Question

Why might CPI not accurately measure real changes in the cost of living? (Discuss
substitution bias, introduction of new goods, changes in quality). Would CPI
overestimate or underestimate cost of living because of the bias?

Answer 1

CPI is calculated on specific number of goods as well as the consumption behavior of urban class. It ignore consumption of rural behavior which makes it an unaccurate measure of cost of living.

CPI tends to overstate inflation due to:

• Substitution bias: As consumers tends to buy cheaper alternate product if the price of a product rises. CPI does not calculate the exact change in consumption due to price chain as it have a fixed weightage as per the product.
• Quality bias: When new products with superior quality launch in the market, producer sets its price high due to high cost of production to build a better quality product. CPI does not calculate the rise in price due to rise in quality but it takes into account the overall rise in price which leads to inflation which creates a problem while calculating CPI.
• New Products: CPI undertakes products which are regularly consumed in the market while they do not consider newly launched products in the market. As new products are technologically updated, they are not under consideration in CPI.