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Birks – Mankiw Chapter 24: Measuring the Cost of Living

A commentary on Mankiw Chapter 24: Measuring the Cost of Living (Mankiw 7th edition)

Mankiw, N. G. (2015) Principles of economics (7th ed.) Ch.24
Principles of macroeconomics
(7th ed.) Ch.11
Mason, OH: South-Western Cengage Learning.

Chapter 24: Measuring the Cost of Living

When reading the chapter, here are some aspects to consider:

  1. Index measures are very common, covering other prices such as export, import, wholesale, and inputs, and other issues such as happiness, corruption, and financial liberalisation.
  2. The textbook material to can be considered in relation to the general steps required to conduct any index. This involves (illustrating for the CPI):
    1. Choice of items (what goods and services to include in the consumer’s bundle)
    2. Choice of weights (what quantities of these goods and services)
    3. Assignment of values (what prices)
  3. If we are to investigate the suitability of an index for any particular application, we can do so by considering the three steps and the specific choices made. If decisions are arbitrary, as they are for many indices on social phenomena, then the resulting measures are questionable.
  4. Consumers do not all buy the same combination of goods in the same quantities. The CPI is therefore an approximation.
  5. The process of finding prices also indicates some possible difficulties. To illustrate, here are some observations I had made in 2006 on the price of 1kg blocks of cheese.
  6. The CPI can be used to determine changes in benefit levels. Alternatively, benefits can be related to some other measure such as average or median wage. A country may take different approaches for different benefits, as mentioned in a brief New Zealand news item here (where superannuation = pension): http://www.radionz.co.nz/news/national/101087/benefits,-super-payments-get-inflation-linked-rise
    Price index adjustments aim to maintain the same absolute levels, whereas adjustment for wages aims to maintain relative levels.
  1. There are additional measurement problems. For some measures, such as production and output, data come in over a period of time. Consequently we might see provisional estimates and later revisions. The news media (especially on television) may give overly sensational coverage to initial estimates. In the UK a provisional estimate of 1% quarterly GDP growth was taken by some it indicate that the country had moved out of recession (defined as two or more successive quarters of GDP decline). However, note this comment from an economist writing in The Telegraph:UK GDP figures revised up: what the economists say
    10:27AM BST 24 Aug 2012
    James Knightley, ING:
    The first reading of GDP was only based on 44 percent of the total data that is used to determine the ‘final’ estimate… Today’s first revision is based on around two-thirds of the data used to produce the ‘final estimate’ so we could yet see further upward revisions – typically GDP is revised by around 0.4 percentage points between the initial and ‘final’ readings.
    There was the loss of a working day in the quarter for the Queen’s Diamond Jubilee, which the Bank of England estimate knocked around 0.5 percentage points off growth.
  2. Housing costs include mortgage interest payments. If inflation is a concern, a central bank might respond by increasing interest rates, which would then flow through to increase the CPI although it actually reflects policies to control inflation. This is a perverse outcome, so a modified version of the CPI could be used to eliminate such effects, and also the effects of one-off inflationary shocks. This is because the real concerns are underlying and ongoing inflationary pressures.
  3. There are several indices that are used for comparisons of price levels. The CPI considers price changes over time in a country. Purchasing Power Parity (PPP) measures compare price levels across countries (there is an OECD Statistics Brief, which describes the approach based on a common basket of goods).
  4. The Producer Price Index is mentioned at the end of chapter section 1a. It can be termed a “leading indicator” for the CPI if changes in the PPI are closely related to later changes in the CPI. If this relationship holds, it can be used to predict future CPI changes. Of course, it only addresses the price changes resulting from changes in domestic producers’ input prices, so it is less likely to pick up imported inflation or price changes due to changes in demand.
  5. The point on substitution bias can be understood by considering that the CPI indicates how much is required to buy the same basket of goods. With changes in prices, you might choose to do something else, in which case the alternative purchases must be preferred to the original basket. In other words, the consumer can move to a preferred position, hence the CPI has overstated the amount required to stay at the same level.
  6. New goods do not always indicate an improvement. Sometimes they drive out older goods, result in discontinuation of maintenance/repair and spare parts, etc.. Think of televisions and the end of analog broadcasting.
  7. Quality changes are not always improvements either, and sometimes consumers do not use all the additional features (as with computers used only for email, say).
  8. Consequently Mankiw probably overstates the case for the CPI overstating inflation. As a general summary, Mankiw bases his claims on a particular framing of the issue, with independent individuals getting satisfaction from their own consumption of goods and services, all bought in the period during which they are consumed, and for which there are no learning requirements. In practice:
    1. People are social and act with others (a relative deprivation approach to poverty considers their ability to participate in the normal activities of society)
    2. Many items are durable (they last and can be used for some time), so they have a physical life of more than one time period. Quality changes or new products can shorten their economic life as they become obsolete.
    3. There are “learning curves” adapting to new technologies, and this implies costs to individuals.
  9. Note also:
