Cost of Living
COST OF LIVING
COST OF LIVING. The cost of living is the monetary cost of maintaining a particular standard of living; its fluctuations are closely tied to rates of inflation and deflation. To estimate the cost of living, such items as food, clothing, rent, fuel, and miscellaneous items such as recreation, transportation, and medical services are considered. The cost of living is usually measured by calculating the average cost of a number of these particular goods and services; the average cost is then used as an index for a given cluster of consumables.
Measuring changes in the cost of living is essential to determine fixed-income payments, such as welfare and social security, family allowances, tax exemptions, and the minimum wage; it is also an important factor in wage negotiations. Because the supply and demand of certain products are subject to change, it becomes difficult to make precise cost-of-living comparisons and adjustments.
Determining the Cost of Living
The cost of living is determined by the amount of money needed to buy the goods and services necessary to maintain a specific standard of living. In 1890, the Bureau of Labor Statistics made the first attempt to gather data on the cost of living in the United States, introducing the cost-of-living index. In 1944 the government changed the name of its measurement from the "cost-of-living index" to the "consumer price index" (CPI), when a presidential committee made a comprehensive study and concluded that the cost-of-living index did not reflect all changes in living costs. Using the CPI, the government can keep track of even incremental changes in retail prices. These changes are then compared to prices in a previously selected base year, which shows the percentage increase or decrease in the cost of living over time. In addition to changes over time, these studies also consider regional differences in the cost of living. The CPI is based on data collected in eighty-seven urban areas throughout the country and from about 23,000 retail and service establishments. Data on rents are collected from about 50,000 landlords or tenants. The CPI also compiles price quotes per month in twenty-three selected areas on approximately 304 commodities and services. It is revised periodically, with short-run comparisons tending to be more accurate than long-run comparisons.
Changes in prices are of major importance to many segments of the population. For workers earning the minimum wage or retired persons living on a fixed income, a rise or decline in living costs partly determines the standard of living that they can achieve and maintain. Price changes also may affect the purchasing power of a person's income. Social security benefits and pensions are also closely tied in with the CPI and may be changed accordingly, through a cost-of-living adjustment. Other legal forms of compensation, such as the property settlement and alimony in a divorce, may also be adjusted periodically to accommodate changes in the index.
The CPI provides a gauge to determine the degree to which inflation and deflation affect the average consumer. However, in times of double-digit inflation, the CPI may exaggerate the rate of inflation the average consumer experiences.
Since its inception the cost-of-living index has been steadily improved in both coverage and accuracy. Revisions in the index are based on comprehensive studies of consumer expenditures to determine "the kind, qualities, and amounts of all goods and services bought by each consumer unit." The patterns of consumer spending determine the relative importance given to each item in the index.
The Cost of Living in American History
During the colonial era, wage earners suffered declines in real income when commodity prices fluctuated in nearly every colony. The inflation that accompanied the Revolutionary War also undoubtedly hurt workers, especially in the eastern seaboard cities, although no detailed statistical study has ever been done on the subject. After the war, prices during the 1790s began another sharp rise; in response, American workers went on some of the first labor strikes in American history. Between 1789 and 1850, there is little evidence of any continuous urban retail price quotations. However, from 1850 on, existing records show that the American standard of living rose at an increasing rate over the long run, increasing on average 1.67 percent after 1850.
During the twentieth century, specifically during the period between 1913 and 1975, the cost of living in the United States increased steadily, though not to the same extent it rose in other parts of the world. The CPI saw its first substantial increase during World War I, rising to a peak of 203 percent change from the base year by 1920. At this time, the cost of living had so far outrun increases in wages that the annual number of labor strikes grew from 1,204 to 3,630 between 1914 and 1919. After 1920, the index remained at about 175 percent for a decade. The index then dipped to 131 in 1933 and recovered slowly to 142 by 1940.
During World War II, the federal government attempted to place a firm lid on the cost of living. Yet, the CPI inched upward to 182 by 1945. Since wage controls were comparatively flexible and employment was brisk, the vast majority of civilians enjoyed a notable increase in real income, an unusual occurrence during wartime. The actual cost of living increased somewhat more than the index showed, due to such factors as ceiling-price violations and the black markets that emerged to trade in scarce commodities. Although some economists dispute the accuracy of the figures for this period, the cost of living was still well below what it would have been had market forces been allowed to operate unrestricted.
