INFO 4470/ILRLE 4470 Price Indices: Theory and Applications John M. Abowd and Lars Vilhuber February 28, 2011

2 Outline The basic problem The basic problem Consumer theory and cost-of-living indices Consumer theory and cost-of-living indices Introduction to the Consumer Price Index (CPI-U and CPI-W) Introduction to the Consumer Price Index (CPI-U and CPI-W) Index number formulae Index number formulae Estimation of the quantity weights Estimation of the quantity weights Estimation of the prices Estimation of the prices Building the index Building the index The chained alternative (C-CPI-U) The chained alternative (C-CPI-U)

3 The Basic Problem When prices and quantities both change, provide a measure of the change in the cost of living When prices and quantities both change, provide a measure of the change in the cost of living Decompose this measure into a price index that captures the overall change in prices and a quantity index that captures the overall change in quantities Decompose this measure into a price index that captures the overall change in prices and a quantity index that captures the overall change in quantities

4 The Cost of Living Index The cost of living index is defined as the minimum expenditure necessary to achieve a given utility level

5 Basic Formulae

6 X 2 X 1 A B C D A: original t=0 B: t=1 (Laspeyres) C: Theoretical D: t=0 (Paasche) u(t=1) u(t=0)

Introduction to the Consumer Price Index (CPI-U and CPI-W) The Consumer Price Index for all urban areas (CPI-U) is the basic national index BLS CPI Home Page The Consumer Price Index for urban wage and salary workers (CPI-W) is customized for households where the head is a wage and salary worker

8 CPI Basic Formulae The lower-level components of the CPI-U are estimated using the geometric formula The aggregate CPI-U is estimated using the Laspeyres formula The chained C-CPI-U is estimated using same lower-level components but with the Tornquist formula applied to the components

Estimation of the Quantity Weights Consumer Expenditure Survey Diary Survey (small frequent purchases) Interview Survey (purchases with 3 month or longer recall, major purchases)

Estimation of the Prices Census Bureau Telephone Point-of-purchase Survey Identifies Retail Outlets Item prices are surveyed by BLS on schedules varying from monthly to annual Quality adjustments use hedonic pricing methods

Building the Index Areas-items determine 8,018 combinations See formulae in Handbook, Chapter 17, pages 35-40

Chained Alternative See Chained Alternatives (C-CPI-U)Chained Alternatives For the NIPA the chained-dollar indices use the Fisher formula. See Chained-Dollar Indexes.Chained-Dollar Indexes