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192 CHAPTER 5 THE THEORY OF DEMAND
5.6 The Consumer Price Index (CPI) is one of the most important sources of information

CONSUMER about trends in consumer prices and inflation in the United States. It is often viewed
PRICE as a measure of the change in the cost of living and is used extensively for economic
analysis in both the private and public sectors. For example, in contracts among indi-
INDICES viduals and firms, the prices at which goods are exchanged are often adjusted over
time to reflect changes in the CPI. In negotiations between labor unions and employers,
adjustments in wage rates often reflect past or expected future changes in the CPI.
The CPI also has an important impact on the budget of the federal government. On
the expenditure side, the government uses the CPI to adjust payments to Social Security
recipients, to retired government workers, and for many entitlement programs such as
food stamps and school lunches. As the CPI rises, the government’s payments increase.
And changes in the CPI also affect how much money the government collects through
taxes. For example, individual income tax brackets are adjusted for inflation using the
CPI. As the CPI increases, tax revenues decrease.
Measuring the CPI is not easy. Let’s construct a simple example to see what factors
might be desirable in designing a CPI. Suppose we consider a representative consumer,
who buys only two goods, food and clothing, as illustrated in Figure 5.27. In year 1, the
price of food was P $3 and the price of clothing was P $8. The consumer had
F 1 C 1

BL has slope – (3/8)
1
BL has slope – (2/3)
2
BL has slope – (2/3)
3
C, clothing 40 B E

A
30
U 1

60 80
F, food

FIGURE 5.27 Substitution Bias in the Consumer Price Index
In year 1 the consumer has an income of $480, the price of food is $3, and the price of
clothing is $8. The consumer chooses basket A. In year 2 the price of food rises to $6, and
the price of clothing rises to $9. The consumer could maintain his initial level of utility U 1
at the new prices by purchasing basket B, costing $720. An ideal cost of living index would
be 1.5 ( $720/$480), telling us that the cost of living has increased by 50 percent. However,
the actual CPI assumes the consumer does not substitute clothing for food as relative prices
change, but continues to buy basket A at the new prices, for which he would need an income
of $750. The CPI ($750/$480 1.56) suggests that the consumer’s cost of living has increased
by about 56 percent, which overstates the actual increase in the cost of living. In fact, if
the consumer’s income in year 2 were $750, he could choose a basket such as E on BL 3 and
achieve a higher level of utility than U 1 .