The social cost-of-living: welfare foundations and estimation

We present a new class of social cost-of-living indices and a nonparametric framework for estimating these and other social cost-of-living indices. Common social cost-of-living indices can be understood as aggregator functions of approximations of individual cost-of-living indices. The Consumer Price Index (CPI) is the expenditure-weighted average of first-order approximations of each individual's cost-of-living index. This is troubling for three reasons. First, it has not been shown to have a welfare economic foundation for the case where agents are heterogeneous (as they clearly are.) Second, it uses an expenditure-weighted average which downweights the experience of poor households relative to rich households. Finally, it uses only first-order approximations of each individual's cost-of-living index, and thus ignores substitution effects.

We propose a 'common-scaling' social cost-of-living index, which is defined as the single scaling to everyone's expenditure which holds social welfare constant across a price change. Our approach has an explicit social welfare foundation and allows us to choose the weights on the costs of rich and poor households. We also give a unique solution for the welfare function for the case where the weights are independent of household expenditure. A first order approximation of our social cost-of-living index nests as special cases commonly used indices such as the CPI. We also provide a nonparametric method for estimating second-order approximations (which account for substitution effects).