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What is Cost of Living? - Expenses & Overview

Instructor: Shawn Grimsley
Most everyone would like a COLA, and we're not talking about soft drinks. In this lesson, you'll learn what cost of living is and some of its key concepts. You'll also have a chance to take a short quiz.

Definition

Cost of living is an economic concept consisting of the general level of prices for goods and services that typical consumers purchase for their activities of daily living. It is used to determine cost of living adjustments (COLAs), which are increases in pay, government benefits or pension benefits to match the rate of inflation so that a person's purchasing power remains the same or is not as adversely affected.

How it Works

Cost of living adjustments may be determined contractually between employees and employers with a set rate, or through the use of a formula using a price index for the calculation. A price index is a weighted average of prices of a market basket of selected goods and services measured over a period of time.

The index uses a base year for the items in the index, which is set at 100. You then measure the increase or decrease in prices each year relative to the base year. For example, let's say an index has a base year of 1980 and the base year value is 100. In 2010 the index value is 125, which means that prices in the market basket of goods and services have increased 25% from 1980 to 2010.

Some examples of indexes that may be used to make COLA determinations include the consumer price index, a cost-of-living index that varies by geographic region, or a chained consumer price index, which tries to take into account changes in customer buying behaviors due to raising prices (such as buying cheaper substitutes).

Common Expenses Considered

Price indexes used for COLAs often include the following expenses:

  • Food and beverages
  • Housing
  • Apparel
  • Transportation
  • Health care
  • Recreation
  • Education
  • Other goods and services that are typical for the average consumer

As you can see, the idea is to generate a basket of goods and services that reflect what a consumer typically purchases so that their compensation or benefits can be adjusted to maintain the same level of purchasing power and quality of life. Remember, however, the idea is to maintain the quality of life, not increase it.

Two Criticisms

COLAs have been subject to some criticism. One criticism is that COLAs don't take into account that the increase in income may push you into a higher tax bracket, which results in payment of more taxes. Since income tax increases aren't taken into account, COLAs don't always leave you in the same economic place you were after price increases because you have less money due to the extra taxes.

On the other hand, some criticize COLAs for not taking into account the fact that consumers will change their purchasing behaviors when facing price increases. For example, they might buy cheaper product substitutes such as standard auto-drip coffee instead of premium whole beans. The chained consumer price index attempts to address this problem.

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