Measuring Cost
Measuring Cost
Measuring Cost
COST OF LIVING
The Cost of Living
Year Job Salary (TL) When we look at the salary changes,
2011 Teacher 1.721 changes might lead you to think that
football has become vastly more
lucrative over the past 10 years.
2022 Teacher 6.449
But……
■ In the preceding chapter, we looked at how economists use gross domestic product
(GDP) to measure the quantity of goods and services that the economy is producing.
This chapter examines how economists measure the overall cost of living.
■ We need all sorts of things to live. These things are typically not free. Therefore, we
need to earn money and need to fix our living standard.
■ So, what’s the cost of living the way we actually live? That is, what’s the cost of buying
the things we buy?
The Cost of Living
■ The Consumer Price Index (CPI) is a measure of the overall cost of the goods and
services bought by a typical consumer.
– When the CPI rises, the typical family has to spend more money to maintain the
same standard of living.
– The Turkish Statistical Institution (TÜİK) reports the CPI each month:
– It is used to monitor changes in the cost of living over time.
How the CPI Is Calculated
1. Fix the basket: figure out what’s in the “basket” of goods that the typical consumer
buys
2. Find the prices paid by the typical consumer for the goods in the “basket”
3. Compute the basket’s cost
4. Choose a base year and compute the CPI for all years
5. Compute the inflation rates for all years
How the Consumer Price Index Is
Calculated
1. Fix the basket: determine what “basket” of goods the typical consumer buys.
– TÜİK identifies a market basket of goods and services the typical consumer buys.
– TÜİK conducts monthly consumer surveys to set the weights for the prices of those
goods and services.
– The Individual Consumption Classification by Purpose (COICOP) was used in
determining the weights and calculating the index, and these expenditures were
grouped under 12 main groups and 43 subgroups. The index included 409 items.
How are the goods and services
obtained?
■ Data sources: The Household Budget Survey is the expenditure and turnover
information obtained from the institutional population individual consumption
expenditure survey, tourism survey and administrative records (mobile phone-fixed
phone call fees, games of chance, insurances ...)
Figure 1: The Typical Basket of Goods and Services (2018)
Education
2%
Recreation and Culture
3%
Communications
4%
Health
3%
Housing, Water, Electricity, Gas and
Furnishings, Household Equipment, Routine Maintenance of Other Fuels
the House 14%
9%
How the Consumer Price Index Is
Calculated
2. Find the Prices: Find the prices of each of the goods and services in the typical
consumer’s basket at each point in time.
– These prices are the prices paid by the typical consumer
How the Consumer Price Index Is
Calculated
3. Compute the Basket’s Cost: Use the data on prices to calculate the cost of the typical
consumer’s basket in different years.
How the Consumer Price Index Is
Calculated
4. Choose a Base Year and Compute the CPI:
– Designate a particular year as the base year, making it the benchmark against
which other years are compared.
– Compute the CPI for a given year as follows:
■ divide the cost of the typical consumer’s basket in the given year by its cost in the base
year
■ multiply the result by 100
C P I in Y ear 2 - C P I in Y ear 1
In flatio n R ate in Y ear 2 = 1 0 0
C P I in Y ear 1
How the Consumer Price Index Is
Calculated: Another Example
■ Base Year is 2002
■ Basket of goods in 2002 costs $1,200
■ The same basket in 2004 costs $1,236
■ CPI for 2004 = ($1,236/$1,200) 100 = 103
■ Prices increased 3 percent between 2002 and 2004
CPI
300
250
200
150
100
50
0
60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12 14 16 18 20
19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 20 20 20 20 20 20 20 20 20 20 20
CPI-Turkey CPI-USA
Video: Measuring Inflation
■ https://youtu.be/0jJKjgE3qfE
Problems in Measuring the Cost of
Living
■ The CPI is an accurate measure of the selected goods that make up the typical bundle,
but it is not a perfect measure of the cost of living.
Problems in Measuring the Cost of
Living
■ Substitution bias
■ Introduction of new goods
■ Unmeasured quality changes
Problems in Measuring the Cost of
Living: Substitution Bias
■ The basket does not change to reflect consumer reaction to changes in relative prices.
– Consumers substitute toward goods that have become relatively less expensive.
– The index overstates the increase in cost of living by not considering consumer
substitution.
Substitution Bias in CPI
■ Suppose Red Apples and Green Apples are the only two commodities and are identical except for
color.
■ Suppose the typical consumer’s basket has, for many years, contained 10 of each type.
■ Suppose the prices in 2015 (the base year) were $2 per apple for both types. So, the cost of the
consumer’s basket was $40 in 2015.
■ Suppose the prices in 2016 are $4 for a Red Apple and $2 for a Green Apple. So, the cost of the
consumer’s basket is $60 in 2016.
■ Therefore, the CPI for 2016 is (60/40) × 100 = 150, indicating a 50% increase in the cost of living
■ But has the cost of living really increased?
■ No. The consumer can switch to zero Red Apples and 20 Green Apples and enjoy the same
satisfaction as always without any increase in cost.
■ Therefore, the CPI exaggerates the true cost of living.
Problems in Measuring the Cost of
Living: Introduction of New Goods
■ The basket does not reflect the change in purchasing power brought on by the
introduction of new products.
– New products result in greater variety, which in turn makes each dollar more
valuable.
– Consumers need fewer dollars to maintain any given standard of living.
