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A Primer on Standard of Living and Cost of Living

In the comments to my post on CPI bias, Don Lloyd accused me of needlessly confusing standard of living and cost of living. Another commenter, Cyberike, had a different complaint:

How much does it cost for the necessary expenses of life and how do the costs compare over 30 years?

Certainly I live in a better house than I did in 1975, but my costs
have gone up by a factor of 5 (500%). My electric bill is outrageous.

But I want to make a new argument:  you have to include those things that are now necessary that did not exist 30 years ago.

I had no cable bill, no internet bill, no cell phone’s. Those items
right there add about $200 to my monthly expenses. I see no one taking
these types of items into account, yet they are certainly factors in
the cost of living. Have they added to my quality of life? Yes. Do we
consider them necessities? Also yes.

I think Cyberike’s concern is a common one. Sure, I have more stuff, but I still feel like I’m struggling. So what’s the meaning of a higher standard of living?

I want to use these comments as a jumping off point for some general observations on the standard of living and the cost of living.

Standard of living is inevitably linked to the cost of living. When we try and see whether we’re better off than we were 30 or 100 years ago, we immediately have a problem. Our incomes are higher which suggest a higher standard of living. But we know that the general level of prices has risen over time, what is called inflation.

So you can’t look at the growth of income alone to measure the growth in material well-being. You have to take account of the increase in prices to accurately measure how much more stuff we can have now compared to before.

(And an obvious challenge is that there is no "we." Some of the things that have gotten a lot more expensive than others
may not be items you consume. And there may be some items that have
actually fallen in price, despite the general rise in prices, that you
consume a great deal of. So each person’s well-being is very difficult
to calculate. The presumption is that if you measure the prices of a broad enough range of goods and services, it will capture the average rise even if it will not be accurate for each individual. And since we’re usually looking at some measure of average income, we’re going to be in the ballpark.)

Conceptually, measuring the change in prices over time is pretty straightforward and has been studied for a long time. You go out and see what people buy. You look at the prices of those things. Then you do it again down the road. The average change in prices, weighted by the shares of the goods and services in total expenditure, is the measure of inflation. You divide the new higher income level by the new higher price level. If incomes have gone up by a bigger percentage than the average price, the standard of living is higher.

The average level of prices is the "cost of living" as economists use the phrase. You have to bring in the cost of living if you want to talk about the standard of living, because of inflation.

In practice, measuring the change in prices is quite difficult. Some of the difficulty is because the mix of goods and services—the "basket" of goods and services as it is sometimes called—isn’t really the same as it was a year ago or ten years ago. One reason is that people will tend to substitute toward goods that have become relatively cheaper and move away from goods that have gotten relatively expensive. So if you’re weighting the prices by expenditure, do you use the old weights of a year ago or the new weights? Economists have been aware of this problem for as long as they have talked about price indices and there are various ways of correcting for this problem.

But the harder problem is that because our standard of living is improving, because we’re better off and more real income, we don’t just  want more than we had before or a wider range of stuff than we had before. We want better versions of what we had before. We want safer cars and higher-quality personal stereos and bigger televisions and houses with more bathrooms and more living space, and less-invasive surgery and shirts that don’t wrinkle. Virtually everything is constantly getting improved, from the deeply important to the trivial, from prostate surgery to dental floss (flavored! smoother! on a stick!).

So just looking at the change in prices, even for the "same" good or service overstates the change in prices because it’s not the same good. Suppose you buy an iPod for $300 that holds 10,000 songs replacing a portable CD player that carried 16 songs for $100. The price of a portable stereo certainly didn’t triple. It probably went down.

Conceptually, this problem is also easy to solve. You use more refined categories of the good than "portable stereo." But then they improve each of the sub-categories. The iPod gets better. It holds more songs than it did before. It gets a color screen. It plays videos. This, too is conceptually fixible via what economists and econometricians call hedonics. But in practice, it’s not just challenging to fix. It’s impossible. The Bureau of Labor Statistics simply doesn’t have enough people to spend the millions (trillions?) of hours it would take to accurately correct for all quality changes. So this inevitably biases the CPI upward, overstating inflation and understating cost of living growth.

