Ellen Frank and Jim Devine (below) are concerned about the reason that the substitution bias is always positive. The answer is from the micro theory textbook: as relative prices change people substitute toward the now less expensive goods and away from the more expensive. A Laspeyres Index, which is what the CPI attempts to be, precludes the possibility of such substitution. Now the actual size of this bias is not large, on the order of 0.3% per year, and hence most people continue to purchase pretty much the same things from year to year. I think that the small size of the substitution effect is the reason that Jim, subjectively, feels that he does not substitute. In fact, if he is like most of us, he does not substitute very much in the current environment where relative prices are not changing very rapidly. Jim is also concerned that the production of a perfect index number may be impossible. Strictly speaking he is right. However, we can do a lot better than we have been doing. While I usually enjoy EPI material, their comment on CPI biases, as it appeared on the Washington Post op-ed page, was an exception. It was a political, not a technical analysis, and was filled with attacks on the motives of the people who were pushing to fix the CPI. Admittedly many of these people are misanthropes, yet the economic/statistical analysis stands. New needs and new goods pose a terrible problem for the construction of a price index. All of the theory begins with a world of N goods and a budget constraint. In addition, in the construction of the CPI month by month, it is often not possible to distinguish between <<me too>> innovations and those that are really of value. I found the Scientific American article very interesting. As I remember, it focused on environmental issues, a major conceptual problem for the CPI. I included a brief comment on this yesterday. The cost of living is probably changing at different rates for different classes, and it may be that it is going up less for the rich than for the rest of us. In fact, since the weights for the CPI depend on purchases, not on people, the CPI may be characterized as a plutocratic index. On the other hand, in addition to the CPI-U, which refers to all urban consumers and is the index most often referred to as <<the>> CPI, there is the CPI-W which refers to wage and salary workers. The two indexes have tracked each other very closely over the years. Dave Richardson ---------- From: pen-l Subject: [PEN-L:3930] the CPI Date: Wednesday, April 24, 1996 10:59AM Dave Richardson writes: the Consumer Expenditure deflator >> is subject to most of the biases noted for the CPI. The one exception is substitution bias -- BEA now uses a superlative index to aggregate the commodity indexes to the national all-items total. This procedure reduces the substitution bias by perhaps 0.1% per year.<< I'm not convinced at all that the "substitution bias" is a bad thing. Assuming I'm a red-blooded American steak-and-potatoes man, if the price of steak rises relative to chicken and I'm forced to abandon my meat-eating ways and swallow fowl, doesn't that hurt my utility? (I'd get less "consumer surplus, right?) This problem would be missed by the Consumer Expenditure Deflator and captured by the Consumer Price Index. Probably these issues can't be solved: isn't the construction of a perfect index number impossible? I wish Dave would look into the Economic Policy Institute's critique of the "CPI over-estimates inflation" hypothesis (which has shown up in Robert Kuttner's BUSINESS WEEK column and Doug Henwood's LEFT BUSINESS OBSERVER). He's much more an expert on this stuff than I am. Even better, is there someone from EPI on pen-l who can comment? Three other comments: (1) we have to pay attention to the creation of new needs. Capitalism as an economic system creates new necessities, so that if one were to receive exactly the same basket of goods in 1994 as in 1976 (as presumed in the CPI calculation), one would definitely be _worse_off_. Receiving an 8-track tape in 1994 would hardly be a boon, right? Being unable to gain access to the newest vaccines would be a minus. (2) Efforts to measure real wages are supposed to be trying in some sense to measure worker happiness. There's an article in the current SCIENTIFIC AMERICAN on the measurement of subjective happiness. I have only skimmed the article, but it suggested that the level of happiness shows no significant trend. Is there any correlation between real wages and subjective happiness? (3) Even if real wages _aren't_ falling, it's pretty clear that the distribution of income has become increasingly skewed over the last two decades. One can see this by calculating a ratio of rich folks' nominal incomes to the nominal wage. It's possible that the cost of living has risen more for the rich than for workers, but this seems unlikely, since stagnant nominal wages relative to property income imply cheap servants. in pen-l solidarity, Jim Devine [EMAIL PROTECTED] Econ. Dept., Loyola Marymount Univ. 7900 Loyola Blvd., Los Angeles, CA 90045-8410 USA 310/338-2948 (daytime, during workweek); FAX: 310/338-1950 "Segui il tuo corso, e lascia dir le genti." (Go your own way and let people talk.) -- K. Marx, paraphrasing Dante A.
