Measuring the Cost of

Living
Measuring the Cost of Living

In measuring the cost of living we

need to turn numerical figures into
more understandable values such as
purchasing power.
Measuring the Cost of Living

By using the Consumer Price

Index(CPI), we will be able to
monitor the changes in the cost of
living.
 What is the
Consumer Price Index?
 The Consumer Price
Index is a measure of
the overall cost of the
goods and services
bought by a typical
customer.
It uses the data of
prices and services over
a period of time to
determine the cost of
living of a typical
customer.
Calculating the
Consumer Price Index(CPI)
1.Fix the basket
5 Steps to
2.Find the Prices
calculate the CPI: 3.Compute the
Basket’s cost
4.Choose a base
year and compute
the index
5.Compute the
inflation rate
 Determine which goods
and services are most
important to the typical
consumer.
If the typical consumer
buys more of product A than
Product B, then the
Product A is more important
than the Product B and should
be given more weight in
measuring the cost of living.
 Find the prices of each of
the goods and services in
each point in time.
By doing this you will
be able to calculate the
Inflation Rate of the goods
and services.
 Use the data on
prices to calculate
the cost of the
basket of goods and
services at different
times.
By keeping the
basket of goods the
same, we can
calculate the
effects of price
changes.
 Designate one year as a base year and benchmark against which other
years are compare.

Formula for computing:

Price of basket of goods and services in current year

Consumer Price Index _______________________________
= x100
Price of basket in base year
 Inflation Rate=

_________________
CPI in year 2 – CPI in year 1
x100
CPI in year 1

After getting the CPI, we’ll use it to calculate the inflation

rate of the goods and services.
Inflation Rate is the percentage change in the price index
from the preceding period.
Step 1: Survey Consumers to Determine a Fixed Basket of Goods
Determine which prices are most important to the typical consumer.
Basket = 10pcs of Product A and 5pcs of Product B

Step 2: Find the Price of Each Good in Each Year

Find the prices of each of the goods and services in the basket at each point in time.

______________________________________
Year Price of Product A Price of Product B
2010 $5 $10
2011 $6 $11
2012 $7 $12

Example: Calculating CPI and Inflation Rate

Step 3: Compute the Cost of the Basket of Goods in Each Year
Use the date on prices to calculate the cost of the basket of goods and services at different times.
2010 ($5 per Prod A x 10 Product A) + ($10 per Prod B x 5 Prod B) = $100 per basket
2011 ($6 per Prod A x 10 Product A) + ($11 per Prod B x 5 Prod B) = $115 per basket
2012 ($7 per Prod A x 10 Product A) + ($12 per Prod B x 5 Prod B) = $130 per basket

Step 4: Choose One Year as a Base Year(2010) and Compute the CPI
Designate one year as the base year, then benchmark against which other years are compared.
2010 ($100/$100) x 100 = 100
2011 ($115/$100) x 100 = 115
2012 ($130/$100) x 100 = 130

Step 5: Use the CPI to Compute the Inflation Rate from Previous Year
Use consumer price index to calculate the inflation rate, which is the percentage change in the price
index from the preceding period.
2010 (115-100) / 100 * 100 = 15%
2011 (130-115) / 115 * 100 = 13.04%

Example: Calculating CPI and Inflation Rate

EXERCISE 2

• For a hypothetical economy in which consumers buy only hotdogs

and hamburgers, the following data are given:
• Basket= 4 hotdogs and 2 hamburgers
• 2010, Price of Hotdogs = $1, Price of Hamburgers = $ 2
• 2011, Price of Hotdogs = $ 2, Price of Hamburgers = $ 3
• 2012, Price of Hotdogs = $ 3, Price of Hamburgers = $ 4
• a) Compute for the CPI 2010, 2011 and 2012
• b) Compute for the Inflation Rate 2010-2011 and 2011-2012.
SEATWORK

• Calculate the price of a bundle/basket of goods

containing 100 units of Good X, 150 units of Good Y
and 25 units of Good Z in 2008, 2009 and 2010. The
price per unit of Good X is $1 in 2008, $1.50 in 2009
and $1.75 in 2010, Good Y’s price is $1.50 in 2008,
$2 in 2009 and also $2 in 2010 and Good Z’s price in
2008 is $3, $3.25 in 2009 and $3 in 2010.
• Calculate the CPI and Inflation Rate for 2008-2009
and 2009-2010.
• Was there inflation between 2009-2010?
Problems in Measuring the
Cost of Living
Problems in Measuring the Cost of
Living
-Substitution Bias
3 Problems with
the Index that are -Introduction of new
widely goods
acknowledged but
difficult to solve. -Unmeasured Quality
Change
Prices tend to change from one year to the other but the
changes are not proportionate. The prices of some goods
go down and some go up.

To respond to this events people would resort to

substitution bias. Substitution bias happens when people
would buy more of the low priced products and buy less of
the high priced ones.
Because of the introduction
of new goods, consumers
will have more variety of
goods to choose from.
Variety will reduce the cost
of maintaining the same
level of economic-well
being.
This happens because
people would prefer
products that make the
value of their money more
valuable.
 Unmeasured quality
change happens when the
quality of a product or
service deteriorates or
lessens.
Companies would sell
their products at the same
price but would offer
less in quality or quantity.
The GDP Deflator versus the
Consumer Price Index
GDP Deflator Versus CPI

GDP deflator is CPI is a measure of

the overall cost of the
the ratio of goods and services
nominal GDP to bought by a typical
real GDP. consumer.
GDP Deflator Versus CPI
Economists and Usually these two will
Policymakers use give the same results.
GDP and CPI to Yet differences will
gauge how quickly cause the results to
prices are rising. diverge.
GDP Deflator Versus CPI

GDP Deflator CPI reflects the prices

reflects prices of all of all goods and
goods and services services bought by
produced consumers.
domestically.
GDP Deflator Versus CPI

GDP deflator is affected CPI is not affected if

when products that are products that are not
not bought by typical bought by typical
consumers are sold at a consumers change
higher price. prices.
GDP Deflator Versus CPI
1st Difference
GDP deflator is not CPI is affected
affected when prices because consumers
outside of the buy goods outside
country changes. of the country.
GDP Deflator Versus CPI
2nd Difference
GDP Deflator compares the CPI compares prices of a
price of currently produced fixed basket of goods and
goods and services to the services to the price of
price of the same goods
the basket in the base
and services in the base
year. year.