Consumer Price Index (CPI) is Not an Effective Yardstick to Measure People's Change in Welfare due to Price Change

The consumer price index (CPI) is a measure of changes in the "cost of living," the amount a consumer must spend to maintain a given standard of living.

What the CPI fails to take into account, however, is that when the prices of different goods rise by different proportions, consumers do not generally buy the same bundle of goods they used to buy. Because the CPI fails to take substitution into account, it tends to overstate increases in the cost of living.

Suppose the only goods in the economy were rice and wheat. For the representative consumer, rice and wheat are perfect substitutes. When the price of each was $2/kg, she bought 10 kgs/mo of each in the reference period, for a total expenditure of $40/mo. If the current prices of rice and wheat are $4 and $6 per kilogram, respectively, the expenditure required to buy the original bundle is $100/mo. The CPI is the ratio of these two expenditures, $100/$40=2.5.

But the consumer can attain her original indifference curve, I0, buying bundle C, which costs only $80 at current prices. The cost of maintaining the original level of satisfaction has thus risen by a factor of 2.0.

References

The Open University of Hong Kong (1998) 'Consumption' in EC301 Economic Analysis of Business and Public Policies, Hong Kong: OUHK.

Pashigian, P B (1998) Price theory and application, New York: Worth.

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