# Cost of Living Adjustment (COLA)

How can we compare the cost of acquiring a good or service at two different times? Our salary today is probably higher than it was 10 years ago, but does that mean that we are richer today? The answer depends on whether we can buy less or more with the money we earn today than with our income of 10 years ago. This means our salaries today must be discounted to account for inflation.

Table 1 2008 CPI Conversion Factor.

The Consumer Price Index (CPI) was designed in 1983 to measure the average cost of living of average consumers. CPI calculated the cost for a basket of products and services (food, housing, transportation, clothing, health, etc.). Although CPI was a good indicator of inflationary pressure for a few years, its value became less and less indicative of the cost of living. The main reason is because CPI was based on a fixed set of commodities and ignored behavioral changes as technologies matured and peoples’ taste for goods and services changed. Furthermore, CPI ignored the impact of consumption on declines in the price of goods. In 1983, an average person traveled fewer miles and paid less for gasoline. The cost of a computer was much higher, however. As prices of some commodities rose sharply, consumers found other alternatives. As a result, the consumer behavior today is widely different from that of twenty years ago, and the “basket” of goods and services used in 1983 does not give a true representation of the change in purchasing power of the average consumer.

The price of any item in dollar-values of year X can be calculated in terms of dollar-value of the price of any item in dollar-values of year Y from the equation below:

Dollar value in year X = (CF in year X)/(CF in year Y). (Dollar value in year Y)

Example: Following the Iran-Iraq war in 1981, the price of Middle Eastern oil reached an all-time high of \$40 a barrel. What was the price in 2005 dollars? Adjusting for inflation, are we paying more or less for gasoline today compared to 1981 prices?

Solution: Using the CPI indicator (Table 1) to adjust for inflation gives us a conversion factor of 0.47; every 2005 dollar was worth only 47 cents in 1981. The price of 1981 gasoline in 2005 dollars can be calculated by dividing the 1981 price by 0.47 (40/0.47 = \$85 in 2005 dollars). Compared to the \$55 price of gasoline today, we are buying oil at a relatively cheaper price than in 1981.

Example: The average of price of gasoline in the US was \$2.60 a gallon at the gas pump in 2004. What was the price in 1950 dollars?

Solution: Consulting Table 1 for CF values, the price of gasoline in 1950 dollars can be calculated as: 0.125/0.977 x \$2.60 = \$0.33.

## References

(1) Toossi Reza, "Energy and the Environment:Sources, technologies, and impacts", Verve Publishers, 2005

Colander, D. C., Economics, 3rd E., Irwin-McGraw-Hill, 1998.

Bosselman, F., Energy, Economics and the Environment, Second Edition, Foundation Press, 2005.

Energy Economics, Science Direct Elsevier Publishing Company. Publishes research papers concerned with the economic and econometric modeling and analysis of energy systems and issues.