Consumer Price Index (CPI): Definition, Calculation, Benefits, and Limitations

What is the Consumer Price Index (CPI)?

CPI or consumer price index measures or tracks the average change in the price of a basket of goods in households with the passage of time. This basket is representative of common household purchases and is used as a standard to measure CPI.

CPI can vary for each country. In the US, the Bureau of Labor Statistics (BLS) calculates CPI every month. 

CPI is a well-known indicator of inflation (reduced purchasing power of consumers due to an increase in product prices) or deflation (increase in purchasing power due to lower product prices). CPI also helps to calculate the cost of living alongside determining the purchasing power of people.

A Brief History of CPI

The concept was first introduced by Lowe Joseph aka Father of Index Numbers in 1822. Joseph proposed the theory of the price basket index where he calculated the difference between the price of a list of goods at different times. This concept was further modified by economists to create its modern-day version popularly known as the consumer price index.

How to Calculate CPI?

To calculate CPI in a year, we have a simple formula:

This CPI helps governments calculate the rate of inflation over time.

Determining the Value of Goods Basket

A basket of goods is an imaginary basket containing a fixed set of items including goods and services commonly purchased by consumers in urban households. For CPI calculation, we need to determine the value of the goods basket.

To determine the value of a basket, detailed information is required. For this reason, surveys are conducted at the individual, household, and business levels. These surveys are also known as “Consumer Expenditure Surveys” in the US.

For the CPI basket, BLS takes 80000+ items into consideration. They keep this basket size huge to get an accurate measurement of price changes for goods and services. 

Then the BLS data collector visits stores or collects online price data from thousands of retail stores and service outlets to determine the basket value. Then they record basket value on a monthly basis to calculate CPI.

BLS replaces the items in the goods basket every four years.

Example of CPI Calculation

Suppose we make our own goods basket by adding a particular set of items (burger, suit, match tickets) to it. We calculated the price of those items in 2022 by adding up the individual item prices. 

Now we are going to calculate the value of this good basket by adding up the individual item values.

Value of Basket (2022) = $25 + $60 + $21 

= $106

Now in 2023, the price of items is not the same, which means that the basket value will also change. So, now we need to make calculations for 2023. 

Now we will add the individual item prices to determine basket value in 2023.

Value of Basket (2023) = $40 + $70 + $24

= $134

After having basket values for 2022 and 2023, now it’s time to calculate CPI by using the formula mentioned above. 

CPI = ($134/ $106) x 100

= 126.41

Then the comparison of CPI in years is used to calculate the inflation rate. Let’s assume that CPI for the year 2022 was 112.7. Using that CPI value, we are now going to calculate the inflation rate for 2023.

Inflation rate = (126.41 – 112.7/ 112.7) x 100

= 12.16%

So, there was an overall 12.61% increase in product prices in one year.

Types of CPI

There are two types of CPI:

• CPI-U (Consumer Price Index For All Urban Consumers)
• CPI-W (Consumer Price Index for Urban Wage Earners and Clerical Workers)

CPI – U Is the CPI calculated for all urban consumers including self-employed, short-term workers, managerial, professional, technical workers, unemployed, retirees, urban wage earners, clerical workers and others not included in the labor force. 

In contrast, CPI -W is for hourly wage earners and clerical workers. CPI- U is a general index and covers more than 87% of the US population.

What are the Benefits of CPI?

Some benefits of CPI include:

1- Economic Indicator

CPI is an important economic indicator as it is an important tool for the measurement of inflation and deflation. It also estimates the purchasing power of the masses.

2- Policy Making

Being an important indicator of economic health, CPI affects the government’s spending and economic policy-making. CPI trends are quite helpful in forming fiscal and monetary policies. It also helps economists to compare the level of economic activity over time.

3- Helps to Adjust the Cost of Living

As a measure of inflation, CPI helps to adjust the cost of living based on the price changes of consumer goods. Whether it’s salary increments, union packages, or retirement benefits, CPI helps to adjust them all according to current economic conditions.

4- Helpful for Businesses

It helps businesses to determine their product prices and make informed economic decisions.

What are the Limitations of CPI?

Despite all the benefits, there are a few limitations to CPI.

1- No Focus on Product Quality

CPI doesn’t take changes in product quality into consideration. This means price variation due to improvement in product quality will not be measured in CPI.

2- A Rigid Measure

CPI can’t justify population diversity as it calculates the inflation rate experienced by an average consumer. Also, CPI calculations are based on price fluctuations for urban consumers. Rural consumers aren’t taken into consideration.

3- No Margin for Product Substitution

When the product prices are significantly higher, people look for cheaper product alternatives and substitutes. However, CPI is calculated against a fixed market basket having no room for a product substitution.

4- Biased Selection of Basket Items

CPI includes the goods and services in the basket of goods that people buy in significant numbers. This automatically reduces the chances of newly introduced products becoming a part of the goods basket.

FAQs

Q: Are CPI and cost of living the same thing?

Ans: Though CPI is referred to as the cost-of-living index (COLI) it’s not the same. CPI tracks the changes in prices of consumer goods and services over time. However, the cost of living index measures the cost of achieving a specific level of living in a specific geographical region.

Q: What goods and services does the CPI cover?

Ans: CPI covers all sorts of necessities. For CPI calculation, BLS keeps 80000+ items in its basket. So, from buying apples to getting tickets for a baseball match, CPI takes in all.

Q: What are the item categories for CPI?

Ans: For the CPI calculation, BLS has categorized these household items into 8 major categories. And these major categories have more than 200 subcategories and specific items. 

The 8 major categories include:

• Foods and beverages
• Housing 
• Apparel
• Transportation
• Medical care
• Recreation
• Education and communication
• Other goods and services

Q: Does CPI cover taxes?

Ans: When it comes to tax inclusion, CPI includes taxes that are directly related to the prices of services and goods i.e. excise and sales taxes. However, CPI doesn’t cover taxes that are irrelevant to the purchasing power of consumers i.e. income tax, social security taxes, etc.