ECO402 Assignment No 01 Discussion and Solution Last Date 2nd December 2014

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Consumer price index (CPI) and cost-of-living adjustment (COLA)
§ Cost-of-Living Index: ratio of the present cost of a typical bundle of consumer goods and
services compared with the cost during a base period.
Example:
Two sisters, A and B whose preferences are identical. Person A and B began their university
education in 1990 and 2000 respectively.
Person A in 1990
- Her parents gave $500 for to A to spend on food and books
- Price of food = $2, and Price of book is $20
- A’s consumption: 100 food and 15 books
ð
I1 = $2´100 + $20´15 = $500
Person B in 2000
- Price of food = $2.2, and price of book is $100
- Her parents decided to give B the amount which is equivalent in buying power to the
budget given to A. How much would be the budget?
- B’s consumption: 300 food and 6 books (same utility level as A’s bundle and B
consumes more food and less books after the price change)
ð
I 2 = $2.2´300 + $100´6 = $1260
§ The ideal cost of living index: the cost of attaining a given level of utility at current
prices relative to the cost of attaining the same utility at base prices
ð In this example, ideal cost of living index: $1260/$500 = 2.52 (152% in the cost of
living)

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