I ran across the principle of substitution a few years ago while writing about the ‘flations. When the prices of certain commodities rose due to inflation, American retirees used to receive cost-of-living adjustments [COLAs] from the Social Security Administration. Starting around 1999 (says this AARP PDF), the SSA began to limit COLAs, claiming that retirees could maintain the same standard of living by buying substitutes:
Economic theory states that if the relative prices of goods and services change, consumers will substitute relatively less expensive goods for relatively more expensive goods. They do this in order to maximize their standard of living given their expenditure budget. The implication of this substitution behavior is at the crux of the CPI [consumer price index] debate: the amount of money that would be needed for these consumers to maintain the same standard of living after a price increase is less than it would be if they still purchased the same quantity of different goods (i.e., if they did not engage in substitution). Hence, a COLI [cost-of-living index] would account for substitution from changes in relative prices. However, up until 1999, BLS [Bureau of Labor Statistics] did not account for any substitution effects.
In 2010 and 2011 it didn’t seem like prices were standing still, but the SSA approved no COLAs at all due to wild energy price changes.
For example, under the current formula, when the price of Porterhouse steak (a good in the ‘beef’ category) increases, the CPI-U and CPI-W consider that a person can switch to purchasing top sirloin (another good in the ‘beef’ category).
Under the proposed ‘chained’ CPI, retirees are also expected to substitute different kinds of meats if steak is too expensive.
… the C-CPI-U accounts for the substitution of chicken, seafood, or pork (goods outside of the ‘beef’ category) when the price of beef increases. Similarly, the chained index will account for the substitution of used cars for new cars if the relative price of new cars increases.
Here’s where the concept of perfect and imperfect substitute goods should come into play – but doesn’t. A perfect substitute good is much the same product; an imperfect substitute means you are giving up something. In practical terms, most processed food is an imperfect substitute for organic food.
Frankly we should be eating less beef, but when we do eat beef, it shouldn’t contain antibiotics, corn, pink slime, or parts of other cows. Likewise chicken should not be grown and force-fed in factory conditions. Seafood should not contain mercury. And some pork is of course more equal than others. All those criteria make for more expensive choices across the board. Chained CPI assumes we can eat just as well buying Jif instead of Crazy Richard’s or Smucker’s Organic, or canned mixed vegetables instead of fresh.
It occurs to me that we are being handed a raft of substitutions in all aspects of our lives. An obvious example is television. When I was a kid you watched melodramas, situation comedies, variety shows, and the news. Melodramas and comedies featured professional actors. Variety and interview shows featured professional entertainers. The news featured professional journalists.
On network TV, sitcoms faded for a while but flourish again. Drama has mostly moved to pay TV. There are a few high-profile dramas left on each network TV station, but they have largely been replaced by cheaper reality programming starring amateur actors pretending to be average people. Over time, the variety and interview show has been replaced by news-like programming and staged interview/freak shows. News is now populated by attractive talking heads, former celebrities, former politicos and comics.
We pay for 200 stations now, and still get commercials but find hardly any more interesting shows than when there were three free network channels, one PBS and one multimedia station showing a lot of reruns. That’s an imperfect substitute.
Music is always changing but the industry calcified after rock and roll. As Frank Zappa noted in the ‘lost’ interview, music executives once took chances on new acts, new stuff. Then the labels brought in a few ‘hippies’ to help with scouting new acts in what they call Artists and Repertoire. Eventually those A&R guys decided they already knew what the people wanted, and used radio playlists and MTV to push those performers. Except for a brief spate of creativity via youtube and vimeo, we’ve had new acts spoon-fed to us ever since. And with Vevo, commercials and license policing, youtube is calcifying as you read this.
As a society, we have essentially substituted credit – what was first called the installment plan, or buying on time – for cash. Consequently we don’t realize the difference between what we can afford now and what we will have to pay in the future.
We are substituting storefront medical centers where medical aides and nurses do most of the work for doctor’s offices. Several years ago, my new doctor sent me to one of those after I fell off my bike. No one there could look at the x-ray and tell me if my wrist was fractured or not. We have substituted running bloodwork and prescribing drugs for diagnosing and treating maladies.
Thanks to internet porn, we have certainly substituted camera-friendly sexplay for intimacy and romance.
And speaking of the internet, we are witnessing the end of net neutrality and the open internet. The substitute internet opens a popup commercial – No, look at this first! – as soon as you visit any sort of site. The substitute internet will favor Disney and Nike and Monsanto and will consign dissent to low bandwidth access, if it is available at all.