Business Courses/Human Resource Management: Help and ReviewCourse
- AuthorJune Wai See Leung
June Leung has a bachelor's degree in biochemistry and has taught high school students STEM topics.
View bio - InstructorShawn Grimsley
Shawn has a masters of public administration, JD, and a BA in political science.
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Learn the cost of living definition. Explore how to figure the cost of living, a cost of living analysis, and common living expenses considered in this calculation.Updated: 11/21/2023
Table of Contents
- What is Cost of Living?
- Cost of Living Adjustments (COLAs)
- Cost of Living Criticisms
- Lesson Summary
Frequently Asked Questions
What are some common expenses considered when calculating a cost of living?
Some common expenses include food and beverages, housing, apparel, transportation, health care, recreation, education, and other goods and services that are typical for the average consumer. This expense does not include luxury items.
How is cost of living calculated?
The cost of living is calculated by taking into account all cost that is required to live in a city. Different calculators and parties will assign different weights to the goods and services. For an individual, they can add into all their essential expense to gain insight into their personal cost of living.
What does cost of living mean?
Cost of living is an economic concept that refers to the general price level for goods and services that the average consumer will purchase for their activities of daily living. It doesn't include all goods and services but a market basket of typical goods and services.
Table of Contents
- What is Cost of Living?
- Cost of Living Adjustments (COLAs)
- Cost of Living Criticisms
- Lesson Summary
Cost of living is an economic concept that refers to the general price level for goods and services that the average consumer will purchase for their activities of daily living. It doesn't include all goods and services but a market basket of typical goods and services. It can also be considered as the price of living in a city. When comparing the livability of different cities, knowing the cost of living definition is helpful. Cost of living analysis takes into account the average income of people living in different areas, therefore is a more accurate view when analyzing whether living in one area is cheaper or more expensive than living in another.
Using a simplified example, if a gallon of milk costs $1 in city A and $5 in city B if only the face value is considered, it may seem like living in city A is cheaper. But taking into account of earning power of people, it may be the case that the average household in city A earns $20 monthly while the average household income in city B is $200, which makes city B the cheaper city to work and live in.
What are Living Expenses?
Living expense refers to the cost of goods and services that the average consumer will purchase for their activities of daily living. As mentioned above, there are some common expenses considered when calculating a city/nation's cost of living, which are listed below:
- Health care
- Apparel
- Recreation
- Transportation
- Housing
- Education
- Food and beverages
- Other goods and services that are typical for the average consumer
Cost of Living Analysis
Cost of living analysis is done by comparing the price of a range of goods and services between cities, and the same basket of goods will be weighted based on spending patterns and individual budgets. Different cost of living calculators has different weighting for different items. Generally, housing, groceries, and transport are weighted higher, while apparel will be weighed less. One can also take into account their spending habit and determine a weighting system for themselves. For example, if a household includes young children, one may consider giving a higher weight to education. In contrast, if the household has grown-up kids, then the weighting for education can be decreased or even taken out of the calculation.
In the example above, for an individual to move from city B to city A, they may have to look for higher wages than they originally have in city B in order to maintain their existing quality of life. The online cost of living calculators can be used as a reference.
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Cost of Living Adjustments abbreviated as COLA is an increase in pay or benefits offered by some employers and governments to offset the rising cost of living attempts to counter the rising cost of living. COLA takes into account the Consumer Price Index for Urban Wage Earners and Clerical Workers as the baseline of calculation. This adjustment aims to provide insight to correspond to the increase in the cost of living and the increase in salary for workers in order to maintain their purchasing power. As inflation, defined as the rate of increase in price over a given period of time, is generally the trend of how the price of goods and services go, COLAs are important for the government and business owners to consider. This adjustment will be reflected in the pay, government benefits, or pension benefits. As COLAs are meant to maintain the quality of life, not increase or decrease it, luxury items are not included in this calculation.
What is Cost of Living Index?
Price index can be used as a tool for measuring inflation as well as the cost of living. It is a weighted average of prices of a selected basket of goods and services measured over time. A base year will be established, which is set at 100, and the increase and decrease in the price of that basket of goods and services will be calculated and compared to the base year. A number larger than 100 indicated an increase in the cost of living and vice versa. An index of 125 compared to the base year means that the price of the basket of goods and services has increased by 25%.
The Consumer Price Index (CPI) published by the Bureau of Labor Statistics is the standard that is taken into account by COLAs as required by the Social Security Act in the United States.
