Question

What are the two main problems arise from the CPI bias. What are the four main ways in which the CPI is an upward-biased measure of the price level?

Answer 1

the CPI is a fixed-weight price index using a fixed basket of goods that are representative of what a typical consumer purchases each month.There are many different CPI's calculated by region,types of products, types of consumers, etc. The most commonly reported CPI is the CPI-U, which is the CPI for all urban consumers.Increases in the CPI level serve as a measure of the consumer inflation rate. The rate of inflation over a period of time is simply the percentage increase in the CPI over the period, often reported on an annualized basis.

Substitution bias- when the price of a product in the consumer basket increases substantially, consumers tend to substitute lower-priced alternatives. For example, if afreeze in Florida causes the price of oranges to skyrocket, consumers may substitute Texas grapefruits for Florida oranges. Since the CPI is a fixed-weight price index, it would not accurately predict the impact of the price increase on the consumer's budget.

Quality bias- over time, technological advances increase the life and usefulness of products. For example, the useful life of automobile tires increased substantially over the past few decades, decreasing the tire cost on a per mile basis, but the CPI does not reflect such improvements.

New product bias- new products are not introduced into the index until they become commonplace, so the dramatic price decreases often associated with new technology products are not reflected in the index.

Outlet bias- the consumer shift to new outlets such as wholesale clubs and online retailers is not well-represented by the CPI.