– Let’s consider an example
– When the iPod was introduced in 2001, consumers found it more convenient to
listen to their favorite music. The iPod was a new option that increased consumers’
set of opportunities. For any given number of dollars, the introduction of the iPod
made people better off. A perfect cost-of-living index would have reflected the
introduction of the iPod with a decrease in the cost of living. A perfect cost-of-
living index would have reflected the introduction of the iPod with a decrease in
the cost of living.
Problems in Measuring the Cost of
Living: Unmeasured Quality Changes
■ If the quality of a good rises from one year to the next, the value of a dollar rises, even
if the price of the good stays the same.
– If the quality of a good falls from one year to the next, the value of a dollar falls,
even if the price of the good stays the same.
– The TÜİK tries to adjust the price for constant quality, but such differences are
hard to measure.
Problems in Measuring the Cost of
Living
■ The substitution bias, introduction of new goods, and unmeasured quality changes cause
the CPI to overstate the true cost of living.
– The issue is important because many government programs use the CPI to adjust
for changes in the overall level of prices.
– The CPI overstates inflation by about 1 percentage point per year.
The GDP Deflator Versus the Consumer
Price Index
■ Economists and policymakers monitor both the GDP deflator and the consumer price
index to gauge how quickly prices are rising.
■ There are, however, two important differences between the indexes
The GDP Deflator Versus the Consumer
Price Index
■ We discussed the GDP deflator in Chapter 1 (Measuring a Nation’s Income)
■ The GDP deflator is calculated as follows:
N o m in al G D P
G D P d eflato r = 1 0 0
R eal G D P
Market value of all
final goods and
services produced in
GDP Deflator 2017 at 2017 prices
for 2017 with = × 100
base year 2009 Market value of all
final goods and
services produced in
2017 at 2009 prices
$600
= × 100
$200
= 300
Market value of all
final goods and
services produced in
GDP Deflator 2017 at 2017 prices
for 2017 with = × 100
base year 2009 Market value of all
Why are the goods
final goods and
produced in 2017 worth services produced in
3 times as much at 2017
prices as at 2009 prices? 2017 at 2009 prices
It must be that 2017
prices are, on average, 3
times as high as 2009 $600
prices. = × 100
This is what the GDP $200
Deflator is saying. = 300
Market value of all
final goods and
services produced in
GDP Deflator 2017 at 2017 prices
for 2017 with = × 100
base year 2009 Market value of all
The GDP Deflator is 300.
final goods and
This indicates that the services produced in
2017 prices of
domestically produced 2017 at 2009 prices
final goods and services
were on average 300
percent of the $600
corresponding prices in = × 100
2009, the base year. $200
= 300
GDP Deflator CPI
■ CPI in 1970 = 10
■ CPI in 2018 = 230
■ Koç Holding paid his workers $5 a day in 1970
■ Q: How much is that in 2018 dollars?
■ A: $115
– CPI rose by a multiple of 23 (= 230/10) from 1970 to 2018
– So, the 2018 equivalent of the 1970 salary would have to be 23 times higher = $5
× 23 = $115
Correcting Economic Variables For The
Effects Of Inflation
■ If you know a dollar amount in year a, what is the equivalent dollar amount—in
purchasing power—in year b?
A cleaner Salary
■ If the consumer price index is 200 in the year 1980 and 300 today, then $600 in 1980
has the same purchasing power as ___ today.
a. $400
b. $500
c. $700
d. $900
Quick Check Multiple Choice
■ If the consumer price index is 200 in the year 1980 and 300 today, then $600 in 1980
has the same purchasing power as ___ today.
a. $400
b. $500
As prices have risen by a
c. $700
multiple of 1.5 (= 300/200)
d. $900
since 1980, any amount in 1980
dollars must increase by a
multiple of 1.5 in order to have
the same purchasing power
Real and Nominal Interest Rates
■ Interest represents a payment in the future for a receipt of money in the past.
Real and Nominal Interest Rates
■ The nominal interest rate is the interest rate usually mentioned in borrowing or lending
contracts.
– It is not corrected for inflation.
– It is the interest rate that a bank pays.
■ The real interest rate is the interest rate that is corrected for the effects of inflation.
Real and Nominal Interest Rates
■ You deposit $2,000 in a savings account, and a year later you have $2,100. Meanwhile,
the consumer price index rises from 200 to 204. In this case, the nominal interest rate is
___ percent, and the real interest rate is ___ percent.
a. 1; 5
b. 3; 5
c. 5; 1
d. 5; 3
Quick Check Multiple Choice
■ You deposit $2,000 in a savings account, and a year later you have $2,100. Meanwhile,
the consumer price index rises from 200 to 204. In this case, the nominal interest rate is
___ percent, and the real interest rate is ___ percent.
a. 1; 5
b. 3; 5
c. 5; 1
d. 5; 3
Summary
■ The consumer price index shows the cost of a basket of goods and services relative to
the cost of the same basket in the base year.
■ The index is used to measure the overall level of prices in the economy.
■ The percentage change in the CPI measures the inflation rate.
Summary
■ The consumer price index is an imperfect measure of the cost of living for the following
three reasons: substitution bias, the introduction of new goods, and unmeasured
changes in quality.
■ Because of measurement problems, the CPI overstates annual inflation by about 1
percentage point.
Summary
■ The GDP deflator differs from the CPI because it includes goods and services produced
rather than goods and services consumed.
■ In addition, the CPI uses a fixed basket of goods, while the GDP deflator automatically
changes the group of goods and services over time as the composition of GDP changes.
Summary
■ Dollar figures from different points in time do not represent a valid comparison of
purchasing power.
■ Various laws and private contracts use price indexes to correct for the effects of
inflation.
■ The real interest rate equals the nominal interest rate minus the rate of inflation.