Microeconomics: Theory and Applications with Calculus, 4e

4.4 Cost-of-Living Adjustment

In spite of the cost of living, it’s still popular.

—Kathleen Norris

By knowing both the substitution and income effects, we can answer questions that we could not answer if we knew only the total effect of a price change. One particularly important use of consumer theory is to analyze how accurately the government measures inflation.

Many long-term contracts and government programs include cost-of-living adjustments (COLAs), which raise prices or incomes in proportion to an index of inflation. Not only business contracts, but also rental contracts, alimony payments, salaries, pensions, and Social Security payments use cost-of-living adjustments. We next use consumer theory to show that the cost-of-living measure ...