Price indexation seems more art than science – Twin Cities

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Ed Lotterman

Measuring changes in price levels in a complex economy is a difficult task, but someone has to do it.

Price indices are basic parameters for monitoring an economy, as are employment and other measures of labor as well as readings of the value of production. Information enables better government policy and informs household – and political – decisions.

There’s an old adage that information is valuable, but it’s not always cheap.

Measuring how much general price levels change and how much available labor is employed is more complicated than people realize. But information is vital. Governments have been doing this now for just over a century.

Much has been learned, although many members of the general public scoff at the final product. Yet even skeptics can benefit from knowing the basic process.

So how do you measure price changes?

Well, start by recording the prices of things at a given time. Then exit and save the prices of the same items to another point. Compare the two in terms of percentage.

OK, but which items? First, decide exactly which price category we want to measure. Each physical good or service produced? Inputs for farmers? Maintenance costs for condominiums? Or all the items households buy to meet their needs and wants?

Obviously, the latter is the most important for most people and for society as a whole. There is now a measure, the “GDP deflator”, which measures the prices of everything produced. But the consumer price index, or CPI, which we read and rely on every month, remains the basic indicator. Each month we get a reading on the costs of a basket of goods compared to where they were the month before and where they were a year ago. This is the annual figure that has made the most headlines lately.

OK, so we want to measure consumer prices — but which ones? Start with the basic necessities that each household buys: food, clothing, housing, transport, health care. Add “luxuries” such as entertainment and recreation, children’s toys, etc.

Take food. People eat meat, staple foods like bread, rice, and potatoes, fruits and vegetables, and desserts. Make a grocery list that covers everything you buy over a long period of time.

Same for transportation. Car payments, insurance, gas, oil changes, bus tickets, plane tickets, etc. For housing, rent or home purchase costs, utilities, maintenance, furniture, appliances. For health care, list insurance, office visits and hospital bills, co-pay or full cost of prescriptions, over-the-counter medications, and more. For entertainment and recreation, list movie, cable TV, sports and concert tickets, bowling, park admissions, fishing reels, golf clubs and hockey sticks.

We can see that this list is getting quite long. There is a trade-off between the accuracy that comes with detail and the effort and cost of recording prices for everything on extended lists.

Also, you have to be consistent. If you simply list “meat”, you must choose specific items and measure those same items monthly or quarterly. You can’t check the price of roast beef one month, pork chops the next month, and then chicken thighs. Month-to-month comparisons would be meaningless. You also know that the relative prices of chicken versus ground beef versus pork roasts can vary significantly over the course of a year. So if you opt for just one, your tabbed indicator will be a poor measure of what’s really going on overall.

This problem appears in all general categories. To have a measure of any usefulness, you end up with a long detailed list. It’s about whether you track the price of canned tuna in oil or spring water and what size and brand of toilet paper rolls you buy.

The list of items is called the “market basket”. The IPC database now contains some 80,000 items. To see the surface, go to www.bls.gov/news.release/pdf/cpi.pdf.

It should also be obvious that not all items are equally important. So you can’t settle for the average prices of Preparation H, Colby cheese, oil filters, rock concert tickets, bread, refrigerators, insulin, gas and manscaping. So we need a “weighted average” of price changes. The “weight” of any item will be the fraction of its purchase relative to the average household’s total expenditure. All weights are decimals which should add up to 100. The BLS press release will tell you the weight of bread is 0.199, ham is 0.050, plane tickets are 0.795, gasoline is 5.227, and shoes for men of 0.202.

It’s just another way of saying that buying gasoline accounts for 5.227% of average household spending and men’s shoes a fifth of 1%. The BLS charts tell you that 13.4% of spending is on food, with 8.3% at home and 5.1% away from home.

Determining all these weights is a task in itself. But tastes and preferences change. New elements arrive while others become useless. As a child, we ate potatoes every day, rice only with raisins in a pudding, and pasta with tuna and mushroom soup in one kind of hot dish or macaroni in another. We ate a lot of lamb but only turkey on Thanksgiving. Over my lifetime, pasta consumption has gone from less than two pounds per person per year to over 30. Mutton has gone from over 12 pounds to less than one. Turkey is the reverse, from 12 ounces to 16 pounds.

Nowadays, men buy little mustache wax, but some get “boyizilian” waxing. Who recently asked a technician to replace the cathode ray tube of his television? But most of us have a DVR and a cell phone.

Thus, there is a thorny issue of which weights to use. Those from the starting point? The most recent period? Continuous operation or a “chained” average over time? And what about regional differences? Rural versus urban? Retired versus 30?

Statisticians and economists base their careers on answering these questions. The methods they devised are very good, but not perfect. The monthly press release and the more detailed explanations referenced therein are good information for any citizen wishing to understand important public issues.

St. Paul economist and writer Edward Lotterman can be reached at stpaul@edlotterman.com.

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