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Cost-of-living index

From Academic Kids

A cost-of-living index measures differences in the price of goods and services over time. Price indexes, such as the U.S. Consumer Price Index, are examples of these indexes. Price indexes measure the cost of purchasing a bundle of goods and services.

If a cost-of-living index describes the welfare changes in terms of the percent of income necessary to leave the household indifferent, it provides a unit-free measure of the change in social welfare.

A Konüs index is a type of cost-of-living index that uses an expenditure function such as one used in assessing expected compensating variation. The expected indirect utility is equated in both periods. This method can be used to introduce risk aversion into cost-of-living indexes.

Indexes can be constructed to allow for substitutions to other items as prices change. These indexes seldom recognize changes in the quality of goods however.

A cost-of-living index is a useful way to consider welfare changes caused by changes in factors exogenous to the individual household, such as inflation, and the monetary, fiscal, and trade policies of governments.

Cost-of-living allowance (COLA)

Employment contracts, pension benefits, and government entitlements (such as social security) can be tied to a cost-of-living index, typically to the consumer price index. A cost-of-living allowance adjusts salaries based on changes in a cost-of-living index. Salaries are typically adjusted annually. They may also be tied to a cost-of-living index that varies by geographic location if the employee moves. Cost-of-living allowance is often abbreviated "COLA" (whereas cost-of-living index is never abbreviated as "COLI").

Stipends or extra pay provided to employees who are being temporarily relocated may also be called Cost of Living Allowances. Such allowances are intended to offset changes in welfare due to geographic differences in the cost of living. Such allowances might more accurately be described as a per diem allowance or tied to a specific item, as with housing allowances. Employees who are being permanently relocated are less likely to receive such allowances, but may receive a base [salary] adjustment to reflect local market conditions.

Annual escalation clauses in employment contracts can specify retroactive or future percentage increases in worker pay which are not tied to any index. These negotiated increases in pay are colloquially referred to as cost-of-living adjustments or cost-of-living increases because of their similarity to increases tied to externally-determined indexes. Most economists and compensation analysts would consider the idea of predetermied future "cost of living increases" to be misleading for two reasons: (1) For most recent periods in the industrialized word, average wages have actually increased faster than most cost-of-living indexes, reflecting the influence of rising [productivity] and worker [bargaining power] rather than simply living costs, and (2) most cost-of-living indexes (see above) are not forward-looking, but instead compare current or historical data.

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