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Unit 21: Cost of Living Index and Its Uses and Limitations of Index Numbers

The following points need be considered in the selection of items for a group of people: (1) items Notes
taken should be such as to represent the habits, tastes and traditions of the average person in the
group; (2) the economic and social importance of the goods and services are also to be examined;
(3) items should be such that they are not likely to vary in quality in appreciable degree over two
different places or different periods of time; and (4) items should be fairly large in number so as to
represent adequately the standard of living for the groups). A fairly reasonable number should be
selected. Again after determining the items to be included in the basket, the question that arises is the
determination of suitable weights for different items in the basket.
To determine the weights, a proper study of consumption habits of persons of that group is to be
made. The usual procedure is to conduct “family budget surveys”. Such surveys help in determining
the items to be entered into the consumption pattern of the group and also help in determining the
weights to be assigned to different items. One problem may occur regarding different qualities of the
same type of commodity. Another problem may concern items of common use which do not occur in
both the base period and the given period.
For a detailed account of this topic refer to Banerjee (1975).
21.1 Cost of Living Index and Its Uses

Meaning and Need
The consumer price index numbers, also known as cost of living index number, are generally intended
to represent the average change over time in the prices paid by the ultimate consumer of a specified
basket of goods and services. The need for constructing consumer price indices arises because the
general index numbers fail to give an exact idea of the effect of the change in the general price level
on the cost of living of different classes of people, since a given change in the level of prices affects
different classes of people in different manners. Different classes of people consume different types
of commodities and even the same type of commodities are not consumed in the same proportion by
different classes of people. For example, the consumption pattern of rich, poor and middle class
people varies widely. Not only this, the consumption habits of the people of the same class differ
from place to place. For example, the mode of expenditure of a lower division clerk living in Delhi
may differ widely from that of another clerk of the same category living in, say, Chennai. The consumer
price index helps us in determining the effect of rise and fall in prices on different classes of consumers
living in different areas. The construction of such an index is of great significance because very often
the demand for a higher wage is based on the cost of living index and the wages and salaries in most
countries are adjusted in accordance with the consumer price index.
The consumer price index numbers were earlier known as cost of living index numbers. But this name
was not a happy one since the cost of living index does not measure the actual cost of living nor the
fluctuations in the cost of living due to causes other than the change in the price level ; its object is to find
out how much the consumers of a particular class have to pay more for a certain basketful of goods and
services in a given period compared to the base period. At present, the three terms, namely, cost of living
index, consumer price index and retail price index, are in use in different countries with practically no
difference in their connotation. However, the term ‘consumer price index’ is the most popular of the three.

To bring out clearly this fact, the Sixth International Conference of Labour Statisticians
recommended that the term ‘cost of living index’ should be replaced in appropriate
circumstances by the terms ‘Price of living index’, ‘cost of living price index’, or ‘consumer
price index’.

It should be clearly understood at the very outset that two different indices representing two different
geographical areas cannot be used to compare actual living costs of the two areas. A higher index for
one area than for another with the same period is no indication that living costs are higher in the one

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