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One of the criticisms of COLAs is that they do not take into consideration of taxes. The increase in income may be charged in a higher tax bracket, which means that the increase in disposable income may not increase as much as the COLAs intended to indicate. Another criticism is that since COLAs take into account a similar basket of goods and services, they do not take into account how people's purchasing behavior and pattern can change as the cost of living changes. For example, people may decrease the times they eat out or rent movies instead of going to the cinema, which COLAs may not be able to represent well.
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Cost of living is an economic concept that refers to the general price level for goods and services that the average consumer will purchase for their activities of daily living. It doesn't include all goods and services but a market basket of typical goods and services. Cost of Living Adjustments is an increase in pay or benefits offered by some employers and governments to offset the rising cost of living attempts to counter the increasing cost of living. It is not a raise but rather an attempt to keep your purchasing power the same by taking into account inflation.
A price index consists of a set of goods and services typically purchased by consumers. The index for the base year is a hundred, and each year the index may increase or decrease depending on inflation or deflation. The index number for the current year can be used to compare against the base year to see how much prices have changed over that period. A price index is often used to determine the level of COLA increases. The index will include products that are typical purchases for daily living of the average population and will not include luxurious items or uncommon purchases. Two criticisms include the failure to take into account different tax brackets due to COLA increases and the fact that consumers often change their buying behavior to adjust to increasing prices.
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Additional Info
Definition
Cost of living is an economic concept consisting of the general level of prices for goods and services that typical consumers purchase for their activities of daily living. It is used to determine cost of living adjustments (COLAs), which are increases in pay, government benefits or pension benefits to match the rate of inflation so that a person's purchasing power remains the same or is not as adversely affected.
How it Works
Cost of living adjustments may be determined contractually between employees and employers with a set rate, or through the use of a formula using a price index for the calculation. A price index is a weighted average of prices of a market basket of selected goods and services measured over a period of time.
The index uses a base year for the items in the index, which is set at 100. You then measure the increase or decrease in prices each year relative to the base year. For example, let's say an index has a base year of 1980 and the base year value is 100. In 2010 the index value is 125, which means that prices in the market basket of goods and services have increased 25% from 1980 to 2010.
Some examples of indexes that may be used to make COLA determinations include the consumer price index, a cost-of-living index that varies by geographic region, or a chained consumer price index, which tries to take into account changes in customer buying behaviors due to raising prices (such as buying cheaper substitutes).
Common Expenses Considered
Price indexes used for COLAs often include the following expenses:
- Food and beverages
- Housing
- Apparel
- Transportation
- Health care
- Recreation
- Education
- Other goods and services that are typical for the average consumer
As you can see, the idea is to generate a basket of goods and services that reflect what a consumer typically purchases so that their compensation or benefits can be adjusted to maintain the same level of purchasing power and quality of life. Remember, however, the idea is to maintain the quality of life, not increase it.
Two Criticisms
COLAs have been subject to some criticism. One criticism is that COLAs don't take into account that the increase in income may push you into a higher tax bracket, which results in payment of more taxes. Since income tax increases aren't taken into account, COLAs don't always leave you in the same economic place you were after price increases because you have less money due to the extra taxes.
On the other hand, some criticize COLAs for not taking into account the fact that consumers will change their purchasing behaviors when facing price increases. For example, they might buy cheaper product substitutes such as standard auto-drip coffee instead of premium whole beans. The chained consumer price index attempts to address this problem.
Summary
Cost of living is simply the price of goods and services the typical consumer purchases for the daily activities of living. A cost of living adjustment is sometimes provided by employers, pension plans, and the government to take into account cost of living increases by increasing pay or benefits. COLAs are often calculated by using a price index that compares the price of certain goods and services at a base year to the current cost of the goods and services. Criticisms of COLAs include that they often don't take into account increases in the person's tax burden and the fact that a person will often adjust her purchasing behavior in light of rising prices.
Cost of Living Overview
| Terms | Explanations |
|---|---|
| Cost of living | an economic concept consisting of the general level of prices for goods and services that typical consumers purchase for their activities of daily living |
| Cost of living adjustments (COLAs) | increases in pay, government benefits or pension benefits to match the rate of inflation so that a person's purchasing power remains the same or is not as adversely affected |
| Price index | a weighted average of prices of a market basket of selected goods and services measured over a period of time |
| Two criticisms | COLAs don't take into account that the increase in income may push you into a higher tax bracket, which results in payment of more taxes; not taking into account the fact that consumers will change their purchasing behaviors when facing price increases |
Learning Outcomes
When this lesson ends, you should be able to:
- Define cost of living
- Identify cost of living adjustments
- Describe a price index
- Explain the possible criticisms of using COLAs
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