    1. 1. The CPI uses a basket of goods based on consumption by all consumers, whereas the consumption patterns of beneficiaries may not be representative and may be subject to different rates of price change;
    2. 2. Adjustment for inflation allows people to stay at a constant level, but the rest of society may be experiencing changes (probably increases) in living standards. It may be thought desirable to maintain relative rather than absolute standards.
  10. One way to think of the adjustment for price level changes over time, changing from nominal to real values, is to recognise that values are equal to price multiplied by quantity. Think of a supermarket bill, which totals all the purchases, with each row giving price per unit times quantity. To simplify, just see this as PxQ. Imagine we have an expenditure figure in year zero, using year zero prices, P0, so we have a value P0xQ. If we want to express this in year 1 prices, P1, we are actually calculating P1xQ. To go from the first to the second, we must divide by P0 and multiply by P1. In general, to go from year A’s prices to year B’s prices, divide by the price index for year A and multiply by the price index for year B.
  11. Indexation can “correct for” inflation in some situations, but don’t assume that it adjusts perfectly. Consider taxes which are set according to nominal values rather than real values. Income taxes are an example, with tax brackets specified in terms of nominal income. To take a hypothetical case where income tax is 10% for the first $14000 and 20% above that. You earn $14000 and pay 10% in tax. Prices and incomes double. Real income stays the same, earnings rise to $28000 and you would pay 10% on the first $14000, but would be paying 20% on the second $14000. Your income tax payments would have more than doubled. This increase in real tax payments is termed “fiscal drag”. If tax brackets are indexed, as with federal income tax in the US (see chapter section 2b), fiscal drag does not arise.
  12. There can still be distortions due to other taxes being determined by nominal values, as with the treatment of interest. Interest income is taxed, and interest payments are, in some situations, tax deductible. If interest rates rise in response to inflation, then tax payments or deductions will also rise. Note that the higher interest rate is in recognition of the erosion in the value of the sum borrowed/loaned as a result of inflation. In other words, this component of interest payments is actually a capital repayment. Consequently this contribution to capital repayment is taxed for the recipient and possibly tax deductible by those repaying the loan.
  13. The use of indexation in long-term contracts indicates a further aspect of markets. Many markets have prices set for some time through contracts. This means that prices are not responsive to changes in market circumstances for much of the contract period.
  14. The suggested relationship between real and nominal interest rates is an approximation. The text states (chapter section 2c):
    real interest rate = nominal interest rate – inflation rate
    Imagine if you lend $100 for one year at 50% interest, when inflation is 25%. At the end of the year you receive $150, but prices have risen by 25%. When you spend the $150 you have to pay higher prices. Just to have the same purchasing power as when you loaned the money, you need $125. The remaining $25 is also subject to the higher price level, so how much more can we buy than before? Calculate $150/$125, and you will see that we can only buy 20% more goods at the end of the year than we could at the beginning. In other words, the real interest rate in this case is 20%, not 25%.
  15. Producer and consumer surplus are illustrated in Figure 7 of Chapter 7 (Consumers, Producers, and the Efficiency of Markets). Have a look at the diagram. Consider the area under the demand curve from the vertical axis to the equilibrium quantity. This consists of the blue triangle plus a rectangle with height equal to the equilibrium price and width equal to the equilibrium quantity. The area of the rectangle, being PxQ, is equal to the total amount paid by consumers for those goods or services. If we were to start selling on the market by offering one unit, someone would be prepared to pay a price 0A for that single unit. If we then offered another unit, it could be sold for a price slightly lower, and so on, unit by unit until we get to the equilibrium quantity, with the last unit being sold at the equilibrium price. In other words, consumers would be prepared to pay the amount that they do pay, PxQ, plus the area of the blue triangle, labelled “consumer surplus”, the extra benefit that consumers obtain over and above what they have to pay. Similarly for suppliers, they may be induced to supply a first unit at a price 0C, and so on using the area under the supply curve up to the equilibrium point. They actually receive the whole rectangle, so they are receiving a producer surplus, a sum over and above that required for them to supply the equilibrium quantity. For various reasons these are just approximations, but they indicate that the net benefits from the activity of producing and consuming the good or service should not be measured as the amount spent, PxQ, but by measuring benefits minus costs, approximately the area in the diagram represented by the two triangles for consumer and producer surplus. We do not observe these and might not expect to be able to calculate them. However, the concepts should indicate to you that commonly used measures of output, income, consumption, etc., are not good measures of net benefit to society. They are based on market prices which, at best, reflect circumstances at the margin.
  16. You may be wondering who gets the producer surplus in perfectly competitive markets, where only normal profits are obtained. Imagine an industry facing an increase in demand. It is already employing workers, but may have to pay more to increase its labour force. This would result in existing workers also getting a rise in pay. In this example, some of the surplus would go to workers in wages, rather than to the firm in profits. Similar changes can occur in returns to capital or in land prices (think of the rise in the price of central city land as a city expands).

Commentary by Stuart Birks, 28 August 2014

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