COST-OF-LIVING INDEXES 

* The CPI is computed each year as the ratio of cost of a typical group of consumer goods and services today in comparison to the cost during a base period.

* Example

- Two sisters, Raheela and Sarah, have same preferences.

- Sarah began college in the year 1987 with a $500 discretionary budget. 

- In the year 1997, Raheela started college and her parents promised her a budget which was equivalent in purchasing power.



• Sarah' Expenditure

• $500=100 lbs of food x $2.00/lb +15 books x $20/book
• Raheela' Expenditure having Equal Utility
• $1,260=300 lbs of food x $2.20/lb +6 books x $100/book
• The cost of living adjustment for Raheela is $760.
• The cost of living index is $1,260/$500 = 2.52 or 252.
• This shows 152 percent increase in cost of living.

* The cost of living index represents cost of attaining a given level of utility at current prices relative to cost of attaining same utility at base prices.

* To do this on an economy basis would entail large amounts of information.

* Price indexes, such as the CPI, use a fixed consumption group in the base period. Known as Laspeyres price index.