The problem gets worse when totally new products come along such as the iPod. How do you correct for the change in quality between a washboard and a washing machine or a horse and a car?

Over small enough periods of time, these distortions are relatively small. Over longer periods of time—a decade or three, a century—it becomes meaningless. How do you compare a dentist’s fee for coping with a tooth infection in 1900 that can kill you to the fee for a modern root canal? How do you compare an iPod to a strolling band of musicians, the only portable stereo available in 1900?

The tools of economics and statistics are strained beyond credibility. So any estimate of our change in our standard of living over 30 or 50 or 100 or 1000 years are crude at best. But there are good guesses and bad guesses. Surely, the average American is many times more comfortable materially than in 1900 and even perhaps compared to 1970.

Ironically, the faster our standard of living grows, the faster the quality and variety of choices that are available to us and the more our measure of the cost of living is overstated and our actual increase in material well-being is understated.

(And yes, I know some people think the CPI is understated. Let’s see them quantify that bias and show it’s anything close to the magnitude of failing to correctly deal with the improvement in quality.)

Which brings us back to Cyberike’s complaint about life today compared to the 1970’s:

I had no cable bill, no internet bill, no cell phone’s. Those items
right there add about $200 to my monthly expenses. I see no one taking
these types of items into account, yet they are certainly factors in
the cost of living. Have they added to my quality of life? Yes. Do we
consider them necessities? Also yes.

These are not the cost of living, as economists define it. But they are the cost of living in the everyday sense of the phrase. "I can’t live without my cell phone." Or e-mail. Or my laptop or my GPS system. "I have to have my digital camera for my trip." Can you imagine having to wait for your film to be developed? Who would put up with that? Well, we could obviously, but few of us choose to. Or can you imagine putting three kids in one bedroom? Impossible. Actually, it’s not. Some people do it today. Americans did it all the time 100 years ago. But the average American family today doesn’t do it. Not because we have to give each kid his or her own bedroom. Because we’re wealthy enough to choose to do so.

That’s called a higher standard of living. You’d feel it more if you went back to 1970 and with your grainy 20" TV and four channels to choose from, your smaller house, your more invasive surgery and your wooden tennis racket and your shorter life span. Some of those things are trivial and don’t really make us any happier. Some of them just become part of our expectations and the thrill of that iPod or that cell phone with a camera and voice-dialing has faded long ago like most material thrills. But most of us, as Don pointed out, would find the choice between 1970 and today an easy one to make. Because there are parts of the comparison that aren’t trivial, such as living longer. And because we’re human. We prefer more to less even though we get used to the "more" and forget how much we longed for it when we had "less."

We can talk all day about the significance of a higher standard of living and whether it makes us happier. But what we’ve been talking about in the recent posts here at Cafe Hayek is that if you want to measure our increased command over goods and services over the last five or 30 or 100 years, it’s harder to measure than it looks and there are good reasons to believe that our overestimation of the cost of living means that our measures of the improvement in our standard of living are understated.

And that brings me to one last point about these issues. No matter how much we have. No matter how great our purchasing power, we will always find it challenging to get buy on what we have. New stuff comes along that seems like a necessity. Of course it’s not a necessity. A house bigger than 2000 square feet is not a necessity. A car with a CD player and drink holders isn’t a necessity. But we will always want to use our expanding standard of living to buy more of what we have and new stuff we hadn’t dreamed of. When the peasant gets his first thatched hut and no longer has to live under a threatening sky, he doesn’t say, that’s it, I’m satisfied, nothing else is necessary to make me happier.

Thomas Sowell said it best. You can read about it here.

We are never satisfied. Something inside us wants more and better. And more and better beyond that. A spiritual fully-realized human being is aware of that drive and recognizes it and searches for something more meaningful and deeply satisfying than an iPod that plays video. But it is that drive for more and better that produces a longer life expectancy along with better dental floss. They both spring from the same source. And that source, that drive, those desires were in that medieval peasant in his thatched hut, in us today in our McMansions and will be in our great-great-great grandchildren tomorrow in whatever way they choose to live their lives.