The CPI spurted upward in 1946, and continued in that direction until it had reached 243 by 1950. After 1950, the CPI drifted gradually but steadily upward, with slight declines occurring during recessions. By 1960, it had attained 299, which was low compared to its 1965 level of 319, its 1972 level of 428, and its 1974 level of 525. In the 1970s, America faced new problems: a combination of inflation, recession, and unemployment to which economists gave the inelegant label "stagflation." Swollen federal deficits, largely the result of expenses incurred in the Korean and Vietnam Wars, had aggravated the problem throughout the 1950s and 1960s. Although some economists believed that a moderate amount of inflation was of no concern or consequence, the presidential administrations from Harry Truman to Jimmy Carter tried to contain inflation. In the meantime, more incomes, especially fixed incomes such as federal old-age pensions, were being protected by what were known as escalator clauses. Modeled after labor contract clauses, the escalator clause makes sure that income is automatically adjusted every three to six months to compensate for changes in the CPI.
With inflation at 10 percent by 1978, President Carter established the Council on Wage and Price Stability. The Council was to set pay-increase standards of 7 percent a year, as well as standards to limit price increases. Unfortunately, the council was generally ineffective in trying to control inflation and rising costs, due largely to the energy crisis. By 1981, President Ronald Reagan had abolished the council when studies showed that workers and companies were unwilling to moderate wage or price increases, as these measures did not appear able to stop inflation.
The Quest for Accuracy
Measuring changes in the cost of living can be difficult. Critics of the CPI believe that the index overstates the actual rise in prices because the manner in which the CPI is calculated is flawed. These same critics also point to what they believe to be weaknesses in the current system, such as the failure of the CPI to reflect improvements that have taken place, the inability of the index to add new items and subtract old ones quickly enough, delays in showing the effects of new methods of distribution on prices, particularly with reference to the rapid growth of discount houses and grocery store chains, and finally the dependence of the index on prices from the base period. This last factor has resulted in overestimations of living costs. The problems with the CPI measurements have often clouded economic realities. During the late 1970s and early 1980s, for instance, interest rates and the cost of new homes were factored into CPI housing costs. However, as critics pointed out, few people buy more than one house a year. Although increases in mortgage rates affect the overall price of a home, they do not affect homeowners who are already paying off a mortgage. Based on this calculation, the CPI was overstating the reported inflation rate by at least 2 to 3 percentage points.
The Boskin Commission
By the mid-1990s, some economists were questioning whether the use of the CPI to determine the cost of living was warranted. In early December 1996, the Boskin Commission, made up of a panel of five academics, stated what they believed to be the distorting effects of the CPI. The council, named after its head, the former chairman of the Council of Economic Advisors, Michael Boskin, announced one of the most extraordinary statistical discoveries in American economic history: CPI projections were off by as much as 30 percent. The magnitude of this error, the panel concluded, had cost American tax payers billions of dollars and distorted numerous economic decisions.
According to the commission, these flaws were the result of faulty procedures used By the Bureau of Labor Statistics, which had in effect elevated the federal budget by more than a trillion dollars. The commission also stated that if corrections were to be made to the CPI, they would save the government, and incidentally the American people, more than a trillion dollars over the next decade.
According to the commission, the CPI should not be considered a cost-of-living index, even though everyone regards it as the barometer of changes in the cost of living. According to the commission, for instance, if the CPI rises 3.5 percent, then labor contracts would follow with automatic wage increases of 3.5 percent to cover the increase in the cost of living. Social security payments and government pensions are also automatically increased to reflect rising costs. Other things such as legal contracts and rents trigger similar automatic increases.
The commission found, however, that the design of the CPI prevents it from representing accurate changes in the cost of living. There are three reasons for the discrepancies. First, the CPI did not account for what the commission called the "Substitution Bias" by which American consumers adapt their consumption patterns to avoid those goods which have increased the most in price. This failure causes the CPI to exaggerate the rate of inflation. The second factor the CPI failed to take into consideration is the "New Goods Bias." The CPI does not adequately account for the impact of new goods, such as cell phones, DVD players, and high-definition television sets, on consumer prices. The third factor that the CPI ignores is the "Quality Change Bias." Simply put, Many of the goods Americans buy are better than those they could purchase in the past. Automobiles are safer and more efficient. Electronics are more sophisticated and more durable. Recognition of these improvements rarely finds its way into the CPI; and if it does, it is usually only as an increase in price, not as an offset to the cost of living. As a result, economists account for improvements in a product's quality as well as increases in its price.
The Boskin Committee has determined that if the defects in the CPI remain uncorrected, they will cause government figures to continue to exaggerate the rate of inflation by as much as a 30 percent a year. When the CPI calculates inflation as 3.6 percent, for example, it is, according to the Boskin committee, really only at 2.5 percent. If unaltered, the current mechanism for gauging the cost of living in the United States will make the possibility of accuracy even more remote.
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