Imagine a Small Town with Only Two Unrelated Inhabitants, David

Essay

Imagine a small town with only two unrelated inhabitants, David and Dixie, both living complex and fulfilling lives. Let us simplify their lives, to better understand the implications of using the CPI as a measure of the cost of living. Suppose David and Dixie consume only potatoes and fish: David consumes 4 potatoes and 6 fish a day, while Dixie consumes 6 potatoes and 4 fish a day. (David has a few more cats to feed, but Dixie likes to feed a couple of birds that nest in a nearby tree.) Initially, prices are $1 a potato and $2 a fish.
a) Calculate David and Dixie's costs of living and their total expenditure.
b) Now, suppose the price of potatoes increases to $2. Calculate the new costs of living and total expenditure. Calculate the CPI inflation rate. What would be the increase in David and Dixie's costs of living, in dollars, according to the inflation rate you have just calculated? What are the actual increases in their costs of living? What have we learned from this exercise?
c) To deal with the harsher economic conditions, Dixie takes in a stray cat to scare away the birds from the tree. Now she consumes 4 potatoes and 5 fish. Recalculate Dixie's actual increase in the cost of living and discuss your result.