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CHAPTER • Consumer Behavior 105 EX AMPLE THE BIAS IN THE CPI In the past decade, there has been growing public concern about the solvency of the Social Security system At issue is the fact that retirement benefits are linked to the Consumer Price Index Because the CPI was a Laspeyres index that could overstate the cost of living substantially, Congress has asked several economists to look into the matter A commission chaired by Stanford University professor Michael Boskin concluded that the CPI overstated inflation by approximately 1.1 percentage points—a significant amount given the relatively low rate of inflation in the United States in recent years.15 According to the commission, approximately 0.4 percentage points of the 1.1-percentage-point bias was due to the failure of the Laspeyres price index to account for changes in the current year mix of consumption of the products in the base-year bundle The remainder of the bias was due to the failure of the index to account for the growth of discount stores (approximately 0.1 percentage points), for improvements in the quality of existing products, and, most significantly, for the introduction of new products (0.6 percentage points) The bias in the CPI was particularly acute when evaluating the costs of medical care From 1986 to 1996, the average increase in the CPI was 3.6 percent, but the medical component of the CPI increased at an average annual rate of 6.5 percent per year Thus, one estimate placed the total bias of the medical insurance part of the CPI at approximately 3.1 percentage points annually This bias has enormous policy implications as the nation struggles to contain medical-care costs and provide health care to an aging population.16 If any remaining bias in the CPI were to be eliminated, in whole or in part, the cost of a number of federal programs would decrease substantially (as would, of course, the corresponding benefits to eligible recipients in the programs) In addition to Social Security, affected programs would include federal retirement programs (for railroad employees and military veterans), Supplemental Security Income (income support for the poor), food stamps, and child nutrition According to one study, a 1-percentage-point reduction in the CPI would increase national savings and thereby reduce the national debt by approximately $95 billion per year in year 2000 dollars.17 In addition, the effect of any CPI adjustments would not be restricted to the expenditure side of the federal budget Because personal income tax brackets are inflation-adjusted, a CPI adjustment decreasing the rate of measured price increase would necessitate a smaller upper adjustment in tax brackets and, consequently, increase federal tax revenues SUMMARY The theory of consumer choice rests on the assumption that people behave rationally in an attempt to maximize the satisfaction that they can obtain by purchasing a particular combination of goods and services Consumer choice has two related parts: the study of the consumer’s preferences and the analysis of the budget line that constrains consumer choices Consumers make choices by comparing market baskets or bundles of commodities Preferences are assumed to be complete (consumers can compare all possible market baskets) and transitive (if they prefer basket A to B, and B to C, then they prefer A to C) In addition, economists assume that more of each good is always preferred to less 15 Michael J Boskin, Ellen R Dulberger, Robert J Gordon, Zvi Griliches, and Dale W Jorgenson, “The CPI Commission: Findings and Recommendations,” American Economic Review 87 (May 1997): 78–93 The Bureau of Labor Statistics adopted changes in the measurement of the CPI, but these changes reduced the bias to only 0.8 or 0.9 percentage points See, Michael J Boskin, “Causes and Consequences of Bias in the Consumer Price Index as a Measure of the Cost of Living,” Atlantic Economic Journal 33 (March 2005): 1–13 16 For more information, see Chapters and of Measuring the Prices of Medical Treatments, Jack E Triplett, Editor; Washington, D.C.: Brookings Institution Press, 1999 (http://brookings.nap.edu/) 17 Michael F Bryan and Jagadeesh Gokhale, “The Consumer Price Index and National Savings,” Economic Commentary (October 15, 1995) at http://www.clev.frb.org/ The data have been adjusted upward using the GDP deflator
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