Cost of Living

COST OF LIVING refers to the income required to maintain a certain standard of living. Many poverty statistics, such as the headcount index, rely on per capita or household income as a primary measure of wellbeing. Owing to differences in price levels, however, a certain income level will provide a different standard of living in various time periods or across differing geographical regions. Most countries have experienced inflation, that is, increasing price levels, over the past century, meaning that the income required to maintain a fixed standard of living has increased over time, resulting in a higher cost of living. Deflation, that is, decreasing price levels, is rare but has also occurred in some countries during specific time periods. Countries that are undergoing deflation experience a lower cost of living as time goes by.

The cost of living is generally measured using a price index. The most widely used price index is known as the Consumer Price Index (CPI). The CPI tracks the cost of purchasing a specific fixed basket of commonly purchased goods over time. For convenience, the CPI is scaled such that in the first year of the measurement, known as the base year, the value of the CPI is set as equal to 100.

Other ways to measure changes in the cost of living also exist. In the United States, consumer price indexes that track more specific baskets of goods such as health-care or food are widely available. The core CPI measures changes in the overall price level, excluding two highly volatile sectors: food and energy. The Producer Price Index (PPI) estimates the cost of purchasing a fixed basket of goods commonly purchased by businesses. The PPI is known as a leading indicator for the cost of living as it is considered a good predictor of future changes in the CPI. Finally, the Gross Domestic Product (GDP) deflator tracks price levels for goods and services produced economy-wide, and is also calculated in a slightly different manner from normal price indexes. The GDP deflator and CPI generally correlate very closely with one another, and in practice they can be used interchangeably.

While measuring changes in the cost of living using the CPI is straightforward, it is not without several difficulties. First, the basket of goods used to measure the CPI represents the goods and services typically purchased by an average urban consumer. The prices of goods and services tend to be lower, particularly for housing, in rural areas. Furthermore, the cost of living for some groups may rise faster or more slowly than the overall CPI depending on that particular group's consumption patterns. For example, the elderly spend a disproportionately high fraction of their income on healthcare, a sector that has experienced above-average inflation over the past several decades. Therefore, a cost-of-living adjustment for the elderly based upon price increases for a basket of goods purchased by an average consumer will undercompensate this group.

In addition, the Consumer Price Index suffers from three theoretical deficiencies. First, since the CPI measures a fixed basket of goods, it does not account for the ability of consumers to switch away from goods whose prices are rapidly increasing to cheaper substitutes. Second, the CPI often fails to account for increases in the quality of goods.

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