A cost-of-living index measures differences in the price of goods and services over time. Price indexes, such as the U.S. Consumer Price Index, are examples of these indexes. Price indexes measure the cost of purchasing a bundle of goods and services.
If a cost-of-living index describes the welfare changes in terms of the percent of income necessary to leave the household indifferent, it provides a unit-free measure of the change in social welfare.
A Konüs index is a type of cost-of-living index that uses an expenditure function such as one used in assessing expected compensating variation. The expected indirect utility is equated in both periods. This method can be used to introduce risk aversion into cost-of-living indexes.
Indexes can be constructed to allow for substitutions to other items as prices change. These indexes seldom recognize changes in the quality of goods however.
A cost-of-living index is a useful way to consider welfare changes caused by changes in factors exogenous to the individual household, such as inflation, and the monetary, fiscal, and trade policies of governments.
Cost-of-living allowance (COLA)
Employment contracts, pension benefits, and government entitlements (such as social security) can be tied to a cost-of-living index, typically to the consumer price index. A cost-of-living allowance adjusts salaries based on changes in a cost-of-living index. Salaries are typically adjusted annually. They may also be tied to a cost-of-living index that varies by geographic location if the employee moves. Cost-of-living allowance is often abbreviated "COLA" (whereas cost-of-living index is never abbreviated as "COLI").