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Question: Is the Consumer Price Index (CPI) a cost-of-living index?
Answer: The CPI frequently is called a cost-of-living index, but it differs in important ways from a complete cost-of-living measure. The Bureau of Labor Statistics (BLS) has for some time used a cost-of-living framework in making practical decisions about questions that arise in constructing the CPI. A cost-of-living index is a conceptual measurement goal, however, not a straightforward alternative to the CPI. A cost-of-living index would measure changes over time in the amount that consumers need to spend to reach a certain "utility level" or "standard of living." Both the CPI and a cost-of-living index would reflect changes in the prices of goods and services, such as food and clothing, that are directly purchased in the marketplace; but a complete cost-of-living index would go beyond this to also take into account changes in other governmental or environmental factors that affect consumers' well-being. It is very difficult to determine the proper treatment of public goods, such as safety and education, and other broad concerns, such as health, water quality, and crime that would comprise a complete cost-of-living framework.
Traditionally, the CPI was considered an upper bound to a cost-of-living index in that the CPI did not reflect the changes in buying or consumption patterns that consumers would make to adjust to relative price changes. The ability to substitute means that the increase in the cost to consumers of maintaining their level of well-being tends to be somewhat less than the increase in the cost of the mix of goods and services they previously purchased.
Since January 1999, a geometric mean formula has been used to calculate most basic indexes within the CPI; in other words, the prices within most item categories (e.g., apples) are averaged using a geometric mean formula. This improvement moves the CPI somewhat closer to a cost-of-living measure, as the geometric mean formula allows for a modest amount of consumer substitution as relative prices within item categories change.
Since the geometric mean formula is used only to average prices within item categories, it does not account for consumer substitution taking place between item categories. For example, if the price of pork increases compared to those of other meats, shoppers might shift their purchases away from pork to beef, poultry, or fish. The CPI formula does not reflect this type of consumer response to changing relative prices. In 2002, as a complement to the CPI-U and CPI-W, BLS began producing a new index intended to more closely approximate a cost-of-living index by reflecting substitution among item categories. It is unlikely, however, that the difficult problems of defining living standards and measuring changes in the cost of their attainment over time will ever be resolved completely.