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ECON1000 CH. 6 continued.docx

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ECON 1000
Nick Rowe

Measuring the Cost of Living Chapter 6 Continued Recap Question: Computing the CPI In a simple economy, people consume only 2 goods. The market basket of goods and prices are given in table. Food Clothing Basket 50 units 10 units 2006 price $4 $10 2007 price $6 $20 First, compute cost of basket each year. 2006 market basket cost: • 50 units of food X $4 = $200 • 10 units of clothing x $10 = $100 • Total: $300 2007 market basket costs • 50 units of food x $6 = $300 • 10 units of clothing x $20 = $200 • Total: $500 Second, calculate CPI for each year: • CPI for 2006: (300/300) x 100 = 100 • CPI for 2007: (500/300) x 100 = 166.7 Third compute inflation rate: (166.7 - 100)/100 x 100 = 66.7% Whats in the CPI Basket? • Shelter: 25.7% • Transportation: 19.6% • Food: 16.9% • Recreation, education, etc. 13.0% • Household operations: 11.4% • Clothing and footwear: 5.6% • Health and personal care: 4.8% • Alcoholic beverafes and tobacco products: 3.1% Problems in Measuring the Cost of Living CPI is accurate measure of selected basket of goods, but it is not a perfect measure of the cost of living Subsitution Bias • Over time, some prices rise faster than others. • Consumers subsitute towards goods that become relatively cheaper. • The CPI misses this subsitution because it uses a fixed basket of goods. • Thus, the CPI overstates increases in the cost of living. Introduction of New Goods • When new goods become available, variety increases which allows consumers to find products that more closely meet their needs • This has the effect of making each dollar more valuable • The CPI misses this effect because it uses a fixed basket of goods • Thus the CPI overstates increases in the cost of living Unmeasured Quality Change • Improvements in the quality of goods in the basket increase the value of each dollar • Statistics Canada tries to account for quality changes o It tries to keep quality of each good in basket "fixed" o If quality of good improves, it has to adjust the price of the good to reflect its former quality in basket • However, Stats Can probably misses some quality improvements, as quality is hard to measure • Thus the CPI overstates increases in the cost of living Question: Consumer Price Index Suppose that lawn mowers are part of the market basket used to compute the CPI. Then suppose that the quality of lawn mowers improves while the price of lawn mowers stays the same. If statistics Canada precisely adjusts the CPI for the improvement in quality, then, other things equal, what would happen to the CPI? Answer: the CPI would fall. Explanation: • In 2009, price of standard mower is $200 • In 2010, the price of upgraded mower is $200 • Hence, the standard mower in 2010 must cost less than $200. Let's say $180. • Since the basket in 2009 and 2010 must be the same (i.e. standard mower in basket) and Stats Can adjusted price for standard mower down (adjusted from $200 to $180) • Then CPI would fall (price of standard mower in 2010 is less than in 2009) Problems with the CPI • Each of these three problems causes the CPI to overstate the cost of living increase • Statistics Canada has made technical adjustments but the CPI probably still overstates inflation by about 0.6% per year. • This is important, because many government programs and many contracts have COLAs tied to the CPI. • What is a COLA? o Cost of living adjustment Correcting Variables for Inflation: Indexation What is indexation? • A dollar amount is indexed for inflation if it is automatically corrected for inflation by law or in a contract For example, t
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