Volume 8, No. 2
Summer 2002

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CONSUMER PRICE INDEX:
UPDATING THE COST-of-LIVING INDICATOR

by Richard Kaye

Recently the federal government has adjusted the Consumer Price Index to better reflect the changing spending habits of the American public. This article will detail these improvements made to the index.

What is the Consumer Price Index?

Basically, the Consumer Price Index is a measure of the average change in prices paid for a fixed market basket of consumer goods and services over a stated period of time. Goods and services included in the market basket are items found in one’s daily life, such as:

*Food and Beverages
*Housing
*Apparel
*Transportation
*Medical Care
*Recreation
*Education and Communication
*Other Goods and Services

How do changes to the Consumer Price Index affect you?

Two indexes or spending patterns are computed from these measurements: the CPI-U and the CPI-W. The CPI-U is based upon all residents of urban or metropolitan areas representing 87% of the U.S. population. The CPI-W, a subset of the CPI-U, represents households where more than one-half of total income is derived from clerical or wage occupations and one household member has worked at least 37 weeks in the previous 12 months. This accounts for approximately 32% of the population.

How is the Consumer Price Index Used?

Whichever index selected, the CPI is used primarily for three purposes: to indicate economic activity, to deflate other economic series in order to make the data comparable, and to adjust dollar values so that one can compare item prices over a span of time. The 36-month average in the 1982-1984 inclusive time frame is used as the base period. It is given an index value of 100.

Strictly speaking the CPI is not a cost of living index, although it is used as such, since it does not measure other factors that affect consumer well being such as crime. It is also very important to realize that the CPI is relevant to the average household, and not to one’s specific situation. If, for instance, a person’s house is fully paid, and without a mortgage or other instrument, the CPI would overstate this “cost of living”. It is sometimes assumed that a provision is made for this expenditure in the index but, in fact, this is not the case. The CPI is an index of price change only, and it does not reflect changes in spending patterns over a period of time.

Challenges of the Consumer Price Index

Since the CPI continues to be used as a measure of cost of living, it is very important that it remain accurate. There are four major concerns with the existing indexes, which could affect the CPI’s precision:

• Substitution- this concern addresses the substitution of a cheaper product to satisfy the need for a more expensive product when relative prices change. For example, substitution occurs when one buys a generic product instead of a name brand.

• Sample Rotation- sample rotation occurs when new items are introduced and receive disproportionate weight (either high or low) in the month of introduction. If a new product appears on the shelf of a market it may be popular in its first month due to its novelty. However, the product’s quality may be low, therefore discouraging repetitive consumption.

• Outlet Substitution- similar to substitution above, outlet substitution exists when a less expensive outlet is substituted without factoring in the impact of changed levels of customer satisfaction. Outlet substitution may occur when one shops at a wholesale store instead of a shopping mall.

• Quality- this final concern addresses improvements in quality not reflected in price. For example, cars have improved in quality over the past years, although their price has remained relatively stable.

Revising the Consumer Price Index

In an attempt to correct the substitution limitation listed above, the Bureau of Labor Statistics will begin - with the August, 2002 release of July, 2002 data - a new index called the Chained Consumer Price Index for All Urban Consumers. This C-CPI-U will supplement but not replace the existing indexes. This measure, called a “superlative” index, will utilize expenditure data in adjacent time periods in order to include the impact of any substitution consumers make across item categories. By doing so, purchase changes made by consumers from changing relative product prices will be included in the index. This new measure is expected to more closely approximate a cost-of-living than existing indexes. Earlier introduced sophistications utilizing a geometric mean for averaging prices within item categories will continue in the new index.

The expenditure data required to construct the index is available only with a time delay, and will be subject to two revisions. It will be issued for national averages only and not be seasonally adjusted. December, 1999 will be the reference base, equal to 100, and data prior to that period will not be computed.

The effect of this improved measure is expected to increase at an average annual rate of 0.1 to 0.2 percentage points less than the present CPI for all Urban Consumers.

In an earlier edition of the Illinois Labor Market Review the Consumer Price Index was explored in some detail, including its shortcomings. For a more comprehensive introduction to the Consumer Price Index, please refer back to the earlier article: Volume 3, No. 3, Fall 1997. It is also available on the web in the archive section of the LMI Source web site — http://lmi.ides.state.il.us. Consumer Price Index data is available at http://www.bls.gov/cpi/.