, but the indexes vary in the extent to which they include single individuals and other occupational groups such as the self-employed or professionals. The U.S. index, for example, includes only wage and salary earners, whether living alone or with families, whereas the United Kingdom index covers all households except those headed by a person with income in excess of a stated amount and those with at least three-quarters of their total income derived from pensions. Sometimes special indexes are prepared for particular groups in the population, such as the indexes for pensioners in the U.K.
CPI (and other inflation measures) in the U.S.
The U.S. Consumer Price Index (CPI), calculated monthly by the Bureau of Labor Statistics (BLS), tracks food, clothing, shelter, fuels, transportation, medical services, drugs, and other goods and services that people buy for day-to-day living.
The CPI is one of three indicators—the other two being the Producer Price Index (PPI) and the Personal Consumption Expenditures (PCE) index—that analysts and policy makers use to track inflation. Learn more about this trio of inflation indicators.
It is quite common for the indexes to refer only to urban areas, and some are restricted to a limited number of cities (e.g., six state capitals in Australia) or even to the capital city alone (e.g., Mexico City). Some indexes are, of course, broader in coverage; the Japanese index, for example, includes all households, urban or rural, except one-person households and those headed by farmers or fishermen. These limitations in the coverage of the indexes are often overlooked. For broad analytical uses such as measuring changes in the national welfare, a comprehensive index is needed that covers the whole population, including persons living in rural areas, single persons, and high-income families in urban areas.
In most countries the consumer price indexes, usually published monthly, include indexes for major categories of expenditures such as food, clothing, rent, and so forth. Sometimes they include more detailed categories (such as dairy products) and even individual items (such as milk). This depends partly on the number of products for which prices are gathered. In countries that can afford more extensive price collection and that need it because of the diversity of products purchased by their consumers, the number of items covered is usually between 250 and 450; but in smaller countries or poorer ones, the number is often between 100 and 150, and in a few countries even less than 50.
The standard CPI formula
The most common formula used in calculating consumer price indexes is a weighted arithmetic mean of price relatives. The price relatives (as described above) are weighted according to the amounts consumers spend on each product; the resulting figures are summed for all goods and services and divided by the sum of the base year expenditures for the same collection of goods and services.
The expenditure weights reflect the relative importance of each item in the expenditures of the population group covered by the index. This information is usually obtained from a survey of a sample of the covered families, in which data is gathered about the expenditures upon each commodity and service. The weights need to be revised from time to time as new products appear and as spending habits change. The main obstacle to frequent weight revision is the cost of the family expenditure surveys, although modern sampling methods have made it possible to obtain reliable results with smaller numbers of observations than were used in the early days of consumer price indexes. In some countries, however, family expenditure surveys are conducted continuously, as they are in the annual surveys in the U.K. or the monthly surveys based on overlapping panels of households in Japan.
Conceptual difficulties
A fundamental difficulty in existing consumer or retail price indexes is that they are defined in terms that are not really appropriate for the uses to which they are put. The official compiling agencies describe them as measures of the change in price of a fixed basket of goods and services. This seems clear enough, but difficulties arise as soon as the index is put to use. One may wish, for example, to ascertain whether an urban family with an income of $20,000 in 1985 was better off than a similar family with an income of $8,000 in 1965. One may find that the consumer price index rose so much that, despite an increase in money income, the family was slightly worse off.
Cost-of-living adjustments (COLAs) and the CPI
In some countries, changes in CPI are used to adjust wages and pensions, among other price-dependent schemes. For example, the U.S. makes annual adjustments to Social Security recipients via a formula based on the U.S. CPI. Considering the challenges and inherent inconsistencies between the CPI basket and real-world costs, the Social Security COLA may or may not accurately reflect the true costs of inflation.
Although this is a fair illustration of the way the indexes are generally employed, the underlying reasoning is defective. In the first place, the implicit assumption is that the family bought exactly the same goods in 1985 as in 1965. Even if all goods in the market were identical for the two dates (no new products and no quality changes), the family would not necessarily purchase the same items; it could logically be expected to substitute goods that had smaller-than-average price increases for goods that had larger-than-average price increases. As a result of these shifts, the family might actually prefer the new bundle of goods at the new prices to the old bundle at the old prices. An index that takes into account the subjective preferences of consumers is called a constant-utility index, since it measures not the change in price of a constant bundle of goods but the change over time in the costs of purchasing bundles of goods that yield a constant level of utility or satisfaction.
Even this formulation is not completely rigorous because the utilities or satisfaction obtained by a given individual from a given bundle of goods will vary over time as consumer tastes change. All that an index can do in strict theory is to measure differences in the money incomes required at different price structures to make a given individual with given preferences indifferent as to the price structures.
Conceptually, there is little doubt that the constant-utility index is superior for virtually all of the analytical purposes for which indexes are used, but there are great difficulties in constructing one that would command wide support and confidence. Some authorities believe that the present indexes could be improved if the physical units were selected so as to represent the characteristics or utilities really sought by buyers. They hold, for example, that it would be more appropriate to compare the costs of an appendectomy or of an obstetrical delivery than the costs of an office visit to a doctor or eight hours of nursing care.