Question

Suppose the Consumer Price Index (CPI) is computed as a Laspeyres price index. Explain the concept of “substitution bias” in using the CPI to measure the change in the cost of living. Be sure to explain what is meant by the “change in the cost of living.”

Answer 1

A cost of living index is a conceptual measurement goal it's not a straightforward alternatives to the CPI. A cost of living index would measure changes over time in the Amount that consumers need to spend to reach a certain utility level or standard of living.the CPI is frequently called a cost of living index but it differs in important ways from a complete cost of t measure.Both the CPI and a cost of living index would reflect changes in the prices of goods and services such as food that are directly purchased in the marketplace but a complete cost of living index would go beyond this to also take into account changes in other governmental and environmental factors that affects consumer well being.

Utility is not directly measurable so the true cost of living index only serves as a theoretical Ideal not a practical price index formula.one of the most commonly used formulas for consumer price indices is the Laspeyres price index which compares the cost of what a consumer bought in one time period with how much it would have cost to buy the same set of goods and services in a later period..

Since the utility from q^O in the first year should be equal to the utility from q^0 in the next year.Lasperyes gives the upper bound for the true cost of living index . Laspeyres only serves as an upper bound because consumer could turn to substitute goods for those goods that have gotten more expensive and achieved the same level of utility from q^0 for a lower cost .