Question

What are four major problems with the way that the CPI is constructed? Provide a real world example of each problem. Then, explain how we could or should correct each of these problems? Are your solutions realistic? Cost effective?

Answer 1

1. Buying Habits: CPI is constructed using the price changes of hundreds of consumer goods in various categories, such as food, clothing, health care, energy and education. The goods are selected using a sample population’s buying habits, that is, what are goods common to the representative sample population. However, there is considerable heteroskedasticity in any given country, that is, there’s huge difference in the income levels, mostly in developing countries. The actual mix of goods and services a person buys may differ from the CPI. For example, India is a much diverse country having the second largest population, with a huge chunk of population living in the rural areas. Here, CPI may not be able serve as a good proxy of either prices of goods or consumer buying habits for more rural areas, or for other demographic groups.
   
2. Substitution effect: The National statistical office of most countries may agree that they do not consider the substitution effect whereas in reality, there are a lot of substitutes. With the rise in price of one good, the consumers may shift to the substitute. For instance, if poor weather caused a shortage of peanuts, the price of peanut butter might skyrocket and prompt consumers to buy substitutes like almond butter, hummus or Nutella. CPI does not incorporate consumer preferences.
   
3. Product quality: The problem with the price index is that it may not be able to capture the additional benefits or value that a consumer may accrue due to the higher price. For example, the cost of mobile phones has increased significantly due to advancement in technology. An individual may gain net benefit from buying the good whose price has increased over time.
   
4. New products: In the dynamic world, the basket of goods can become outdated. New products do not become the part of the basket until they become common consumer goods, which may take significant amount of time. For example, with the advancement in technology, the price of outdated technology may decline sharply, which may not be captured by CPI and the index would tend to be overestimated.

Recommendations:

1. The dynamic market goods index: In addition to the fixed goods basked, another index could be constructed which allows for substitution and provides same standard of living as the original basket for different demographics.
   
2. Quality adjustments: quality adjustment could be quantified to monetary values due to change in characteristics of the products. Measuring the impact of change in shape, size, quality, and functionality or other benefits / losses, if quantified may help to compare the old product with the new product as perceived by the consumer. However, it may not be cost effective.