One of the least discussed, but potentially most significant, provisions in President Obama’s budget is the use of the “chained consumer price index” (chained CPI), to measure the effect of inflation on people’s standard of living. Chained CPI is an effort to alter the perceived impact of inflation via the gimmick of “full substitution.” This is the assumption that when the price of one consumer product increases, consumers will simply substitute a similar, lower-cost product with no adverse effect. Thus, the government decides your standard of living is not affected if you can no longer afford to eat steak, as long as you can afford to eat hamburger.

The problem with “full substitution” should be obvious to anyone not on the government payroll. Since consumers did not choose to buy lower-priced beef before inflation raised the price of steak, they obviously preferred steak. So if the Federal Reserve’s policies create inflation that forces you to purchase hamburger instead of steak, your standard of living is lowered. CPI already uses this sort of substitution to mask the costs of inflation, but chained CPI uses those substitutions more frequently, thereby lowering the reported rate of inflation.

This is from Ron Paul, “Chained CPI Chains Taxpayers,” November 11. It shows a fundamental misunderstanding of the CPI and the idea of substitution.

Start with the second sentence: “Chained CPI is an effort to alter the perceived impact of inflation via the gimmick of ‘full substitution.'”

By using the words “gimmick” and “perceived,” Paul makes it sound as if the purpose of the chained CPI is to trick people into thinking that their cost of living has not gone up as much as the old CPI said. That’s not true. The purpose of the chained CPI is to get a more accurate read on how much the cost of living has gone up.

The idea of substitution is basic economics. When the price of one good rises a lot and the price of another good rises a little or not at all, and those goods are, in many people’s minds, substitutes, people will tend to substitute out of the good whose price has risen more and into the good whose price has risen less. So the purpose of the chained CPI is to take account of that in order to estimate the cost of achieving a given level of utility.

I’ll illustrate with a simple example. Imagine someone buys only two goods: chicken and steak. Each month he buys 10 pounds of chicken and 10 pounds of steak. The price of steak is $7.00 a pound and the price of chicken is $3.00 a pound. So he spends $100 a month.

Now the price of chicken rises to $4.00 a pound and the price of steak stays at $7.00 a pound. If the Bureau of Labor Statistics were to price the old bundle (10 pounds of each), it would say that the cost of that bundle is now $110. So the apparent increase in the cost of living is 10%. But some people would substitute a little out of chicken and a little more into steak. The fact that they would do that says that they don’t need that $110 to get the same level of utility. They might need only $108 or $109. So the method of pricing a fixed bundle overstates the increase in the cost of living.

Why do I have the lower-priced item rise in price and the higher-price item not rise in price? To get at the fact of relative price changes and to offset a trick–a “gimmick?”–that Ron Paul pulls. The naive reader reading his quote above will probably think, “Those idiots (or worse) at the Bureau of Labor Statistics. Don’t they know that hamburger, for the vast majority of people, is inferior to steak?” Of course, it’s inferior for most people. And the BLS has never tried to kid us that it isn’t. Substitution is about changing the proportions in the bundle you buy in response to relative price changes.

I’ve written about this before, when Brett Arends showed the same misunderstanding in a Wall Street Journal op/ed.

The BLS lays it out here.