Question

1. The table below shows price and quantity data for a hypothetical economy.

Quantity Demanded 2018	Prices 2017 (base year)	Prices 2018 (current year)
10 kilograms (kg) coffee	$6/kg	$2/kg
10kg tea	$4/kg	$4/kg

Assume that a typical consumer’s food basket contains only coffee and tea. Moreover, assume that consumers are completely indifferent between coffee and tea. If the official “food inflation rate” for 2018 is calculated using a Paasche index, the substitution bias is demonstrated by the fact that the official (i.e. calculated) food inflation rate is

1. 40% while the actual food inflation rate is more likely 25%.
2. 25% while the actual food inflation rate is more likely 40%.
3. ‐40% while the actual food inflation rate is more likely ‐25%.
4. ‐25% while the actual food inflation rate is more likely ‐40%.

why is it more likely -25%?

Answer 1

Paasche price index is used to measure inflation and genral price evel in economy . The Paasche index is a composite index number of price arrived at by the weighted sum method.The weights are assigned to commoditires as per the quantity of the goods.
Price index for base year is taken as 100

Paasche index = (Price in current year * quantity in current year )/(Price in base year * quantity in base year )*100

IN case of more than one quantity . summation is used in both numeraot and denominator

Paasche index = (2*10 + 4*10)/(6*10 + 4*10)*100
= 60/100*100
=60

Therefore official inflattion rate - 40 %

Only option c qualifies

-40% is the official inflation rate and -25% is the actual inflation rate .

Actual inflation rate is less than offical inflation tate becuase of the substitution bias.Substitution bias occurs when prices for items change relative to one another. Price index overstates inflation becuase it does not account for the substitution effect, when consumers choose to substitute one good for another after its price becomes cheaper than the good they normally buy.Since the CPI is calculated by measuring the cost of a fixed bundle of goods, changes in the pattern of consumption triggered by changes in good's relative prices are overlooked.


Here in the observation year , as the price of coffee decrease below tea , people will substitute coffee for tea .This gives undue weightage to coffee beause it will constitute a major portion of the basket as compared to earlier .

AS a result actual inflation is lower than 40 which is -25 % .