Problems with the Consumer Price Index (CPI): Videos & Practice Problems

The main biases in the Consumer Price Index (CPI) that can lead to an overstatement of inflation include substitution bias, quality bias, new product bias, and outlet bias. Substitution bias occurs when consumers switch to cheaper alternatives as prices rise, but the CPI assumes constant consumption. Quality bias ignores improvements in product quality that can affect prices, attributing all price increases to inflation. New product bias arises when new technologies are not included in the CPI basket, missing initial price decreases. Lastly, outlet bias reflects changes in shopping habits, such as buying from discount stores, which can result in lower prices not captured by CPI calculations.

Substitution bias affects the accuracy of the Consumer Price Index (CPI) by assuming that consumers purchase the same quantity of goods and services regardless of price changes. In reality, when prices rise, consumers often switch to cheaper alternatives. For example, if the price of apples increases, consumers might buy more oranges instead. The CPI, however, does not account for this substitution and continues to calculate inflation based on the original basket of goods, leading to an overstatement of inflation.

Quality bias in the context of the Consumer Price Index (CPI) refers to the failure to account for improvements in the quality of goods and services over time. As technology advances, products often become more efficient and feature-rich, which can lead to higher prices. However, these price increases are not solely due to inflation but also reflect the enhanced quality. The CPI tends to attribute the entire price increase to inflation, ignoring the value added by quality improvements, thus overstating inflation.

New product bias is a problem for the Consumer Price Index (CPI) because it fails to include new technologies and products in the CPI basket when they first enter the market. These new products often start with high prices that decrease over time as production becomes more efficient. By not including these products initially, the CPI misses these price decreases, leading to an overstatement of inflation. For example, when cell phones were first introduced, they were expensive, but their prices dropped significantly over time. The CPI did not capture these decreases, thus overstating inflation.

Outlet bias impacts the measurement of inflation in the Consumer Price Index (CPI) by not accounting for changes in where consumers shop. Over time, more people have started shopping at discount stores or online, where prices are often lower than traditional brick-and-mortar stores. If the CPI calculations are based on prices from traditional stores, it will not reflect the lower prices consumers actually pay, leading to an overstatement of inflation. For example, buying in bulk from a warehouse club can be cheaper than buying the same items individually from a grocery store, but the CPI might not capture this price difference.