Consumer Price Index (CPI) or Cost of Living Index Number: Construction of Consumer Price Index|Difficulties and Uses of Consumer Price Index

A statistical measure that helps in finding out the percentage change in the values of different variables, such as the price of different goods, production of different goods, etc., over time is known as the Index Number. The percentage change is determined by taking a base year as a reference. This base year is the year of comparison. When an investigator studies different goods simultaneously, then the percentage change is considered the average for all the goods. 

What is Consumer Price Index (CPI)?

The index reflecting the average increase in the cost of the commodities consumed by a class of people and helping them maintain the same standard of living in the current year as in the base year is known as Consumer Price Index (CPI). The main aim behind their design is the measurement of the effects of change in the prices of a basket of goods and services on the purchasing power of a specific section of society during the current period with respect to the base period. Other names for Consumer Price Index are Cost of Living Index Numbers, Price of Living Index Numbers, and Retail Price Index Numbers.

Why is Consumer Price Index needed?

One needs to measure the Consumer Price Index because other general index numbers do not show the effect of the change in prices of different commodities on the cost of living of different classes of people consuming these items. Besides, different classes of people consume a different variety of commodities. Also, it is not necessary that the same commodity is consumed in the same proportion by different classes of people. Therefore, to study the effect of change in prices of different types of commodities, Consumer Price Index Numbers are constructed separately for different classes of people.

Construction of Consumer Price Index

The steps required to construct Consumer Price Index are as follows:

Step 1: Determination of the scope and coverage of the Index

The first step to constructing CPI is deciding the specific class of people for whom the index numbers are intended. This class of people includes government employees, industrial workers, middle-income or low-income class people, etc. Besides the class of people, the first step also includes clearly marking the coverage (geographical area like rural, city, town, urban, etc.).

Step 2: Family Budget Enquiry

The next step involves conducting a family budget enquiry. It is done by randomly selecting a sample of adequate number of representative families from the selected class of people for whom the index is designed. The enquiry conducted should be held in a normal period of economic stability. 

In simple terms, Family Budget Enquiry helps in determining how much an average family of the class selected spends on the consumption of different commodities. The commodities are classified under five major groups; viz., Clothing, Food, House Rent, Fuel and Lightning, and Miscellaneous. These major groups are sub-divided into smaller groups termed sub-groups. For example, the major group Food is sub-divided into pulses, milk and milk products, fruits, vegetables, cereals, etc. Usually, these sub-groups are further divided into smaller parts, so that the commodities included in them can be mentioned individually. However, only the commodities, which are consumed by a group are included in the index numbers.

Step 3: Obtaining Price Quotations

The last step of constructing CPI is collecting retail prices. This step is very difficult and important because the retail prices of different commodities vary from place to place, shop to shop, and even customer to customer. There cannot be one formula for collecting retail prices; however, while collecting the following mentioned broad principles may be observed:

• The retail price should be that, which is actually charged by the customers.
• It should relate to a fixed list of items and there should be prefixed quality specifications for these items.
• Discount provided for cash payment and interest rate for the payment should also be taken into consideration.
• In this period of price control or rationing, illegal prices are openly charged to the customers. Hence, along with controlled prices, these prices should be taken into account.

As the most essential component of cost of living indices consists of prices of commodities, it is necessary to pay considerable attention to the methods used for price collection and to the price collection personnel. 

For conversion of prices into index numbers, it is required to weigh the prices or their relatives because the relative importance of different items for different classes of people is not the same.

How to collect prices?

Prices are usually collected by special agents or through mailed questionnaires or sometimes with the help of published price lists. The price collected by special agents is more reliable as they visit the retail outlets and collects the price from them. However, it is essential to properly select and train these agents. Also, a manual of instructions and manual of specifications of items to be priced should be given to these agents.

How to verify the prices?

One can verify the prices of commodities by methods such as purchase checking or check pricing. With the former method, the actual purchases of goods are made. However, in the latter case, the price quotations of the commodities are verified by means of duplicate prices obtained by different agents.

Difficulties in the Construction of Consumer Price Index

The difficulties faced while constructing Consumer Price Index (CPI) are as follows:

1. Prices used while constructing the cost of living index are retail prices. These prices vary from shop to shop, customer to customer, and place to place. Therefore, the index numbers prepared on these prices cannot be used for different classes of people or different places.

2. Besides, it consists of many commodities with unstable quality, which will not be used by customers at different point of time.

3. Lastly, the ratio of expenditures on different commodities at different point of time and by different persons are not the same, creating difficulty in constructing cost of living index numbers. 

Methods of Constructing Consumer Price Index (CPI)

The two methods of constructing Consumer Price Index Numbers are Aggregate Expenditure Method or Weighted Aggregate Method, and Family Budget Method or Method of Weighted Average of Price Relatives.

1. Aggregate Expenditure Method 

This method is quite similar to Laspeyre’s Method of Constructing Weighted Index. For the application of this method, one has to estimate the quantities of commodities consumed by the particular group in the base year. The figures estimated are used as weights. After that, the total expenditure on each commodity for the base and current year is calculated. The formula to determine Consumer Price Index under this method is as follows:

2. Family Budget Method

This method involves carefully studying the family budgets of a large number of people for whom the index is meant. After that, the aggregate expenditure of an average family on different commodities is estimated. The estimated values constitute the weights. The formula to determine Consumer Price Index under this method is as follows:

Uses of Consumer Price Index Number

The Consumer Price Index is important because of the following reasons:

1. It helps in formulating wage policy, negotiating wages, rent control, price policy, taxation and general economic policy formulation.

2. It is used by government and business units for regulation of the Dearness Allowance (DA) or for granting bonuses to employees to compensate them for the increased cost of living due to the price rise.

3. These are also used for the measurement of purchasing power of the consumer in rupees. The purchasing power of the rupee is the value of a rupee in a given year as compared to the base year. The formula to calculate the purchasing power of the rupee is as follows:

The formula shows that the purchasing power of the rupee is the reciprocal of the consumer price index.

For example, If the Consumer Price Index for a given year is 150, then the purchasing power of a rupee will be 

It means that the purchasing power of a rupee in the given year is 67 paise as compared to the base year.

4. When the price of the commodities increase, the amount of these goods and services, which money wages (or real wages) can buy, decreases. The index number tells us the change in real wages and the formula to determine the real wages is as follows:

Example:

During a specific period, the cost of living index rises from 100 to 200 and the daily wages of a worker was also raised from ₹50 to ₹90. Has the worker really gained, and if he has, then by how much in real terms?

Solution:

With the rise in the cost of living index from 100 to 200, the daily wages of the worker should increase to: 

However, the daily wages have gone up only to ₹90. Therefore, the worker has not gained. In fact, the real wages of the worker has gone down. 

The real wage of the worker is \frac{90\times100}{200}=₹45 as compared to ₹50 before the price rise.

5. These numbers are also used for the analysis of markets for particular kinds of goods and services.

All India Consumer Price Index Numbers

Three Consumer Price Index Numbers (CPIs) are constructed in India. These are as follows:

1. CPI for Industrial Workers with the base year as 1982. It is published by Labour Bureau, Shimla.

2. CPI for urban non-manual employees with the base year as 1984-85. It is published by Labour Bureau, Shimla.

3. CPI for agricultural labourers with the base year as 1986-87. It is published by Central Statistical Organisation.

These three Consumer Price Index Numbers are determined every month for analysis of the impact of changes in the retail prices on the cost of living of the three above-mentioned broad categories of consumers.