How to deal with changing prices?
1 What’s the Consumer Price Index (CPI)
Is measure of the overall cost of the goods and services bought
by a typical consumer.
What is in a typical consumer’s “basket”? Housing (biggest weight),
Transportation, Food & Beverage, Medical Care, Education,
Recreation, Apparel, Other goods & services.
What has been getting more expensive over the years? Tuition & Fees,
Medical care, Shelter, CPI, Food. Why? Because now more people
want education.
2 How to compute your Entertainment Price Index
(EPI)
2013 2014
Good Quantity Price Cost Price Cost
Popcorn 2 $4 $8 $6 $12
Limeade 2 $4 $8 $4 $8
Movie ticket 1 $8 $8 $10 $10
Basket Price $24 $30
Index (EPI) $24 / $24 x 100 = 100 $30 / $24 x 100 = 125
Market Basket Quantity 2014 Price 2015 Price
Karaoke Machines 1 $37 $54
Downloads 3 $1 $2
Basket Cost in 2014 = $37 + $3 = $40
Basket Cost in 2015 = %54 + $6 = %60
Price Index in 2015 = ($60/%40) x 100 = 150
3 How to calculate price inflation?
Inflation Rate = (CPI2 – CPI1)/CPI1 x 100 = (150 – 100)/100 x 100% = 50%
Inflation rate tells us that our money buys less things now than it did in earlier years.
4 Problems with CPI
4.1 Substitution Effect
People can switch any time. We switch away from things. If we fix the bundle as is, the CPI tells us that
the prices are increasing, but it does not tell us that people are walking away from particular goods.
We are switching to substitutes.
When prices change from one year to the next, they do not all change proportionately. Consumers
substitute toward goods that have become relatively less expensive. If a price index is computed
assuming a fixed basket of goods, it ignores the possibility of consumer substitution and, therefore,
overstates the increase in the cost of living from one year to the next.
We do not consume the same “bucket” of goods over time. The quality of products could change, we
could want something else, etc. Say that beef is expensive, we would switch to tofu. Our standard of
living has gone down, but the CPI would not know that, we still have beef in the bucket. It overstates
inflation, if we switch to a good, and overstates standard of living, if we substitute to a cheaper good.
4.2 Quality Changes
Manufacturers/sellers bypass inflation by product shrinkage. The quality of the product has changed.
If the quality diminishes with the same price, it does not change CPI. CPI does not measure quality
increase/decrease. The other side of the coin would be the CPI understating the standard of living: An
old computer in the 1970s cost 2k, an apple computer is now 1.5k. It does show the price decrease, but
does not show the quality increase.
If the quality of a good deteriorates from one year to the next while its price remains the same, the
value of a dollar falls, because you are getting a lesser good for the same amount of money. Similarly,
if the quality rises from one year to the next, the value of a dollar rises.
4.3 Introduction of New Products
CPI does not measure your increase in standard of living with these new products.
When a new good is introduced, consumers have more variety from which to choose, and this in turn
reduces the cost of maintaining the same level of economic well-being. The increased set of possible
choices makes each dollar more valuable. The consumer price index is based on a fixed basket of goods
and services, it does not reflect the increase in the value of the dollar that arises from the introduction
of new goods.
4.4 MIT’s Billion Prices Project (BPP)
They look at 500 million traded items online and update that daily. CPI is monthly. Sometimes the CPI
does not match the BPP, but it’s usually not far off.
Several studies written during the 1990s concluded that the consumer price index overstated inflation
by about point per year.
5 Nominal or Real? Purchasing Power
Real receipts count change in price, nominal does not. For example, nominally, it’s Star Wars TFA. After
the adjusted gross (to inflation) it’s Gone with the Wind. The nominal interest rate is 2%.
THE REAL INTEREST RATE IS THE NOMINAL - ACTUAL INFLATION RATE.
Video: if there is hyperinflation, our student loans will be worth really small, but our own money cannot
pay for anything else in the market.
6 GDP vs. CPI
The GDP deflator is the ratio of nominal GDP to real GDP. Because nominal GDP is current output
valued at current prices and real GDP is current output valued at base-year prices, the GDP deflator
reflects the current level of prices relative to the level of prices in the base year.
The GDP deflator reflects the prices of all goods and services produced domestically, whereas
the consumer price index reflects the prices of all goods and services bought by consumers.
This first difference between the consumer price index and the GDP deflator is particularly
important when the price of oil changes. The United States produces some oil, but much of
the oil we use is imported. When the price of oil rises, the consumer price index rises by much
more than does the GDP deflator.
Various prices are weighted to yield a single number for the overall level of prices. The group
of goods and services used to compute the GDP deflator changes automatically over time. This
difference is not important when all prices are changing proportionately. But if the prices of
different goods and services are changing by varying amounts, the way we weight the various
prices matters for the overall inflation rate.
AMOUNT IN TODAY’S DOLLARS = AMOUNT IN T DOLLARS X (PRICE LEVEL TODAY / PRICE LEVEL IN YEAR T)
